CAMBRIDGE – Last month, the United States Congress succumbed to Citigroup’s lobbying and repealed a key provision of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act: the rule that bars banks from trading derivatives. The Dodd-Frank law’s aim was to prevent another financial crisis like that of 2007-2008; the repeal reduces its chances of success.
Derivatives are contracts that derive their value from changes in a market, such as interest rates, foreign-exchange rates, or commodity prices. Banks can use derivatives to hedge risk – say, by ensuring that oil producers to which they lend lock in today’s prices for their product through derivatives contracts, thereby protecting themselves and the bank from price volatility. The borrower is thus more likely to be able to repay the loan, even if its product’s price falls. But derivatives can also be used for speculative purposes, allowing banks to take on excessive risk.
The last crisis originated in the real-estate market, following a large and unexpected decline in home prices. It then spread to financial institutions that could not cope with the losses associated with mortgage delinquencies, foreclosures, and the depreciation of housing-related securities. Derivatives exacerbated the crisis, particularly after the portfolio of the bankrupt Lehman Brothers, then the world’s fourth-largest investment bank, was liquidated. The next day, the US government had to extend an $85 billion bailout to American International Group (AIG), the world’s largest insurer, owing to its inability to back up its deteriorating derivatives position. These failures disrupted worldwide derivatives markets, causing financial markets to seize up.
The Dodd-Frank rule that Congress just repealed, known as the “swaps push-out rule,” would have required that most derivatives-trading activities occur outside of government-insured banks. If a bank fails, the government stands behind most deposits. Though it does not formally guarantee anything else, it usually finds it easiest and quickest to bail out the entire bank – including its derivatives facility. If, however, derivatives are no longer embedded in the guaranteed bank, the government could more easily bail out a bank, while leaving the derivatives subsidiary to fend for itself.