We cannot go a day without someone raising the alarm about the gigantic derivatives market, which has a notional value of over half a quadrillion dollars. But despite all the talk about how difficult it is to regulate this ultra-complext market, there’s a really, really easy way to stop derivatives from posing any threat to the financial system.
The first thing we need to do is understand exactly how derivatives create systemic risk. The best place to start is with the story of what happened to AIG, the world’s most toxic company. AIG sold credit default swaps on hundreds of billions of dollars of credit instruments, promising its customers that it would make good on any shortfalls from the revenue streams of those instruments.
When AIG turned out to have insufficient capital to collateralize these obligations, it fell into financial ruin. The bankruptcy of AIG on its own wouldn’t have been a financial calamity. What made its collapse so threatening was that so many big banks had built their balance sheets around AIG’s credit default swaps. If AIG went under, the balance sheets of many banks would have been exposed as far weaker than investors, creditors or regulators had thought.
Regulators require banks set aside capital to guard against future losses. When banks buy riskier assets, they have to set aside more capital. Setting aside capital is costly because banks cannot use that money to lend or trade–it is basically idle money. To avoid setting aside more capital, banks used credit default swaps to make risky assets look less risky. Because someone else promised to make good if the assets went bad, the banks were able to treat the assets as less risky.
If AIG had declared bankruptcy, the banks would not have been able to rely on AIG’s credit default swaps to reduce risk. Regulations would have required them to add billions more to capital reserves, and banks didn’t have those billions readily available. To meet the reserve requirements once the swaps were rendered worthless, they would have had to quickly sell assets at a time when everyone else was doing the same thing. This scene–everyone selling and no one buying in a scramble to raise capital–is the financial armageddon regulators feared when the bailed out AIG.
The problem wasn’t so much that banks had purchased credit default swaps from AIG. It was how they used them–to reduce their risk on paper and allow more capital to be deployed in the markets.
Once you’ve grasped that concept, the solution to systemic risk created by credit default swaps is easy. We just have to stop giving banks balance sheet credit for buying credit default swaps. That is, we need to require that banks set aside the full amount of capital we think they need to reserve against the risks on their balance sheets without regard to any “credit enhancements.”
That’s it. One simple change that doesn’t require any new regulatory oversight or bans on trading derivatives.
Of course, implementing this change will be very difficult. In the first place, we’d be accomplishing the regulatory equivalent of the collapse of AIG. Banks would have to raise more capital and lend out less in order to fill the balance sheet hole created by full discounting credit default swaps. In order to make this process less painful, the change would probably have to be phased in over a number of years.
We’d also have a smaller global banking system and less available credit. This would mean that it would be more difficult for individuals and businesses to borrow, slowing economic growth. But the banking system would be far more stable.
Some advocates of credit default swaps would probably argue that this proposal has the perverse incentive of telling banks not to insure against balance sheet risks. In a sense, it does do this by refusing to give banks credit for purchasing credit default swaps. But since banks proved so bad at gauging the counter-party risk when buying credit default swaps–in part because they were buying them to meet regulatory requirements rather than actually insure against risk–we might decide that the actual cost of this anti-insurance incentive isn’t so high.
Risk management professionals might object on similar grounds. They may argue that not giving banks balance sheet credit for asset insurance would create a divorce between the real risks faced by banks and the regulatory view of their risk. If a bank has insurance that limits losses on $100 worth of assets to just $5, why should it have to reserve against those $95? The response is quite simple: we don’t believe the banks are good at knowing in advance whether that insurance is actually worth anything, so we’re not giving them credit for it.
More importantly, banks and financial firms that want to protect themselves against risk above and beyond balance sheet requirements would still be free to purchase credit default swaps. Naked credit default swaps could still be used to hedge against risks that are otherwise uninsurable. The derivatives markets would remain free and open, and credit default swaps could still be used as genuine risk management tools.
This simple change in the way capital reserves at banks are calculated is the functional equivalent of raising the reserve requirements themselves. Perhaps the costs to the economy would be too high. But we should at least keep in mind that we can eliminate this source of systemic risk if we want to.
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