WASHINGTON — A top bank regulator jumped to the defense of derivatives Tuesday, saying the recent criticism of the swaps market was "far broader" than the actual role it played in the financial crisis.
John Walsh, the acting comptroller of the currency, said new rules to address transparency and interconnectedness in the market were needed. But he noted that risks in the swaps market stem more directly from losses on credit products backing derivatives, than from the market itself. Walsh said critics overestimate the market's scope, and derivatives have many beneficial uses for the banking industry.
"Warren Buffett colorfully labeled derivatives 'financial instruments of mass destruction' and, for some, they are not just a sophisticated component of a bank's product portfolio, but toxic instruments that should be pushed out of the banking system entirely," Walsh said in remarks prepared for the American Securitization Forum's annual conference. "That is a vast overreaction, and it worries me that misperception could motivate redesign of the system.
"Lack of understanding feeds misperception, and derivatives are not particularly well understood, even by some top policymakers."
Walsh's agency and other federal regulators are currently drafting a rule required under the Dodd-Frank Act to set minimum margin and capital levels for certain swap dealers and other participants in the derivatives market.
"Even if we accurately recalibrate the risks involved, the financial crisis demonstrated the need to improve regulation of derivatives," he said. "Dodd-Frank includes a number of provisions aimed both at mitigating risk and increasing transparency, through improved risk practices, increased official oversight, and the use of clearinghouses and exchanges."
But Walsh warned about going too far. For example, he signaled that regulators are sympathetic to concerns about margin requirements for U.S. banks' foreign branches, which are part of the regulators' pending proposal to implement the Dodd-Frank section. Some in the industry have complained that applying the standards to foreign operations could hurt banks' international competition.
"We understand these concerns, and we will be carefully considering all of the issues raised in the comment letters as we move ahead on the regulation," Walsh said.
He said while instruments such as credit-default swaps should be scrutinized, he pointed to other products that he said have greater potential to cause shockwaves in the financial system. "The core problem was not CDS but synthetic" collateralized debt obligations "based on the replication of poorly underwritten subprime mortgage securitizations …"
In fact, Walsh added, a credit-default swap can help banks hedge risk in many cases, among other uses for derivatives.
"Even if derivatives were implicated in the market collapse of 2008, they continue to provide important benefits for lenders and their customers," he said. "Derivatives provide the banks we supervise with important and prudent means of managing credit exposures; for example, hedging the risk of a loan by using a credit default swap for protection in the event that the borrower defaults."
