Congress targets major cause of banking crisis: derivatives

The House Financial Services Committee announced a plan Tuesday to give regulators tools needed to crack down on banks' risky behavior. It will be a tough job, experts say.

By , Staff writer

Washington policymakers helped calm a financial storm. Now, they are trying to prevent a repeat.

The House Financial Services Committee unveiled a package of reforms for the US banking system Tuesday. The bill aims to give financial regulators the tools and the mandate to monitor risks in the financial system and to create a process for restructuring large financial firms that get into trouble.

But some finance experts worry that bailing out banks with a $700 billion relief fund was the easy part. Much more difficult, they say, is reining in risk for the future.

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Consider one prominent piece of the financial crisis that sent the economy into a deep recession last year: the failure of insurance giant AIG. To date, no firm has required a larger bailout (some $120 billion in all).

AIG collapsed under the weight of its complex investments known as derivatives. Specifically, the firm was a big player in "credit default swaps," charging fees to customers and in return promising to cover the bonds if they default.

In the unexpected turmoil of the credit crisis, the firm couldn't cover its promises. Washington came to the rescue, concerned that an AIG bankruptcy would undercut the solvency of other large firms.

Now, the House Financial Services Committee has approved a measure to tighten oversight of such derivative contracts – part of its larger package of financial reforms. The legislation would push most derivatives trading onto formal exchanges or electronic trading platforms. Today, the contracts typically trade "over the counter" in a less-formal system.

Will the reforms work?

Although many experts say that won't hurt, it's not clear the legislation would greatly reduce the risk posed by trillions of dollars in derivative investments.

"Would it prevent a repeat of the same crisis? In this case,... no," says Joseph Mason, a finance expert at Louisiana State University.

To contain risks from derivatives, he says bank regulators will have to do a better job looking over the shoulder of firms like AIG. But derivatives are so widely used and so complex that regulators will have a hard time rooting out all risky behavior, regardless of where the trades happen, he says. Moreover, regulators are often pressured not to crack down on banks too heavily during good times.

This is just one piece of a much larger challenge, Mr. Mason adds. The government's massive rescue of the financial system has made it increasingly hard to determine which firms are "too big to fail" and which would be allowed to fail if they get into trouble.

The crisis appears to have pushed more segments of the financial industry – such as AIG or an investment firm like Goldman Sachs – within the safety net of being "too big” or important to fail. The larger the safety net gets, the harder it is for regulators to credibly say that marketplace discipline will guide the financial industry, since the feeral government will be, in effect, decreasing the penalties of failure.

This means the burden on regulators to manage risks keeps getting larger.

Transatlantic split

This debate has flared into the open recently, as European and US regulators have taken different tacks on the question of the acceptable size of large banks.

The European Union this week nudged the bank ING, based in the Netherlands, to sell some divisions as a condition of getting a bailout. Federal Reserve Chairman Ben Bernanke, by contrast, warned against being too quick to downsize financial giants. He said the global economy's complex businesses need complex banks to support their financing needs.

Derivatives are a case in point. Many firms want the kind of protection that derivatives offer against credit risk, or against changes in currency or interest rates. Many experts say it would be wrong to try to turn back the clock on financial innovation. But they also say regulators haven't figured out how to tame the risks involved.

Mr. Bernanke has said the costs of any future bailouts should fall on financial firms, not on taxpayers.

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