Saturday, June 20, 2009

Origin of a Crisis

Last week Mark Thoma argued that the "shadow banking system" was primarily responsible for last fall's financial crisis. A blogger at The Atlantic tried to refute that claim, arguing that the crisis was started at institutions which were heavily regulated.

It seems that they’re both right, in a sense. Many of the big problems came from institutions that were regulated in the traditional markets in which they operated, but were not regulated while conducting off-balance-sheet trades. CDS trades, for example, were not subject to traditional capital requirement regulations, and many regulated banks were heavily engaged in these. So the ability of regulated banks to engage in activities which were not regulated was a huge problem.

Obviously, something should be done about derivatives, particularly the CDS’s. You can regulate traditional banking operations all you want, but if you are ignoring the potential for massive liquidity risk in unregulated trading, then you’re wasting your time, or, worse, creating a sense of false security.

But what can be done about derivatives? I do not believe that they can be made safe through regulatory oversight; they are simply too complex for regulators to properly value. And because of correlation issues, market participants are even less able to quantify liquidity risk because they do not have access to information regarding the overall positions of their counter-parties. (Presumably, the regulatory agency would have this information, but that is a big presumption.)

So, if they are not safe now, and they cannot be safely overseen, I think the answer is to ban them.

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