Will the 'Cure' for Systemic Risk Kill the Economy?

In his Pulitzer Prize winning book, Dr. Siddhartha Mukherjee elaborates on the risk of excessive treatment. He notes, "One could double and quadruple doses of radiant energy, but this did not translate into more cures. Instead, indiscriminate irradiation left patients scarred, blinded, and scalded by doses that had far exceeded tolerability." To avoid analogous problems in the economy, financial policymakers should consider a common sense principle referenced in Secretary Geithner's speech. Referring to a parallel reform effort to strengthen banks' capital cushions, he said that requirements were "set at a level designed to allow institutions to absorb a level of losses comparable to what we faced at the peak of this crisis." However, the basic principle espoused in this statement -- that reforms should be calibrated to losses -- is not evidenced in regulators' proposed margin rule.

Total cash necessary to meet all such requirements could exceed $6 trillion globally, according to one estimate.

Although U.S. financial institutions lost $49 billion on derivatives since inception of the crisis, one regulator's economic analysis projects that $2.05 trillion would need to be sidelined to meet the rule's requirements. This amount would cover 42 times the derivatives losses incurred since the crisis began. Moreover, margin is but one of several policy tools that will govern how much cash market participants are required to set aside. Total cash necessary to meet all such requirements could exceed $6 trillion globally, according to one estimate. If accurate, such extraordinary requirements would indeed far exceed tolerability, causing the toxic side effects of reform to overwhelm the curative benefits.

In addition to properly dosing their treatments, policymakers must also selectively apply them only to portions of the market that threaten financial stability. "Killing a cancer cell in a test tube," Mukherjee notes, "is not a particularly difficult task: the chemical world is packed with malevolent poisons that, even in infinitesimal quantities, can dispatch a cancer cell within minutes. The trouble lies in finding a selective poison -- a drug that will kill cancer without annihilating the patient." In their response to the financial crisis, policymakers have sometimes indiscriminately applied their treatments, directing them at both the cancerous cells of systemic risk and the nearby healthy tissue.

They have, for example, prescribed similar treatments to community banks, pension funds, and other such "financial end users" as those they applied to systemically risky players like AIG. Additionally, their proposed margin requirements also apply -- albeit to a lesser degree -- to manufacturers, hospitals, property companies and other "non-financial end users." End users use derivatives to reduce risk to rising interest rates, exchange rates, and commodity prices. AIG, on the other hand, used derivatives to accumulate risk, betting that housing prices would continuously rise. It is this significant speculative activity -- not the prudent risk management of end users -- that threatened the financial system.

Though the cure for many cancers is far from achieved, lessons from its early pioneers can inform our approach to dealing with other complex problems. These lessons teach policymakers to be selective in the application of their treatments and to deliver them in proper doses. The value of these lessons is evidenced by their results.

Freireich recounts, "We knew better when we treated Janice in 1961, and in the late 1980s her picture appeared on the cover of Cancer Research, because she had been cured." Just as scientists moderated their early chemotherapy treatments to avoid fatal toxicities, financial policymakers must do likewise with their policy prescriptions to ensure the economy is not harmed by the toxicity of excessive treatment.

Image Credit: REUTERS/Mike Segar

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Luke Zubrod is a director at global risk management advisor Chatham Financial, an advisor to over 1,000 end users of derivatives.  His grandfather, C. Gordon Zubrod, led the National Cancer Institute's early efforts to cure cancer. More

Zubrod leads Chatham's government and regulatory advisory team, advising public and private companies on over-the-counter derivatives regulations. He has actively participated in the public policy debate on derivatives regulation, testifying before Congress and providing advice and recommendations to congressional staff and to staff of various regulatory agencies. Over the last decade, Zubrod has advised CFOs and treasurers across a wide range of industries on managing their interest rate and currency risks, most recently leading Chatham's advisory practice to U.S. public real estate companies. Prior to joining Chatham, Zubrod worked as a management consultant at Deloitte. He lives in Kennett Square, Pennsylvania with his wife and three kids.

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