Streetwise Professor

Can you say that any more?  Well, even if use of the word “retarded” is increasingly frowned upon, there are some special cases in which its use is so evocative, and hence so appropriate, that it should be blessed.

The compromise on the Lincoln amendment is one such case:

The bill also includes a provision, authored by Sen. Blanche Lincoln (D., Ark), which would limit the ability of federally insured banks to trade derivatives. This provision almost derailed the bill following vehement objections from New York Democrats. Ms. Lincoln worked out a deal in the early hours of Friday morning that would allow banks to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk.

Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.

Under any modern understanding of what “risk” means, this makes no sense.  Ever heard of diversification, or the fact that “risk” of a particular position is attributable to its contribution to the payoff distribution of the entire portfolio of risks, not anything inherent to the position itself?  (Meaning that even if energy prices are volatile, doing energy swaps may not be that risky in a portfolio context.)  Under any modern understanding of the economics of financial intermediation (in which information about counterparties is vital) this makes no sense either.  (Meaning that the costs of intermediation are lower if information obtained in trading one instrument with a counterparty can be used when dealing in other instruments.)  Under any modern understanding of counterparty risk, where maximizing netting opportunities can be quite valuable, this makes no sense; splitting up businesses in an arbitrary fashion like this reduces scope economies from netting and other things.  It also makes no sense even on its own terms, because yes, banks use interest rate and credit derivatives to manage their own risks, but from my understanding of the provision, banks will still be able to be dealers in these products, and the whole basis of Lincoln’s proposal (to the extent that it had one) is that dealing is a particularly risky activity.  Not that I am buying into that argument; I’m only pointing out that is that’s what you believe, this provision is contrary to that belief.

This is transparently a compromise to save the face of a senator in over her head, who made a wild legislative proposal to stave off a primary challenge.  The banks were willing to throw a couple of bones in order to save their biggest books; metals, energy, and ags are small potatoes compared to interest rates and credit.  Lincoln gets to do what senators do best–pose.  The banks largely escape major damage.

Even by sausage making standards, this is revolting.  It is good that the most egregious parts of the Lincoln proposal have been jettisoned.  It is bad news, however, for liquidity and hedging in the disfavored products, especially commodities.  This, along with the position limit measure in the bill, and the clearing mandate, will increase the costs of managing commodity price risks in particular.

All pain, no gain: the only thing that can be said is the pain could have been a lot worse.