Is Simon Johnson Embracing the FDR Framework?

A couple of months ago, your humble blogger met Professor Johnson at the Boston University hosted State of Financial Reform conference.  At the time, Professor Johnson express reservations about the FDR Framework.  In particular, he was uncomfortable with the idea that governments must ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

In a Bloomberg column, Professor Johnson appears to have begun embracing the FDR Framework and its emphasis on bringing sunshine to all areas of the financial markets.

On the face of it, Glencore International AG doesn’t look too scary. With about $80 billion in assets, the Swiss-based commodities trader is a lightweight in comparison to global megabanks like Goldman Sachs Group Inc. (GS), one of its trading rivals. Goldman has assets more than 10 times Glencore’s, is more leveraged and has less capital. 

So why do executives at Goldman, Citigroup and JPMorgan Chase argue that lightly regulated or unregulated companies operating “in the shadows” -- private equity firms, hedge funds and commodities traders like Glencore -- risk another financial calamity? 

What Glencore’s rivals are really worried about is competitive advantage. It’s about to sell $11 billion in shares through an initial public offering in London and Hong Kong. That fresh capital will allow Glencore to expand at a time when its Wall Street competitors’ hands are tied. Glencore doesn’t face the same limits that banks do in proprietary trading, capital reserves, leverage and compensation. This may be unfair, but it’s not the right reason to subject Glencore to the same tough regulatory regime as banks, nor the right lesson to draw from our recent experiences. 

The real question regulators should ask is this: How much of a risk would Glencore pose to the world’s financial system? To use the terminology proposed by Mervyn King, governor of the Bank of England, is Glencore “too important to fail” -- meaning that its bankruptcy would bring down other significant parts of the financial system or real economy? 

... Today Glencore trades and produces minerals and metals like zinc, aluminum, cobalt and coal, as well as grains, cotton and sugar. It owns refineries and drilling rigs and holds large stakes in other mining companies. 

Glencore also has a large amount of capital and little leverage, judging by its shareholder equity, which is worth 25 percent of assets....

There is little sign that a government would feel the need to save Glencore and protect its creditors if it were on the brink of collapse. A restructuring of its debts should not be disruptive to the world economy. Based on the limited information in Glencore’s 2010 annual report, even its derivatives book seems unlikely to create system-wide risk. 

Still, this could change quickly. Derivatives are the wild card. Glencore almost certainly will qualify for the so-called end-user exemption under the Dodd-Frank financial reform legislation, meaning that it may not have to follow new clearing and margin requirements (although these rules are still under discussion). It would be relatively easy for a firm with Glencore’s balance sheet and insight into the physical side of commodity markets to ramp up its involvement in the financial side of commodities. 

We do not want commodity traders like Glencore, Cargill Inc., Paris-based Louis Dreyfus & Cie., an oil major or any other nonfinancial company to be tempted to take financial risks that are big relative to the size of the system. 

Even supposedly expert financial firms can destroy themselves with the mismanagement of risk -- a process made potentially even more devastating to everyone involved through derivatives. 

Remember that Lehman Brothers Holdings Inc. (LEHMQ) was not a megabank -- its balance sheet was about one-fifth the size of Citigroup’s and the largest European banks’. But Lehman’s web of connections through derivative transactions turned out to pose a system-wide threat -- about which the Treasury Department and the Federal Reserve were completely unaware until the day after Lehman went bankrupt. 

The end-user exemption should be interpreted narrowly and applied evenly. If Glencore or a similar company wants to engage in financial speculation or market-making, those activities should be walled off from their physical operations and legitimate hedging needs, as my MIT colleague John Parsons has been arguing. 

Regulators need as much visibility as possible into derivatives transactions around the world. The major players in these markets -- including firms like Goldman -- do not want transparency, primarily because they don’t want their pricing structure to be widely known.

It was transactions between the big Wall Street firms and largely unregulated mortgage originators that brought us the subprime crisis. The open secret of Wall Street is that the “shadows” are often made possible and profitable by the big banks. [emphasis added] 

One example: structured investment vehicles, the undercapitalized, off-balance-sheet entities that large banks created in 2007 and 2008 to house subprime mortgage investments. 

The Treasury Department has been pressing hard to lighten the transparency requirements on derivatives markets, including most recently with its baffling decision to exempt foreign exchange swaps from clearing requirements. 

The best way to deal with potential shadows is to shine a bright light on all markets.  [emphasis added] 

Restricting who can avail themselves of the end-user exemption is one very good way to ensure that the shadows do not get too dark and that stand-alone commodity traders do not become too important to fail.