Derivatives are more or less the side bets that banks, hedge funds, and other investors make with one another on the value and worth of things trading in other markets. These thing vary from field products such as corn to subprime mortgages. Derivatives are sometimes beneficial in buying insurance against wild financial disasters, such as futures, while at other times, they are dangerous because the feed big banks addictions to hefty bonuses. At worst, derivatives can be both, hence the urgent need for regulation.
I support the argument that these countries with the largest banks and deep pockets are also the ones with the strongest moral hazards, and as such in the direst need for derivative regulation. The Federal Reserve and the global financial watchdogs collaboratively reported that the world’s largest banks cannot comprehensively account for all the risks that they have taken or are taking when they are trading derivatives (Gongloff). When crises happen, banks and regulators might perceive the value of bank liquidity variedly. For instance, regulators might require that banks be well capitalized when financial crises occur so that they can avoid costly bail-outs, but banks have some different incentives. They don’t internalise bail-outs and probably write derivative contracts that consign them to significant liabilities during such crises.
Countries with strong moral hazards need derivative regulation because minimum bank capital requirements target standard lending and exclusive trading mechanisms including equities and bonds. Even though these minimum bank needs meet their task of containing excessive lending and investments in precarious assets, the banks can still transfer the risks by applying derivative contracts, for example, the Credit Default Swap contract. The most recent increase in minimum bank capital requirements outlined in Basel III might make it easier for banks to transfer such risks using these CDS contracts.
The motivation to transfer risks using derivative contracts such as CDS is stronger in the case where the fiscal sector is concentrated, banks are significantly larger, and the nation can afford to bail out them during a financial disaster (the nation has deep pockets). Countries such as the USA that can provide such massive bail outs have a relatively large banking system compared to the duty base of the country. The cost of autonomous borrowing is relatively cheap during a money crisis and the nation has strong and liberal fiscal policies. The result of this postulation is that large banks within such nations will internalise the reality that transferring risks using derivative contracts will have a large individual impact of the average fire sales. Regulators will therefore provide massive bail outs in an effort of propping up the prices of assets. The country can also provide a massive bank bail-out, making banks anticipate the same in case of a crisis. The overall consequence is that these banks see these derivative contracts as less risky.
In summary, derivative contracts are complicated than regular loans, bonds and equity acquisitions and have different accounting standards. To estimate the exposure banks face to financial crises due to derivative positions, regulators require banks particular operational level information and practical risk models values. Some countries have already administered derivative regulations, although they are barely transparent and not optimally designed. Greater information disclosure is essential to enable designing of derivative rules. For large banks and financial institutions, derivatives can improve their welfare by allowing them to circumvent risks and increase risk sharing. As for now, there is still too little and hypothetically wrong derivative regulation.
Work Cited
Gongloff, Mark. "Banks Could Still Blow Up The World". The Huffington Post. 2014. Web. 10 Mar. 2016.
