The Obama administration promised to reform the financial system and make it safe for the rest of us, but recent Congressional action is more likely to reset the fuse for another explosive calamity. The time bomb in this case is that arcane financial instrument known as derivatives–the hedging devices that the big banks sell to investors, corporations and other banks to reduce risk or evade the requirements to hold adequate capital on their books.
As the financial meltdown demonstrated, derivatives do not reduce risk. They amplify it and spread it around interlocking networks of unwitting investors. That house of cards collapsed worldwide a year ago. It would be tragic to let the bankers build a new one. Some reformers think all but the simplest, most visible forms of derivatives should be prohibited by law. The president prefers instead to regulate them. Derivatives, his advisers explained, would be less dangerous if they were traded openly in financial markets, just like stocks and bonds. Regulators could then put the brakes on dangerous excess if they saw it developing. Anyway, that was the theory.
But the “reform” legislation approved by the House Financial Services Committee on October 15 is a fiesta of exemptions, exceptions and twisted legalese that effectively defeat the original purpose. Only experts can divine the actual meaning of the bill’s densely worded provisions, and many of them have reacted with disgust. The “entanglements of derivatives exposures” among oversize banks “is the equivalent of the San Andreas Fault of our financial system,” veteran financier Robert Johnson testified at an October 7 hearing on the draft bill. If Congress does not disarm derivatives, he warned, it could lead to another cascade of failure that would give regulators no choice but once again to rush to the rescue of the banks dubbed “too big to fail.”
That risk is not theoretical. The largest banks that dominate this lucrative business seem to have gotten pretty much what they wanted–a free hand to keep peddling the indecipherable derivatives beyond the reach of regulators. According to the Financial Times, Goldman Sachs plans to market a new financial instrument that will allow banks to reduce the capital required to hold risky assets on their balance sheets. Goldman calls this product “insurance” and expects to sell it to the banks with toxic portfolios, enabling them to shift the risk off their balance sheets. It is not clear whether the new bill will interfere with this “innovation.” Goldman evidently does not see a problem.