Financial Sectors, Is More Regulation The Answer?

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Cheong Jun Yoong's picture

Financial Sectors, Is More Regulation The Answer?

The recent more than $2 billion trading lost on derivatives of J.P. Morgan has spurred more discussion about the effectiveness of current regulatory framework of financial sectors. This incident further substantiate one dominant view that emerged since the global financial crisis of 2008, which is excessive leverage and risky speculation (especially on derivatives) made by banks are causing financial instability; therefore these reckless risk-taking activities should be curtailed to prevent further potential devastation to the economy.

To understand why this claim has gained such traction since the financial calamity of 2008 we need to know what a derivative is and how does it play such an important role in financial sectors yet beget such frequent criticism. Warren Buffett once famously said “Derivatives are financial weapons of mass destruction” in his annual letter to shareholders at 2002, so what exactly are derivatives and how can it be so destructive?

In the broadest sense, derivatives are any financial contracts that derive their value from other underlying assets(such as bonds and equity) and they are usually traded between two or more parties. Most derivatives are characterized by high leverage, futures contracts and options are the most common form of derivatives, but what Warren Buffet referring as “financial weapons of mass destruction” is the OTC(Over The Counter) derivatives. OTC derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. In OTC markets, there is counterparty default risk since the contracts are made privately between the parties and are unregulated, therefore generating a network of interdependencies among market actors and promotes risk volatility. These instruments which supposedly are designed to mitigate and manage risk had instead multiplied risk and spread it around throughout the economy.

According to Bank of International Settlements (BIS), the total outstanding OTC derivatives is $708 Trillion (that is about 11 time the global GDP) as of June 2011 and the top 5 banks in the US now account for a massively disproportionate amount of it which is 96% of the $250 trillion in total outstanding U.S. derivative exposure according to Office Of the Currency Comptroller (OCC). Considering that the U.S. banking sector has only $16 Trillion in total balance sheet assets, this is reckless to the extreme. This unregulated market presents a massive financial risk as one institution's failure could potentially bring down or adversely affect a large number of biggest financial institutions because of counterparty risk. Thus it became clear that the reasons OTC derivatives promote systemic instability are fundamental.

In addition, the deregulation of financial sectors in US had leads to financial concentration. According to Professor Luigi Zingales from University of Chicago Booth School of Business, in 1984, the top five U.S. banks controlled only 9 percent of the total deposits in the banking sector. By 2001, that figure had increased to 21 percent and, by the end of 2008, to almost 40 percent. The financial industry was larger, more concentrated, more complex, more leveraged and more interconnected than ever before. The repeal of Glass-Steagal Act in 1999 has allowed banks to merge with insurances companies and investment houses, therefore making it possible for some banks to become “Too Big To Fail”. This term is often characterized by certain financial institutions that have become so large and interconnected that their failure possess systemic risk to the whole economy, therefore government or central bank are compelled to rescue them if they are in dire straits. By allowing this to happen, government has created a moral hazard. Nobel Laureate Economist Paul Krugman described moral hazard as "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly." When the firm is doing well the bank executives get the upsides (often in form of rewarding year-end bonuses), but when the firm suffer tremendous losses the cost are borne by taxpayers. Firms might be encouraged to participate in excessive risk-taking activities if they believe they will not have to carry the cost of potential losses, as there will be financial bailout provided by government or central bank to prevent systemic threats to the economy. 

Federal Reserve Chairman, Ben Bernanke, said in 2010 that “It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms.  If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.” Yet more than 4 years have passed since the global financial crisis, here we are in a same situation again. Six largest bank holding companies in U.S. currently have assets valued at close to $9.5 trillion, which is around 62.5 percent of GDP , where before the crisis they only had balance sheets worth around 55 percent of GDP. The problems of “Too Big To Fail” banks are now worse than it was before the crisis; these banks have become even bigger and virtually nothing has been done to regulate OTC derivatives or to control the extreme risk they pose.

The Dodd-Frank Wall Street Reform and Consumer Protection Act enacted in 2010 did not solve the  problems. Although it include some useful reforms but it lacks fundamental reforms that would be needed to solve the “Too Big Too Fail” problems, even the “Volcker Rule” which supposed to prohibit banks from speculating(proprietary trading) with federally insured deposits faces enforcement difficuties as it is hard to differentiate between a hedge against a specific or aggregate position and a proprietary trade. While “Dodd-Frank” Act is over 2300 pages long, it is full of loopholes to be exploited and banks will always find ways to exploit new rules as quickly as lawmakers can write them. Therefore more regulations are not going to eliminate the systemic risk in the economy, especially not when the enforcement of rules and regulation are heavily up to the discretion of regulators. This is shown clearly in the recent J.P. Morgan lost on derivatives when the regulators sat idly by as these financial institutions loaded up many toxic derivatives.

