Financial reform bill up for vote soon
July 14, 2010
Below is an excerpt from a statement by Dean Baker, co-director of the Center for Economic and Policy Research, on the approval of the financial reform bill, followed by a statement from Jim Collura of the Commodity Markets Oversight Coalition on the derivatives reform section of the proposed legislation:
From Dean Baker: “The final compromise bill … will improve regulation in the financial sector. However, given the severity of the economic crisis caused by past regulatory failures, the public had the right to expect much more extensive reform.
“On the positive side, the creation of a strong independent Consumer Financial Protection Bureau stands out as an important accomplishment. Such an agency would have prevented some of the worst lending practices that contributed to the housing bubble ….
“The requirement that most derivatives be either exchange-traded or passed through clearinghouses is also an important improvement in regulation. [See second article.] However, important exceptions remain, which the industry will no doubt exploit to their limit.*
“The creation of resolution authority for large non-bank financial institutions is also a positive step, although the fact that no pre-funding mechanism was put in place is a serious problem. Also, the audit of the Federal Reserve’s special lending facilities, as well as the ongoing audits of its open market operations and discount window loans, is a big step towards increased Fed openness.
“On the negative side, there is little in this legislation that will fundamentally change the way that Wall Street does business. The rules on derivative trading will still allow the bulk of derivatives to be traded directly out of banks rather than separately capitalized divisions of the holding company. The Volcker rule was substantially weakened by a provision that will still allow banks to risk substantial sums in proprietary trading.
“More importantly, there is probably no economist who believes that this bill will end the risks of too-big-to-fail financial institutions. The six largest banks will still enjoy the enormous implicit subsidy that results from the expectation that the federal government will bail them out in the event of a crisis.
“Also, the fact that no regulators, most obviously Ben Bernanke at the [Federal Reserve], were fired for failing to prevent the crisis leaves in place serious doubts about the structure of incentives for regulators. Cracking down on reckless behavior by politically powerful financial institutions will always be difficult for regulators. On the other hand, if regulators know that failing to crack down carries no consequences, even when it leads to disastrous outcomes, we can expect that regulators will have a strong bias toward ignoring reckless behavior.
“It is possible that Congress may take stronger steps toward restructuring the financial sector, most obviously in the context of a financial speculation tax. While this is not likely to pass at the moment, in the context of severe budget pressures, a tax that can raise $150 billion a year in revenue may look more appealing than most alternatives. Such a tax would do far more to restructure the industry than this financial reform bill.”
Center for Economic and Policy Research
More on derivatives reform
Several recent articles erroneously state that the derivatives reforms in the financial reform bill will cost small and medium businesses millions in added costs. This is not true as commercial end users will be exempt from the new requirements.
The Commodity Markets Oversight Coalition has sent out the following letter, written by Jim Collura, that spells out what is really in the bill as well as provides a good background to the use of derivatives (Also available at http://stopgamblingonhunger.com/)
Derivatives reform will benefit -- not burden -- end users
In the course of the two-year long debate on how best to reform the derivatives markets, much attention has been given to the concerns of so-called “end-users,” or businesses that use derivatives to hedge against various forms of risk, including not only airlines, utilities and manufacturers, but also small business farmers, gasoline stations and home heating companies.
However, end-users have had growing concerns about the state of the derivatives markets that predate the 2008 financial collapse. Many have argued that these concerns are addressed, not exacerbated, by proposed reforms included in Wall Street reform package.
For more than a century, derivatives have been used by producers, processors, transporters and marketers of commodities – such as gasoline, home heating oil, wheat and livestock – to insulate their businesses and consumers from price risk. And for much of their history, they were a stable, reliable and transparent means of doing so.
However, if you speak to anyone who has used derivatives products for more than a decade, they will tell you that everything changed in 2000. The financial industry successfully secured blanket exemptions from Congress and federal regulators that led to a transformation of derivatives markets from simple commodity exchanges to the opaque and unregulated, multi-trillion dollar markets we know today.
To remain competitive, regulated exchanges weakened their own prohibitions on speculation, and allowed traders in the U.S. to access new subsidiaries in countries with weaker oversight. Over-the-counter and foreign derivative trading markets boomed, to the detriment of the traditionally stable domestic environments.
These changes lead to a “Wild West”-like environment. Excess volatility became the norm. Price spikes in commodities, most especially those experienced in 2007-2008, seemed to be dislocated from supply and demand fundamentals. Speculators were diving head-long into derivatives, and by 2008, came to dominate commercial hedgers four-to-one.
As commodity speculation swelled, retail gasoline and home heating oil prices surged beyond $4 per gallon. Trade associations attributed as much as $1 or more of these prices to speculation, despite the more than adequate inventories and a decline in demand. Global food prices were similarly rocked and the UN estimates that an additional 130 million people were driven to hunger as a result.
Derivatives reform will address many of these issues. Mandatory reporting, clearing and capital requirements for all derivatives would create transparency and much needed confidence in these markets, while a hedge exemption for bona-fide end-users would protect commercial businesses. It would also require that foreign exchanges doing business in the U.S. register with our regulators and encourage new cooperation with overseas agencies.
The bill also contains new tools that will help the Commodity Futures Trading Commission (CFTC), the principal regulator of derivatives, police against fraud and manipulation. It would also protect end-users from excessive speculation by expanding a 1936 statute requiring the CFTC to limit the size of speculators’ positions to over-the-counter markets and, importantly, in the aggregate across all markets.
Still, news coverage and op-eds have suggested that end-users are unified in opposition to reform due to fears that it will result in new government regulation and capital requirements, despite the well articulated hedge exemption and support for the legislation from airline, trucking, gasoline, home heating, and various agricultural industry groups.
If the “Wild West” was tamed by law and order, then the derivatives markets will be tamed by increased transparency, stability and confidence that legislative reform will bring. An important and reliable tool that hedgers have relied on for years will be returned to them and for this reason, end-users will benefit – not be burdened by – long overdue and comprehensive reform.
The only derivatives users that need worry about this reform are those that have exploited the status quo recklessly and irresponsibly, driving up costs for all Americans and threatening our nation’s economic stability and competitiveness. They fear it, and rightly so.