Wednesday, December 16, 2009

Grading Financial Reform

Original posted on by Thomas F. Cooley, Viral Acharya, Matthew Richardson and Ingo Walter:

An important reason why some financial institutions became too big to fail in the recent crisis was that they were too interconnected to fail--regulators and markets did not have sufficient information on the exact nature of these links. Many of these connections had to do with positions in over-the-counter derivatives such as credit default swaps (CDS). Besides this issue of opacity, OTC derivatives are also potentially a mechanism for banks to avoid the more stringent margin- or collateral-requirements they face when similar products are traded on exchanges or clearinghouses.

The bill unfortunately succeeds only partially in addressing these issues. On the positive side, it does require that all OTC positions be reported in a centralized data registry with full regulatory access. This should allow regulators to prepare better for future failures of financial firms. It appears unlikely, however, that market transparency will be enhanced other than through provision of aggregated position information. Negatively speaking, the bill does not mandate centralized clearing of OTC derivatives except when a clearinghouse is willing to accept them. While regulators would review products for possible clearing, ultimately clearing houses are run by participating dealers. Hence, it appears that the bill leaves considerable, perhaps almost all, discretion to financial firms as to which products will be centrally cleared.

Failure to move CDS--even the standardized ones--to central clearing was a key contributor to the crisis: CDS clearing, a "utility" function, remained inside Bear Stearns, a private risk-taking firm, and so when Bear collapsed, there were widespread fears of contagion through CDS interconnections. Therefore the bill is at best disappointing and lacks sufficient conviction in addressing the systemic risk issues relating to OTC derivatives.

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