A new report released yesterday by Americans for Financial Reform and the Roosevelt Institute offers a wide ranging analysis of the status of financial regulatory reform.
Without having read the entire report, it seems like a good overview of persistent issues in financial reform such as capital regulation and regulatory enforcement. As the title of the report--An Unfinished Mission: Making Wall Street Work For Us--suggests, the authors view much work still to be done in making financial markets safe and fair.
Over-the-counter (OTC) derivatives (or swaps) are the focus of the report's first chapter, by MIT financial economist John Parsons. Unfortunately, Parsons makes two fundamental mistakes that undermine his entire analysis.
Parsons paints with too broad of a brush when he generalizes from the disastrous use of a specific kind of derivative by American International Group (AIG) to the derivatives market generally. According to Parsons, AIG's collapse "[m]ore than any other single event...provides...clarity behind the need to regulate the [entire] derivatives market."
But the collapse of AIG shows no such thing. AIG collapsed because it took on too much risk with credit default swaps (CDSs) written on mortgage-related securities. When the market value of those securities fell, AIG was unable to meet the ensuing collateral calls. But even at their peak, mortgage-related CDSs at most accounted for 20% of the CDS market, and a tiny fraction of the unregulated swaps market overall. This is important because CDSs and other unregulated swaps not tied to the mortgage market--including CDSs referencing bonds and interest rate swaps--performed well during the financial crisis and were not a source of instability.
So while a lack of regulation may have enabled AIG's derivatives disaster, it certainly did not cause it. To the contrary, the derivatives that helped bring down the system were part of broader governance failures throughout credit risk transfer markets.
Regulatory Reform Isn't a Straight Path
Much of Parsons' chapter reviews the widely accepted goals of derivatives reform and laments the lack of progress in meeting them. These goals consist of universal oversight, transparency, and central clearing. To reformers like Parsons, the hardest part of reform is implementation, not design.
But it's hardly clear what a properly regulated derivatives market looks like. For example, it's not obvious that swaps should be generally cleared by central counterparties. Moving swaps to clearinghouses creates a new class of "too big to fail" entities that may take on excessive risk due to implicit government subsidies or poor regulation. It is also unclear to what extent centralized clearing is a better form of risk management. Central clearing may, among other negative consequences, reduce the efficiency of netting out risk exposures.
Even when it comes to the broad goal of reducing systemic risk, it's remarkably easy to take one step forward and two steps back. Proponents of reform should be more sensitive to that.