At the risk of committing a heresy, we want to advance a view that is much out of favor these days — that many derivatives and structured products are valuable aspects of modern finance and play a crucial role in the management of risk by corporate America. Within the bounds of prudent practices and sound regulation, they should not be discouraged for financial institutions, including banks.
Yes, we have come through a period where some lax practices and less-robust regulation allowed derivatives trading activities to almost burn down the house. However, every advance in financial development has involved a painful period of trial and error. This phenomenon is not limited to finance; to a very real extent, crashes have been the price of improvements in aviation, and fires and explosions have been the cost of harnessing energy.
Ups and downs, some quite costly, have been the reality of finance for two centuries. In most human endeavors, lamentably, we advance by learning from our mistakes, and finance is no exception. This is a hard reality, but it is not justification for throwing out the baby, the bathwater, the tub and the plumbing.
In respect of capital markets, derivatives and other structured products, there are two main benefits that are self-reinforcing.
First, many of these products are at their core all about risk management. The ability to transfer and hedge risks permits financial institutions to lower the overall risks they and their customers take and to diversify their overall risk exposures.
Structured products, including products carefully tailored to manage specific risks, can fulfill these tasks more efficiently and more effectively than generic or standardized transactions. Can these products be misused? Yes, but so can loans and other more traditional products. That is no reason to stop using them.
Second, these products and activities help to deepen and broaden the liquidity of financial markets. They provide the basis for economic expansion in a modern society. Robust capital markets, undergirded by derivatives and structured products, are essential if modern, developed economies are to grow at a strong pace to achieve job creation and promote economic well-being.
This is not to say that new and untested products or new market entrants should be allowed to grow unchecked. Excessive growth in respect of firms and products and almost any asset class is always a sign to take a closer look. Good supervision should be all about restraints on excessive growth and unfair or deceptive business practices through tailored capital charges and other more direct mechanisms.
But the capital markets are global, complex, varied and interdependent. To avoid unintended and damaging effects, the supervisor's tool of trade should be a scalpel, not a meat-ax. And restraint should not neglect the fact that corporate structures in and of themselves do not lower risk to the overall organization. Good corporate governance, good product architecture and good risk management — for products generally, but particularly for new and rapidly growing products — are much more effective in ensuring that business is conducted in a manner that is beneficial to the organization and socially purposeful. Nor should regulatory restraints be overly focused on institutional size. Over time, if they are successful, smaller organizations have and will become leaders in these products and markets in terms of innovation and risk management.
Restraints should also be rooted in science, based not on biases, but on adequate information that has been carefully analyzed and considered.
Risk management and financial services regulation and supervision are themselves still in their infancy relatively speaking. A century ago, there was no Federal Reserve System and no Federal Deposit Insurance Corp. Twenty years ago there was little, if any, capital markets-based bank supervision. Modeling risk, stress testing and risk-based compensation practices are reasonably new or very new, at least for some institutions. The rapid and dynamic advances in risk management and supervision that are taking place will likely make financial activities safer over time. However, advancing rules and restraints that are not themselves adequately tested, or that are static and inflexible, not only puts a blanket on financial markets and economic growth; it also makes institutions and markets riskier, not safer.
It might also be noted that the development of capital markets and the creation and utilization of various capital market products have given developed countries, particularly the U.S., a competitive advantage for many decades. Given the sophistication of our markets and regulators, there is no reason to suspect that these competitive advantages cannot be continued.
However, efforts exist to prevent the utilization of these products in a fluid, flexible fashion. Such efforts, if successful, will prove to be enormously costly to our financial systems, our system of finance and ultimately to economic development and job creation. Just as we should have been more moderate in allowing growth in one area of the markets in the past decade — mortgage-related securitization and structured products — so we should be prudent and cautious in the utilization of regulatory and supervisory restraints in this decade.
