Banking is a very tricky business because modern finance has specialized to the degree that it is no longer as simple as when the bank held the savings of the community, and lent it to businessmen. A financial institution is a small piece of a long list of specialists from saver to investor and back again, involved in one or more of the following: origination, underwriting, repackaging, custodian, and warehousing of both sides of the transaction. Its basically like the molecular biology of a cell: there are many important, complicated processes going on, and details matter a great deal.
Further, because financial contracts have virtually zero marginal costs, sometimes an inflated 'face value' arises because it is easier to keep adding offsetting ones, rather than extinguishing some and starting over, the way a futures open interest works. The reason why derivatives are not transparent is that they come in some many different flavors they escape any reasonably finite taxonomy--they are 'over the counter' and thus have idiosyncratic terms.
So when Tyler Cowen makes his bold opinion on the current banking crisis, by saying we should apply capital requirements to derivatives, such a proposal leaves innumerable questions that will make regulation almost surely miss its mark. But first, Cowen seems to think regulation is a reasonable quid pro quo for guaranteeing these guys. But the bail out of Bear Sterns was not an obligation of the Fed. Unlike the S&Ls this is like bailing out Long Term Capital management. They were afraid of the contagion effects. If the Fed decides to impose regulations on derivatives for everyone, not just those institutions currently regulated by the Fed, what a huge power grab by an already overextended institution. Remember when Thatcher remarked to Gorbachev that it was nice that she didn't have to decide how much, and at what price, steel was going to be. Competitive markets decentralize what are really very difficult questions that no one person should have to answer (hmm, maybe they should read more Hayek at George Mason). But lets say we are going to do it, because Federal regulation of the energy, education, and drugs has been so successful.
How much capital for derivatives? Good question. Should it be weighted by risk? If so, how does one measure risk? Considering that risk is a function of the collateral, which comes in many different flavors (traded debt, pools of mortgages, pools of bank lines), and then are structured very differently, with differing levels of subordination, differing rules for the waterfalls of cashflows depending on various metrics of collateral quality. It's a mess. If you think market participants are confused, make it a political issue, so not only do you have to explain this to dunderheads like Hillary, Nancy, and Dennis, but then you have to expect them to add something like the Community Reinvestment Act, so disabled lesbians of color can start lobbying for more equity (i.e., loans given out the way Huey Long gave out construction contracts).
You may think this is no different than regular lending, but you would be wrong. For example, lets say you have two swaps, but they both offset each other almost exactly for interest rate risk, but as they have different counterparties, they have differing credit risk. How about swaps from the same counterparty, but differing interest rate exposures, partially netted. How much should capital be netted? And if the US banks have capital requirements greater than economically necessary, how many seconds before all swaps would move offshore?
If something is too complicated for the market, it goes double for government. And as finance is really about contracts, ideas, it doesn't have to put up with heavy handed regulation, especially when New York is not the origin of the capital (we aren't capital suppliers). London, Hong Kong, or Tokyo would be glad to pick up the slack. As it stands now, mortgage regulation has led to loan documents where you have to 'sign here' about 15 times, and you still have to pay several ridiculous processing fees that look like your phone bill and add about $500 too much to these things, and in the end, no one reads all those 15 things they initial and sign (which are helpfully put in 8-point font because we at least want to save trees, and no one even pretends to read them). A couple more pages to initial and ignore, perhaps? They can't even get rid of mandatory title insurance which is way overpriced, and other antiquated parts of the process.
Tyler has the seemingly reasonable but totally naive recommendation of someone from 30,000 feet, which given the breadth of things he comments on, is unsurprising.
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