Yves Smith has a long excerpt from testimony by Robert Johnson before the House Financial Services Committee on regulation of OTC derivatives. (Johnson’s testimony is not up at the committee site.) Johnson brings together the issues of too big to fail and derivatives regulation: “Absent a drastic simplification of derivative exposures and a transparent and comprehensive improvement in the monitoring of those positions when imbedded in large firms, complex derivatives render these behemoth institutions Too Difficult to Resolve (TDTR).”
In short, he argues that even if you give regulators the ability to “resolve” a Tier 1 financial institution in the event of a crisis, regulators will be afraid to pull the trigger as long as there is still this complicated web of non-standardized derivatives linking it to the rest of the financial system. In addition, this creates a bizarre incentive: if you think that you can escape being shut down by having an intimidatingly complex derivatives portfolio, then you will go out and create such a portfolio.
I think there is a real risk in financial regulation that it becomes too technical and technocratic. We already know that the people who are into finance, economics, and economic policy are suckers for complicated models — the new flavors are contingent capital and size-based capital requirements. But we have to weigh their theoretical elegance against the chances that they will not work, or will be overridden by other considerations, in a crisis. For example, here’s Mervyn King on contingent capital:
“[E]xperience has shown that it is difficult to assess risks of infrequent but high-impact events, and so it is dangerous to allow activities characterised by such risks to contaminate the essential – or utility – services that the banking sector provides to the wider economy. Both of these drawbacks mean that it is almost impossible to calculate how much contingent capital would be appropriate.”
In other words, since crises are by definition tail events, there is no good way to estimate the amount of contingent capital that will be needed beforehand, so there is a high risk that financial institutions won’t have enough and we’ll be left where we are today. Assuming perfect regulation is no different from assuming any other can opener.
By James Kwak