Thursday, May 16, 2013

Big banks demonstrate again why regulations won't restrain their activities

The New York Times carried an interesting article on how the big banks managed to undermine any regulation intended to restrain their risk taking.

This provides further confirmation that the combination of complex regulation and regulatory oversight doesn't work to make the financial system safer.  In fact, relying on complex regulation and regulatory oversight makes the financial system riskier and more prone to crashes.  Our current financial crisis being a case in point.

The only proven method for restraining bank risk taking is requiring the banks to disclose on an ongoing basis their current exposure details.  With access to this information, the market then exerts restraint on the banks.
Under pressure from Wall Street lobbyists, federal regulators have agreed to soften a rule intended to rein in the banking industry’s domination of a risky market. 
The changes to the rule, which will be announced on Thursday, could effectively empower a few big banks to continue controlling the derivatives market, a main culprit in the financial crisis. 
The $700 trillion market for derivatives — contracts that derive their value from an underlying asset like a bond or an interest rate — allow companies to either speculate in the markets or protect against risk. 
It is a lucrative business that, until now, has operated in the shadows of Wall Street rather than in the light of public exchanges. Just five banks hold more than 90 percent of all derivatives contracts....
Here is a prime example of why regulation fails.

Did federal regulators think that the problem posed by derivatives was a lack of price transparency?

Hello, the problem posed by derivatives is that the banks can lose a substantial amount of money on them.  Just look at JP Morgan's losses on the London Whale's CDS trade.

The way to restrain banks from exposing themselves to potentially catastrophic losses on a large derivative portfolio is to require that they disclose their current exposure details, including derivatives.

With this disclosure, banks will dramatically shrink their derivative exposures for fear that the market will trade against them.  Jamie Dimon confirmed this when he tried to hide the CDS trade.
In the aftermath of the crisis, regulators initially planned to force asset managers like Vanguard and Pimco to contact at least five banks when seeking a price for a derivatives contract, a requirement intended to bolster competition among the banks. Now, according to officials briefed on the matter, the Commodity Futures Trading Commission has agreed to lower the standard to two banks. 
About 15 months from now, the officials said, the standard will automatically rise to three banks. And under the trading commission’s new rule, wide swaths of derivatives trading must shift from privately negotiated deals to regulated trading platforms that resemble exchanges. 
But critics worry that the banks gained enough flexibility under the plan that it hews too closely to the “precrisis status.” 
“The rule is really on the edge of returning to the old, opaque way of doing business,” said Marcus Stanley, the policy director of Americans for Financial Reform, a group that supports new rules for Wall Street.
So the CFTC's rule making is all about the idea that buyers of derivatives are too lazy to call multiple banks and compare prices.

If buyers cannot be troubled to get competing quotes, they are agreeing to overpay.
Making such decisions on regulatory standards is a product of the Dodd-Frank Act of 2010, which mandated that federal agencies write hundreds of new rules. ...
It is rules like this that further confirm that Dodd-Frank should be repealed (the only worthwhile parts are the Consumer Financial Protection Bureau and the Volcker Rule).
In an interview on Wednesday, Mr. Gensler said that, even with the compromise, the rule will still push private derivatives trading onto regulated trading platforms, much like stock trading. He also argued that the agency plans to adopt two other rules on Thursday that will subject large swaths of trades to regulatory scrutiny. 
“No longer will this be a closed, dark market,” Mr. Gensler said. “I think what we’re planning to do tomorrow fulfills the Congressional mandate and the president’s commitment.”...
Unless market participants know each bank's exposure details, derivatives are a closed, dark market.

If banks are performing the role that they are suppose to, acting as middlemen as oppose to taking proprietary bets, they should have no problem making this disclosure.
While the regulator defended the derivatives rule, consumer advocates say the agency gave up too much ground. To some, the compromise illustrated the financial industry’s continued influence in Washington. 
“The banks have all these ways to reverse the rules behind the scenes,” Mr. Stanley said.... 

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