Commentary | Economic Growth

Too complex to regulate?

Lawmakers seeking to prevent a repeat of the greatest financial meltdown since the Great Depression are considering ways to impose tighter regulations on big investment banks, where trading of credit default swaps and other derivatives reached unsustainable levels, helping bring the economy to the brink of disaster in 2008. Although they are commonly described as a form of insurance against defaults on home mortgages, the credit default swaps sold by A.I.G. and other firms became so widespread and complex over the past decade that it became almost impossible for the banks themselves, let alone outside regulators, to sort out the real value of these popular investments or assess the risk.
The rise in trading of derivatives — sophisticated financial instruments whose value is derived from something else such as home mortgages — also underscores how far so many banks have strayed from what should be their main mission of providing lending to individuals and small businesses to help support growth in the general economy. Critics note that derivatives trading escalated to a rapid back-and-forth exchange of paper certificates where the value often had little connection to real economic activity.
If “Too Big to Fail” and “Too Connected to Fail” have become the slogans justifying the repeated government bailouts of some major banks and insurers such as A.I.G., these firms’ continued resistance to tighter government restrictions might be summed up as “Too Complex to Regulate.”
That complexity is neither necessary nor useful, argue Robert Johnson, an EPI board member who previously served as managing director of Soros Fund Management as well as chief economist for the Senate Banking and Budget Committees; and Sony Kapoor, a former investment banker who now heads the international think tank Re-Define (Rethinking Development, Finance, and Environment). In recent interviews, Johnson and Kapoor discuss how Wall Street uses extreme complexity as a shield to pad its profits and keep regulators guessing, and why banks need to return to the sort of activities that serve people on Main Street.

Q. The trading of derivatives and credit default swaps, which are at the core of the current economic instability, are often presented as something that is too complex for the average person to understand. Why?

Johnson: They (the banks) make things hard to understand so they cannot be easily copied, which enables them to charge a higher profit margin. Complexity in and of itself doesn’t help them avoid regulation, but their declaration of instruments such as credit default swaps as stock when they are actually insurance contracts was a misnaming designed to avoid regulation.

Kapoor: Wall Street has a very strong incentive to make things as complex as possible. Complexity is used as a tool to fool regulators and to avoid tax. You set up new subsidiaries, you make new products that haven’t been addressed by regulations. Regulators are very hard-pressed to get any information.

Q. It’s been pretty well documented how the rise of credit default swaps contributed to the demise of some major investment banks. How have they contributed to the pain much of the rest of the country is feeling in the form of lost jobs, lost homes, and general economic instability?

Kapoor: Risk taking is essential to the creation of jobs and economic prosperity, but risks need to be taken by those who understand them and have the capacity to bear them. But in pursuit of profits, the banks ended up sending the risks to nontransparent corners of the market, and to less sophisticated actors who did not understand the risk, and to entities such as pension funds that did not have the capacity to bear it.

Johnson: There were two problems. First, the credit default swaps were commonly treated as income, rather than as the equivalent of an insurance policy, which might have to be repaid. And two, they were allowed to be written on third-party risks. It was as if I were allowed to bet on whether someone else’s house was going to burn down, which is not the way insurance usually works.

Q. At its peak, the size of the credit default swap market was $45 trillion. How did it get so big?

Johnson: It got so big because there were no transactional costs and no regulation. It was a completely unregulated market.

Q. What were the warning signs that should have been heeded?

Kapoor: When you have banks earning a 25% return on equity in an economy growing at only 3 or 4%, that is not just a warning bell, but a clanging fire alarm. Everybody rationally knew it was not sustainable in the long run but as long as the music was playing, the banks were going to keep dancing. It was not in their interest to stop, which is another reason you need regulation.

Johnson: Complexity was also a problem. When you shock a system, complexity makes it difficult to assess the counter parties. The other big institutions are also highly leveraged and you can’t assess whether they are solvent or insolvent. They become un-analyzable. They don’t even know themselves. When you have a situation where several big institutions are intertwined with each other and some are insolvent, there is a cascading effect that can make them all insolvent.

Q. What are your thoughts on the proposals put forth in the Obama administration to step up regulation?

Johnson: I think it is a step in the right direction, but it is probably not sufficient. The proposals for regulating over-the-counter derivatives favor the finance industry too much. I understand they are also considering a form of the Consumer Product Safety Commission to oversee derivatives trading, which would be a move in the right direction.

Kapoor: A lot of people are saying, let’s save the system first and then regulate. But in my understanding, these two issues are inseparable. Crisis came about because of a total breakdown of trust. That issue of trust cannot be resolved by going back to business as usual.

Q. The history of Wall Street seems to be a series of financial scandals, followed by calls for stricter regulation, and then a scandal of a different sort arising a few years later. Given the complexity on Wall Street, and bankers’ strong interest in avoiding regulation, can we realistically expect anything to change for the better? What is needed to accomplish meaningful regulatory reform?

Johnson: I would say that if you look at A Short History of Euphoria (John Kenneth Galbraith), it makes the point that financial markets are treated like they are rational, and yet the history of markets is one of boom and bust and crash. Many people prescribe remedies without accurately diagnosing the animal. Understanding that markets do not behave rationally makes you realize that they need much greater regulation. They need much greater capital set-asides.
Big banks should be like public utilities, where they perform a stable function. Casinos and hedge funds ought to be separate from the banks. In recent years, the banks used deposit insurance to get funds for their casinos. Society has been subsidizing the funding of these institutions and their volatile, risky activities.

Kapoor: Subsequent to each crisis, the regulatory reforms that have happened have addressed the particular cause of that crisis. None have addressed the fundamental instabilities that lie at the heart of finance. It is remarkable not how much it crashes, but how little it crashes.
We need to increase competitiveness and reduce barriers to entry in the finance system so that we have more institutions that are not too big to fail. We need a principle of diversity that prevents insurance firms, hedge funds, banks, a
nd Japanese housewives from engaging in all the same investing activities. We also need reforms to bring about simplicity since the financial system left to itself will make more and more complex products designed to maximize profits and minimize regulation. And we need more fairness: a system which in good times pays its fair share of taxes, so that in bad times, it doesn’t take the economy down with it and make taxpayers, workers, and investors pay.
Finally, we need an accountable financial system where it is not good enough to say to politicians, to labor unions, and to Main Street that this is too complex and if you touch it, it will explode. No one touched it, and it exploded anyway. If it is too complex to understand, it is too complex for stability.

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