Instead of more watered down regulations, a fundamental and structural reform of financial system would be a better solution. Trading derivatives on regulated exchanges would be a major step forward, as it would increase transparency, force standardization of contracts and provide legal certainty.  Since derivatives can be a source of off balance sheet financing, regulation would also make the true leverage of financial firms visible to investors.  Regulation can also ensure that counterparties can cover losses and would therefore help to contain speculation and greatly reduce systemic risk.

Furthermore, a restoration of Glass-Steagall-era separation of commercial and investment/merchant banking might be a good idea, although this will definitely not be an easy task. Paul Krugman said that “The key point is not that the bet went bad; it is that institutions playing a key role in the financial system have no business making such bets, least of all when those institutions are backed by taxpayer guarantees.”. Banks with government-guaranteed deposits shouldn’t be allowed to engage in risky speculation. Additionally,  these “Too Big To Fail” banks should be required to more equity capital as a share of their assets compare to smaller banks, as this would reduce the potential of these large banks to become even larger, as suggested by Allan Meltzer, a professor of political economy at Carnegie Mellon University. He also claim that increasing equity capital means that a bank's stockholders are the ones who absorb the losses that taxpayers were forced to accept in 2008, as the real goal of financial regulation is not to protect the banks but to shield taxpayers from the cost of any institutional failure.

As the Nobel Laurete Economist Joseph.E.Stigliz said “the new law must curb the practices that jeopardized the entire global economy, and reorient the financial system towards its proper tasks – managing risk, allocating capital, providing credit (especially to small- and medium-sized enterprises), and operating an efficient payments system.”  A serious financial reform is long overdue, a solid and comprehensive regulatory system is needed to prevent us from bumping into another global financial crisis again.

References: 
  1. Krugman, Paul (2009). The Return of Depression Economics and the Crisis of 2008. W.W. Norton Company Limited.
  2. Luigi Zingales (2012). How Political Clout Made Banks Too Big to Fail. Retrieved from http://www.bloomberg.com/news/2012-05-29/how-political-clout-made-banks-too-big-to-fail.html
  3. Ron Hera (2010). Forget About Housing, The Real Cause Of The Crisis Was OTC Derivatives. Retrieved from http://articles.businessinsider.com/2010-05-11/wall_street/30031818_1_otc-derivatives-credit-default-swaps-investor
  4. Derivative (Finance) (n.d.) retrieve from http://en.wikipedia.org/wiki/Derivative_%28finance%29
  5. Comptroller of the Currency (2011). OCC Quarterly Report on Bank Trading and Derivatives Activities Second Quarter 2011.  Retrieved from http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq211.pdf
  6. Ben S. Bernanke (2010). Preserving a Central Role for Community Banking. Retrieved from  http://www.federalreserve.gov/newsevents/speech/bernanke20100320a.htm
  7. Paul Krugman (2012). Why We Regulate. Retrieved from http://www.nytimes.com/2012/05/14/opinion/krugman-why-we-regulate.html?_r=4
  8. Allen Meltzer (2012). Banks Need More Capital, Not More Rules. Retrieve from http://online.wsj.com/article/SB10001424052702304192704577405821765336832.html
  9. Joseph E. Stiglitz (2010). Financial Re-Regulation and Democracy. Retrieved from http://www.project-syndicate.org/commentary/financial-re-regulation-and-...

Comments

Dear Mr. Cheong,

Re: "Instead of more watered down regulations, a fundamental and structural reform of financial system would be a better solution. Trading derivatives on regulated exchanges would be a major step forward, as it would increase transparency, force standardization of contracts and provide legal certainty."

Do you feel that the move towards central clearing for credit default swaps is part of that structural reform? Does it matter whether it is prompted by Dodd-Frank or not?

Yes I do think that a central clearing for CDS can solve most of the problems regarding derivatives, and it should set the condition that only parties that bought the underlying assets can buy a CDS against it to prevent excessive speculation and a domino effect as happened in the AIG event.

Well it doesn't matter anymore since Dodd-Frank had been enacted, the issue is Dodd-Frank doesn't solve the problems that caused the Global Financial Crisis.

Dear Mr. Cheong, I enjoy reading your observation and would only suggest bracing for more central clearing as per the popular consensus on derivatives. Personally, I am more reserved on giving praise to altering the structure of financial tools under the banner of transparency. I think you are right in saying that it doesn't matter anymore because legislation is already going through to do this.