|Lynn Stout; Lynn Stout|
Addiction counselors tell their clients, "We can't help you until you admit you have a problem." It's time for American financial institutions to admit they have a gambling problem.
This is not a metaphor or figure of speech. Derivatives are literally wagers, agreements that one person will pay money to another if some specified event occurs – if interest rates rise, a currency falls, I'll Have Another wins the Belmont Stakes. A
As the insurance industry shows, wagers can be used to offset risk. When you buy fire insurance, you are betting the insurance company that your house will burn down. If it burns, you win the wager, offsetting the loss of your home.
But wagers are also used to speculate, by trying to profit from predicting the future better than others can. If I bet the Yankees will make the World Series, I'm seeking profit, not trying to reduce risk.
Betting – including betting with derivatives – is a zero-sum game. Winners' gains always come from losers' pockets. Worse, unless a bet is truly insurance, both sides take on risks they weren't exposed to before.
So when banks turn away from the boring business of making loans and helping real companies raise money by issuing stocks and other securities, to focus instead on risky trading primarily to make profits, we should expect to see exactly what we have seen. There are more big winners – hedge fund manager
The 2008 credit crisis has proved, painfully, how systemic risk harms our economy. And banks' gambling in the zero-sum attempt to earn more dividends for bank shareholders and bigger bonuses for bank executives doesn't provide investment capital directly to real businesses, the way lending and "underwriting" (helping companies raise cash by selling stocks and bonds) do.
While derivatives traders often repeat (without solid evidence) the self-serving claim that their trading is essential for liquid markets and accurate prices, no one who lived through the derivatives-triggered liquidity crunch and wild price swings of fall 2008 should attach much value to these unsupported assertions.
History tells us what we can do to keep our financial institutions from collapsing in derivatives-fueled disasters. After the Depression,
That wave of financial deregulation explained both the sudden rise of an enormous derivatives market and the trading disasters and institutional collapses that followed.
The Dodd-Frank Act attempts to stuff the systemic-risk genie back in the bottle by once more restricting deposit-taking banks from making risky bets with their own accounts (the so-called Volcker rule) and moving speculative derivatives trading back into regulated clearinghouses. Unfortunately, the financial industry has responded by sending out an army of lobbyists and lawyers to try to dilute the rules and create loopholes big enough, in the words of
Our banks still won't admit they have a problem. That means we still have a problem too.
Stout is a professor of business law at
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