Without better regulation, it's all just an expensive game. (photo: tamaki via Flickr)

President Obama recently called for specific changes to regulation of the finance business. One of these proposals is an especially good idea.

The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

There doesn’t seem to be a written proposal. The New York Times reported the following:

The administration wants to expand that cap to include all liabilities, to limit the concentration of too much risk in any single bank. Officials said the measure would prevent banks at or near the threshold from making acquisitions but would not require them to shrink their business or stop growing on their own.

The Obama administration said the new proposals were in the “spirit of Glass-Steagall” — a reference to the Depression-era law that separated commercial and investment banking, which was repealed in 1999.

The anonymous administration person betrays a fundamental ignorance of Glass-Steagall. As the NYT reporters indicate, it didn’t have anything to do with concentration. It simply barred commercial banks from engaging in investment banking. Concentration is an anti-trust issue. However, an aggressive form of the President’s proposal should help control the risk that taxpayers will have to bail out the finance business again.

Fortunately, one of the smartest Republicans, Senator Bob Corker of my home state, realizes that financial regulation is a non-partisan issue, and is working with Senator Dodd. Good financial regulation rationalizes markets, raises the opportunity cost of fraud, and gives the taxpayers some hope that they won’t be called on to bail out banks in another crisis. Senator Corker is trying to find enough common ground to move something forward. I hope he and others will recognize the value of the President’s proposal.

This stuff is complicated, and requires explanation. Here are the bullet points.

1. There is a problem of concentration in swaps dealings.
2. Trading in swaps isn’t like a real market.
3. Risk management for swaps is problematic.
4. Crucial aspects of swaps trading cannot be captured in models.
5. Counterparty risk cannot be calculated accurately.
6. There is no evidence that benefits of swaps exceed their costs.
7. How would it actually work?

I’ve written about all these things in earlier posts and will take them up again. For now, here are short takes on 2 and 7.

2. Trading in swaps isn’t like a real market.

Let’s start with credit default swaps. Theoretically, CDS players try to maintain balanced books. Suppose JPMorgan agrees to sell protection on a specified reference entity. To balance its book of CDSs, it must either sell the CDS or buy protection from another player. AIG failed to balance its book, and we know how that turned out. JPMorgan claims that it has a reasonably balanced book.

There isn’t anyone who needs to be a protection seller. Each time JPMorgan becomes a party to a new CDS, it has to engage in active selling, either to sell its CDS or to persuade someone else to sell it protection, in which case, the problem moves to that seller.

The British Financial Services Authority did a study of the retail side of Lehman Brothers swaps. It found that 46% of 157 cases involved unsuitable advice. There are plenty of similar cases of “unsuitable advice” in the US, although I am not aware of a similar study. Some people might use a tougher term than “unsuitable advice”.

The same thing is true for interest rate swaps. The big difference is that actual banks, as opposed to Goldman Sachs, have huge loan portfolios, so some interest rate swaps might balance their own loan portfolios.

This isn’t how real markets work. People aren’t talked into buying bread or TVs. When they do buy, they shop. They don’t wait for their grocer to “put them into” chicken thighs, the way brokers “put their customers” into ETFs or BBB corporate bonds. This is a business that only exists if traders can talk someone else into being a counterparty.

7. How would it actually work?

For this purpose, banks are i) bank holding companies under current law, and ii) finance businesses which would be considered too big to fail under proposed law. Initially, banks would be limited to the amount of swaps and related derivatives (those listed in the OCC reports) that they currently have. Each quarter they would be required to reduce their holdings by a specified amount. Banks insist that there is a real market. Therefore, we can expect that other buyers and sellers will take up the slack. The level of exposure would be reduced over time so that no bank would have more than 5% of the outstanding notional values of any of the various swaps.

President Obama thinks that a good idea is a good idea, regardless of who comes up with it. I hope Senator Corker and some of the other smart Republicans see the wisdom of this theory.