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

By Luke Zubrod

What cancer research can teach us about how to reform the derivatives market

600 comp screens REUTERS Mike Segar.jpg

"I do not know whether the elderly woman died from cancer or its cure." - Dr. Siddhartha Mukherjee, author of "The Emperor of All Maladies"

Some medicines powerful enough to cure also hold the power to kill. That's why carefully selecting drugs and properly calibrating their doses are essential disciplines in the treatment of an illness. There are three ways in which early successes in combating diseases like cancer can offer important insights to financial policymakers tasked with implementing reforms to mitigate systemic risk.

First, too much of even the right medicine will kill patients -- just as excessive amounts of well-intentioned regulation will hamper economic activity. Second, remedies need to be carefully formulated to address the severity of a particular illness -- and new derivatives rules should be calibrated to the losses that could reasonably be expected in a severe financial crisis. Third, treatment should attack only the cancerous cells, not the healthy tissue -- in a similar sense, regulation should focus on firms where their derivatives use poses systemic risk, while leaving other firms untouched.

This week, the comment period ends for some important new rules that will govern derivatives. As regulators finalize the regulatory framework, they can learn from commonly accepted medical principles. Ignoring them could significantly harm economic growth -- diverting trillions of dollars from productive economic use. Emil Freireich, an early cancer research pioneer who was part of the team at the National Cancer Institute ("NCI") that successfully cured childhood leukemia in the early 1960s, highlighted one such lesson in recalling the initial use of a potent experimental drug regimen: "The doses we gave her were too high, and she almost died of toxicity...By not recognizing when to stop, the first patient got two extra days of chemotherapy and that was the thing that almost killed her."

In a speech before the International Monetary Conference earlier this month, Treasury Secretary Tim Geithner exhorted world governments to adopt a global standard for margin requirements in the derivatives market. Such requirements, recently proposed by U.S. regulators, will govern how much cash companies need to set aside against their derivatives trades. Because this cash -- an amount which could exceed annual federal tax receipts -- would otherwise be available to invest in the economy, it is critical that U.S. regulators properly calibrate their rules before attempting to export them around the globe.

If margin rules are excessive or apply to firms that pose no risk to financial stability, they will blunt economic growth and job creation without proportional benefit.

These rules influence the cash resources businesses are able to invest in new plants and equipment, loan to small businesses, and dedicate to research and development. They will also affect the prices of everyday products like airline tickets, cereal, and life insurance. If margin rules are excessive or apply to firms that pose no risk to financial stability, they will blunt economic growth and job creation without proportional benefit.

As financial policymakers work to insulate the economy from future threats, they face significant challenges. Chiefly, they must craft policies that target a problem -- systemic risk -- about which they understand little and which is constantly evolving. Federal Reserve Chairman Ben Bernanke acknowledged this recently when he said, "...much work remains to better understand sources of systemic risk, to develop improved monitoring tools, and to evaluate and implement policy instruments to reduce macroprudential risks."

While significant, these obstacles are not insurmountable. By examining medical disciplines like cancer research that also faced huge challenges, policymakers can increasingly target the sources of systemic risk in ways that do not unnecessarily burden 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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