Whether it would be wise to introduce the animal to these Islands may be a question. It would be important to first learn more of the nature of the creature, for they may prove an evil.” – 1883 issue of Planters Monthly

In 1883 sugar farmers introduced the mongoose to the Hawaiian Islands to combat a significant threat to their crop – a growing rat population.

This would prove a disastrous decision. The mongoose did not fix the problem and it created significant unintended consequences. The rats, active mostly at night, were largely undeterred by the mongooses, which hunted by day. Further, the mongoose almost destroyed indigenous bird species such as the Hawaiian goose.

What does the mongoose have to teach us about financial regulation? As it delivers a strong response to the credit crisis in its financial regulatory reform bill, Congress should heed the lessons of the mongoose and exercise due caution to ensure that its fixes are effective and do not create new problems.

Nowhere in financial regulatory reform is the lesson of the mongoose more relevant than with “Section 716” – a controversial provision in OTC derivatives legislation that would force banks to spin-off their swaps desks into new entities, or lose access to federal assistance like FDIC insurance. Hailed by its proponents as ending the “derivatives casino” and “quarantining highly risky swaps trading,” this provision would instead – like the introduction of the mongoose to the Hawaiian Islands – be the wrong fix for legitimate problems in the derivatives market.

In fact, rather than addressing these problems, it would more likely harm US financial market stability, reduce lending and hurt Main Street businesses and small banks. This is why European and Asian governments have refrained from including similar provisions in their derivatives proposals.

The provision, in its current form, would not just preclude banks from trading and speculating with derivatives, it would limit the ability of banks to manage their own interest rate risk – a risk that arises naturally from taking deposits and making loans.

Failure to properly manage interest rate risk was a key contributor to the savings & loan crisis more than two decades ago. Banks that do a large amount of lending usually have a correspondingly large book of hedges - trades that reduce or eliminate the associated interest rate risk; however, Section 716 would put a ceiling on the amount of hedging a bank could do.

As such, the financial stewards of our banking system have roundly criticised Section 716 as one that would harm – not strengthen – US financial market stability. Fed Chairman Ben Bernanke notes, “Forcing these activities out of insured depository institutions would weaken both financial stability and strong prudential regulation of derivatives activities.” FDIC Chairman Sheila Bair adds, “One unintended outcome of this provision would be weakened, not strengthened, protection of the insured bank and the Deposit Insurance Fund.”

Spinning off swaps desks would require banks to raise massive amounts of capital – over $200 billion according to one estimate. Moreover, though market participants acknowledge that capital requirements may need to be increased to reflect lessons of crisis, the derivatives legislation already grants regulators sweeping authority to do so absent Section 716. To the extent capital requirements are currently inadequate to cover the actual risk of loss, they should rightly be increased. However, we must be careful and not arbitrary in our approach, as such funds would be directly subtracted from lending and could work at cross-purposes to our economic recovery.

Proponents have argued that this cost is worth bearing. They say that banks that engage in risky activities like swaps should cease to enjoy the implicit subsidies provided through government programs like deposit insurance and access to emergency funds at the Fed.

While attractive on its face, this analysis fails upon closer scrutiny. Though politicians have suggested that derivatives were “central to the crisis,” the data suggests otherwise. Less than 4 per cent of financial institution losses during the credit crisis resulted from derivatives. In fact, there were eight classes of financial products that contributed to financial institution losses to a greater extent than derivatives. The biggest contributor was actually the most basic of all banking products – loans, which have produced 10 times more losses than derivatives. The banking crisis was thus not chiefly a derivatives problem – it was a lending problem.

Main Street businesses, which represent less than 10 per cent of the OTC derivatives market, will also be harmed by this provision. In addition to facing an increasingly constrained lending environment, such businesses, which did not contribute to the financial crisis, will be saddled with paying banks a healthy return on the capital set aside to create these swaps spin-off entities. Further, derivatives legislation aimed at reducing counterparty risk would ironically result in weaker trading partners for businesses. Chairman Bair observes, “By concentrating the activity in an affiliate of the insured bank, we could end up with less and lower quality capital, less information and oversight for the FDIC, and potentially less support for the insured bank in a time of crisis.”

Additionally, absent changes signalled this week by Senator Lincoln, well over 100 small and mid-sized banks will have cause to shut down – not spin-off – their swaps desks. These banks primarily offer swaps to their commercial customers, not to generate a significant source of revenue, but as a way of meeting customer demand for risk management products and competing with the big banks in their communities.

Because derivatives are not a large source of revenue for these banks, they are unlikely to bear the expense of capitalizing new swaps entities. This will make their commercial lending businesses less competitive against the big banks; it will leave their commercial customers with fewer hedge counterparties, and those that remain will face less competition, ultimately leading to higher rates.

However, the harmful impact of the bill extends well beyond small banks. Large US banks will also be competitively disadvantaged when squaring off against foreign banks. In fact, European and Asian banks – many of which have been operating in the US for years – will quickly fill the vacuum created by the diminished competitive capacity of US banks, ultimately ceding the US’s global leadership in offering this critical tool for minimising business risk. Mr Bernanke emphasised this point when he noted, “Foreign banks will have a competitive advantage over US banking firms in the global derivatives marketplace, and derivatives transactions could migrate outside the United States.”

Problems revealed by the credit crisis necessitate improvements to the derivatives market. Indeed, many mechanisms already in the bill address shortfalls in transparency and collateralisation among systemically risky financial institutions. But improvements should target the problems and be carefully measured against their impact on our economy. Rather than targeting real problems, Section 716 has served to distract attention from parts of the bill that merit serious public policy debate.

More than a century after the mongoose was introduced to the Hawaiian Islands, its lessons remain valuable. At the very minimum, before seizing on purported solutions like Section 716 that have been subject to little public scrutiny and that have potential to seriously harm our economy, we should, as the author suggests, “first learn more of the nature of the creature, for [it] may prove an evil.” Still further, we should call this provision what it really is – a mongoose that will damage, not fix, our economy.

Luke Zubrod is a director at global interest rate and currency risk management advisor Chatham Financial, an advisor to over 1,000 end users of derivatives.

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