One of the biggest problems with Basel III and current banking regulation is that it fails to tackle the regulation of derivatives adequately. Far too little information about derivative contracts is in the hands of the regulators and academics, making it extremely difficult to calculate risk. Countries with large banks and deep pockets, which are also the countries with the strongest moral hazard, are the ones in greatest need of derivative regulation.
Why do we need derivative regulation?
During a crisis, regulators and banks might view the value of bank liquidity differently. For example, while regulators would want banks to be well capitalised during systemic financial crises in order to avoid providing costly bail-outs, banks have different incentives. Banks do not internalise bail-out costs and are much more likely to write derivative contracts that leave them with large liabilities during systemic crises.
One might wonder why countries with strong moral hazard need derivative regulation on top of minimum bank capital requirements. Minimum bank capital requirements, for the most part, target standard bank lending and proprietary bank trading instruments such as equity and bonds. Even if minimum bank capital requirements serve their role of containing excessive lending and investment in risky assets, banks can still shift risk using derivative contracts such as Credit Default Swap (CDS) contracts. Given the recent increase in minimum bank capital requirements in Basel III, banks might find it relatively cheaper to shift risk using derivative contracts, such as CDS contracts.
My research shows that banks’ incentives to shift risk using derivative contracts are stronger if the financial sector is very concentrated (banks are large) and the country can afford a larger bank bail- out during a financial crisis (has deep pockets). Countries that can afford large bail-outs are the ones where the banking sector is not too large relative to the tax base of the country, the cost of sovereign borrowing is likely to be relatively low in a crisis and/or the country has an independent monetary policy. The USA is a good example of such a country.
What is the intuition behind this result? Large banks internalise the fact that the more they shift risk using derivatives, the larger their individual impact on aggregate fire sales will be. This makes regulators provide larger bail outs in an attempt to prop up asset prices. Similarly, if a country has deep pockets, it can afford to provide a larger bail-out. As a result, in countries with large banks and where the cost of the bail-out is lower, banks expect a large bail-out in a crisis, which makes them perceive derivative contracts to be less risky.
Why is derivative regulation so challenging?
Derivatives are much more complicated contracts than regular loans, bond and equity purchases and have very different accounting standards. In order to estimate the exposure of banks to systemic crises caused by derivative positions, regulators will need both bank specific transaction level data and fairly complex value at risk models. While some countries have already enforced derivative regulation in one form or another, they are non-transparent and potentially not optimally designed. The US$2 billion loss of JP Morgan due to CDS trades in 2012 and the bail-out of AIG are prime examples of why greater disclosure of information is crucial and regulators should put more effort in designing optimal derivative regulation.
Of course one should not forget that derivatives can also improve welfare by allowing firms and financial institutions to hedge risk and by improving risk sharing. Therefore, one needs to be careful not to overregulate. However, the current state of affairs seems to be one of too little and, potentially the incorrect type of derivative regulation.