The derivatives rules in the Senate financial reform bill pose a serious threat to the financial system because they leave critical institutions — including but not limited to derivatives clearing houses — without a lender of last resort. A major feature of the legislation prohibits any "swaps entity" from receiving federal assistance such as deposit insurance or access to the Federal Reserve's lending facilities. The bill will force banks to spin off their derivatives activities into separate corporate entities. Yet, sweeping the risks inherent in derivatives trading off bank balance sheets does not make them disappear.
In our view, the powers of the central bank as lender of last resort should continue to be available so that the government is prepared to respond in a timely, cost-effective way to dire threats. Section 13(3) of the Federal Reserve Act currently provides for such emergency lending. Proposed oversight by a proposed systemic-risk council might improve the use of such Fed lending facilities, and would highlight the central role of the Treasury in quasi-fiscal decisions. However, it makes no sense to operate a large portion of the financial system without access to the lender of last resort. Systemic intermediaries and institutions will still expect to be protected by government in a crisis.
What happens to the risks of derivatives trading if swap entities are separated from banks? Where feasible, a bank will tuck these risky activities into a subsidiary whose risks will affect the bank's holding company. It may seem safe, but when things go bad, risks often come home to roost. That is a lesson of our recent crisis.
Many risky assets were held indirectly by banks in off-balance-sheet structured investment vehicles that shielded the banks from market discipline and regulatory oversight. However, when the investments soured, SIV losses quickly migrated back to the balance sheets of the banks.
Another possibility is to take the segregation of risks a step further and not allow any bank to engage in certain types of derivative activities altogether. This approach is analogous to the one taken by the Volcker rule, the idea that banks should not be allowed to engage in proprietary trading. But again, moving risks out of the banking system does not remove them from the financial system.
And any broad prohibition of derivatives use by banks would make it difficult for them to hedge existing risks.
Wherever it might be located, derivatives trading has the potential to generate risks that need to be regulated and monitored by any new systemic-risk overseer. The notion that systemic risks arise only in narrowly defined banks should have been put to rest by the recent crisis. And the view that a government will tolerate the failure of a critical financial utility — such as a clearing house or exchange for derivatives — that seriously threatens the financial system simply begs credulity.
To contain the cost of the inevitable safety net, there is little alternative to an improved regulatory system that empowers market discipline, taxes the practices that breed systemic risk, and makes the financial system less vulnerable to the failure of its constituent parts.
To be sure, the Senate bill has important good features. Above all, it will help shift trading of most derivatives from over-the-counter transactions to organized exchanges, which have greater ability and incentive to monitor systemic risks. In particular, exchanges can impose effective margin and collateral requirements.
Yet, segregating risks or favoring clearing houses accomplishes little unless there are stringent capital adequacy standards and rules to compel the transparency needed for effective market discipline of counterparties.
Simply cutting off the derivatives world from the crisis response mechanisms of the central bank is misguided because moving risks around do not make them go away.
To a large extent the wish to remove swaps entities from the safety net of Fed lending is a response to the understandable anger regarding the bailout of AIG.
But anger is not a good basis for legislation.