Derivatives Regulation Misses The Mark

There was a hearing this morning held by the House Financial Services Committee titled, "Reform of the Over-the-Counter Derivative Market: Limiting Risk and Ensuring Fairness." Much of the discussion centered on Committee Chairman Barney Frank's (D-MA) proposal to regulate the derivatives market, which differs in significant ways from that offered by the Obama administration. I worry that proposed derivatives regulation misses the mark on a few levels.

Bloomberg has a nice article on that committee hearing, if you want specific details. I'd rather think about the bigger picture and where derivatives regulation really fits in.

Congress has an awful lot on its plate these days, but fixing the financial system should be its chief priority, as it's clearly the timeliest. Yet, finance is big and broad. There are lots of different aspects that politicians might seek to write new rules for. So where should it begin? I think the rather uncontroversial answer is with whatever causes led to the financial crisis that prompted one of the worst recessions in U.S. history.

So far, Congress has done a pretty poor job of adhering to this seemingly obvious strategy: the only financial regulation imposed so far this year was for the credit card industry. It played absolutely no part in the crisis.

How do derivatives fit into the picture? They certainly shouldn't be the focal point. In reality, derivatives played an exceedingly small part in the crisis. Their most notable contribution was through AIG's infamous credit-default swap fiasco. Even then, however, the problem was not so much a failure with derivatives as it was a mistake in capital reserves. And the reason those capital reserves were so far off stems from the ratings of underlying securities being very inaccurate. Yet another reason to shake one's head disparagingly at the rating agencies.

Some talk of capital reserves is present in the Frank proposal, but in very broad strokes. I'm unconvinced that his changes to capital would make a huge difference. A better focus might be to reform the rating agencies while forcing some extra cushion in capital reserves. Even though only banks' capital reserves are based on security ratings by law, the rest of the industry has historically placed a great deal of weight on them as well, giving them that natural function with derivatives.

How about the rest of the proposal, seeking to restructure the derivatives market and "ensuring fairness"? Those might be laudable goals, but they have absolutely nothing to do with what caused the crisis. As a result, that aspect should have no part in the priorities being discussed for financial regulation at this time. Congress should be simplifying its regulatory ambitions so to make sure it gets through the important, less controversial stuff first. That's not what it's doing.