VOLCKER AND DERIVATIVES / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( HIGHLY RECOMMENDED READING )

REVIEW & OUTLOOK

JUNE 24, 2010.

Volcker and Derivatives

The end game for financial reform.

Financial reform in the hands of a Democratic Congress is looking eerily similar to health-care reform: Public skepticism is proving to be no brake on the liberal ambitions, and substance is increasingly divorced from the problems Washington claims to be solving.

The bill emerging from House-Senate conference seems less concerned with preventing future bank bailouts than with preventing future bank profits. And if some Main Street companies suffer collateral damage in the drive to reduce Wall Street's over-the-counter derivatives trading, Democrats appear to view them as acceptable casualties.

As early as today, House and Senate negotiators may agree on a Volcker Rule, limiting the risks big banks can take in trading for their own account, as well as a separate set of rules regulating the derivatives trades banks can do on behalf of clients. America doesn't need both.

A Volcker Rule won't be easy to implement but it makes policy sense: limit the opportunities for banks to speculate with federally insured deposits. Combined with high capital standards, this won't lead to perfect outcomes—we're talking about regulation, after all—but it would once again draw a risk-taking line that was crossed too often in 2008.

The other new rules, however, could harm taxpayers and commercial customers more than banks. For taxpayers, the danger comes from Senate plans to force much of the derivatives market through too-big-to-fail clearinghouses. Lead Senate negotiator Chris Dodd has backed a plan to explicitly give these clearinghouses taxpayer assistance in the event they face a liquidity crisis.

The other dangerous idea is to force commercial companies to post additional margin even if they do not speculate but are simply using derivatives to hedge legitimate risks. A recent Business Roundtable survey finds that 90% of large corporations use derivatives and that the average firm would have to tie up 15% of the cash on its balance sheet if subjected to the new margin requirements.

To take one example, Caterpillar might pay a bank to assume the risk of currency fluctuations in foreign markets so that it can focus on making bulldozers. It's possible that, depending on the movements of the dollar against foreign currencies, such a contract will ultimately require Caterpillar to pay more to the bank. Forcing banks to demand more cash up front from such companies is like saying regulators should approve every loan a bank makes, and review every single decision to extend credit.

The theory that derivatives caused the financial crisis also continues to take a beating, most recently from regulation cheerleader Elizabeth Warren. The Troubled Asset Relief Program's Congressional overseer recently put out a report on the government's 2008 seizure of AIG. While the report has its flaws, Ms. Warren explodes the myth that the entire problem at AIG was caused by its credit-default-swap contracts. She explains that it was the housing bets, many of which were made without using CDS, that brought AIG to the brink of collapse.

The message to Congress is to take Volcker but pass on punishing derivatives. Which means we'll probably get the opposite.

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