Regulatory measures to reduce systemic risk are proving to be ineffective, possibly counterproductive

What a Surprise – Published on naked capitalism, by Yves Smith, September 12, 2012.

In an perverse case of synchronicity, one headline last night touted regulatory efforts to address systemic risk as another highlighted bank efforts to increase it. And the ongoing efforts of banks to expand risk creation is no accident. As Andrew Haldane of the Bank of England has pointed out, the payoffs to bank employees are like an option: they have capped downside (annual paydays and no clawbacks) and considerable upside. 

The way to increase the value of an option is to increase volatility. And the financial services industry has and continues to be in the position of generating endogenous risk via leverage, complexity, and opacity.

One part of the telling juxtaposition was a Reuters article on how the Fed and the Office of the Comptroller of the Currency directed major banks to develop “recovery plans” to stave off collapse:

They told banks to consider drastic efforts to prevent failure in times of distress, including selling off businesses, finding other funding sources if regular borrowing markets shut them out, and reducing risk. The plans must be feasible to execute within three to six months, and banks were to “make no assumption of extraordinary support from the public sector,” according to the documents//

… Translation: the regulators are aware of the banks’ plans to finesse the clearinghouse requirements, and they neither intend to put a kebosh on it (which could easily be done by taking the position that any collateral transformation to meet clearinghouse requirements was an integrated part of the clearinghouse posting and could not be done separately on bank balance sheets) nor understand the impact of their flatfootedness.

This massive fail results from the refusal to deal with the derivatives problem head on. For some peculiar reason, economists and regulators have bought the idea that financial “innovation” is always and ever good and should therefore be given free rein. Even though the crisis would seem to have proven decisively otherwise, no one seems willing to question the value to anyone other than banksters of the continuing growth of over-the-counter derivatives markets. And the ever rising “need” for more collateral is the direct result of the explosive growth of the derivatives market. This chart from ECONNED is somewhat dated but gives you an idea:

(Chart: Notional Amounts of Derivatives Outstanding, by Bank of International Settlements)

Mind you, we aren’t opposed to plain vanilla products like simple interest rate swaps. Even though those lead to large notional amounts, the actual financial exposures, and hence collateral requirements, are comparatively small. By contrast, as we’ve argued, the social value of the credit default swaps market is questionable, and the case for limiting it severely is strong (see ECONNED for details). Similarly, bespoke OTC derivative are used almost entirely for either gaming accounting or regulatory arbitrage. Restricting their use would be beneficial, not simply in terms of lowering systemic risk but also in curbing rule-skirting.

It seems that Richard Bookstaber’s observation can’t be repeated enough: in tightly coupled systems, the only way to reduce risk is to reduce interconnectedness. Otherwise, measures to reduce risk actually wind up increasing it. And that looks to be precisely what the introduction of clearinghouses will achieve. (full text and chart).

Links:

Big Banks Hide Risk Transforming Collateral for Traders, on Bloomberg, by Bradley Keoun, Sept. 11, 2012;

Statement on the 2012 US Elections: from the Solidarity National Committee, August 31, 2012.

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