{"id":270963,"date":"2024-08-05T12:00:24","date_gmt":"2024-08-05T11:00:24","guid":{"rendered":"https:\/\/www.transcend.org\/tms\/?p=270963"},"modified":"2024-08-05T05:53:13","modified_gmt":"2024-08-05T04:53:13","slug":"how-unelected-regulators-unleashed-the-derivatives-monster-and-how-it-might-be-tamed","status":"publish","type":"post","link":"https:\/\/www.transcend.org\/tms\/2024\/08\/how-unelected-regulators-unleashed-the-derivatives-monster-and-how-it-might-be-tamed\/","title":{"rendered":"How Unelected Regulators Unleashed the Derivatives Monster \u2013 and How It Might Be Tamed"},"content":{"rendered":"

\u201cIt was not the highly visible acts of Congress but the seemingly mundane and often nontransparent actions of regulatory agencies that empowered the great transformation of the U.S. commercial banks from traditionally conservative deposit-taking and lending businesses into providers of wholesale financial risk management and intermediation services.\u201d
\n<\/em>\u2014 Prof. Saule Omarova, \u201cThe Quiet Metamorphosis, How Derivatives Changed the Business of\u00a0 Banking<\/em><\/a>\u201d University of Miami Law Review, 2009<\/p><\/blockquote>\n

4 Aug 2024 –<\/em> While the world is absorbed in the U.S. election drama, the derivatives time bomb continues to tick menacingly backstage. No one knows the actual size of the derivatives market, since a major portion of it is traded over-the-counter, hidden in off-balance-sheet special purpose vehicles. However, when Warren Buffet famously labeled derivatives \u201cfinancial weapons of mass destruction\u201d in 2002, its \u201cnotional value\u201d was estimated at $56 trillion. Twenty years later, the Bank for International Settlements estimated that value at $610 trillion. And financial commentators have put it\u00a0as high as $2.3 quadrillion<\/a>\u00a0or\u00a0even $3.7 quadrillion<\/a>, far exceeding\u00a0 global GDP, which was about $100 trillion in 2022. A quadrillion is 1,000 trillion.<\/p>\n

Most of this casino is run through the same banks that hold our deposits for safekeeping. Derivatives are sold as \u201cinsurance\u201d against risk, but they actually add a heavy layer of risk because the market is so interconnected that\u00a0any failure can have a domino effect<\/a>. Most of the banks involved are also designated \u201ctoo big to fail,\u201d which means we the people will be bailing them out if they do fail.<\/p>\n

Derivatives are considered so risky that the Bankruptcy Act of 2005 and the Uniform Commercial Code grant them (along with repo trades) \u201csuper-priority\u201d in bankruptcy. That means if a bank goes bankrupt, derivative and repo claims are settled first, drawing from the same pool of liquidity that holds our deposits. (See David Rogers Webb\u2019s\u00a0The Great Taking<\/em><\/a>\u00a0and my earlier articles\u00a0here<\/a>\u00a0and\u00a0here<\/a>.) A derivatives crisis could easily vacuum up that pool, leaving nothing for us as depositors \u2014 or for the \u201csecured\u201d creditors who are junior to derivative and repo claimants in bankruptcy, including state and local governments.<\/p>\n

As detailed by Pam and Russ Martens, publisher and editor, respectively of\u00a0Wall Street on Parade<\/em><\/a>, as of Dec. 31, 2023, Goldman Sachs Bank USA, JPMorgan Chase Bank N.A., Citigroup\u2019s Citibank and Bank of America held a total of $168.26 trillion in derivatives out of a total of $192.46 trillion at all U.S. banks, savings associations and trust companies. That\u2019s four banks holding 87 percent of all derivatives at all 4,587 federally-insured institutions then in the U.S.<\/p>\n

In June 2024, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board jointly released their findings on the eight U.S. megabanks\u2019 \u201cliving wills\u201d \u2013 their resolution or wind-down plans in the event of bankruptcy. The Fed and FDIC\u00a0faulted all of the four largest derivative banks<\/a>\u00a0on shortcomings in how they planned to wind down their derivatives.<\/p>\n

How Banks Guarding Our Deposits Became the Biggest Gamblers in the Derivatives Casino<\/strong><\/p>\n

Banks are not just middlemen in the derivatives market. They are active players taking speculative positions. In this century,\u00a0writes Professor Omarova<\/a>, the largest U.S. commercial banks have emerged \u201cas a new breed of financial super-intermediary\u2014a wholesale dealer in financial risk, conducting a wide variety of capital markets and derivatives activities, trading physical commodities, and even marketing electricity.\u201d She notes that the Federal Reserve has allowed several financial holding companies to purchase and sell physical commodities (including oil, natural gas, agricultural products and electricity) in the spot market to hedge their commodity derivative activities, and to take or make delivery of those commodities to settle the transactions.<\/p>\n

It was not Congress that authorized that expansive definition of permitted banking activities. It was the Office of the Comptroller of the Currency (OCC), part of the \u201cadministrative deep state,\u201d that permanent body of unelected regulators who carry on while politicians come and go. As Omarova explains:\u00a0<\/strong><\/p>\n

Through seemingly routine and often nontransparent administrative actions, the OCC effectively enabled large U.S. commercial banks to transform themselves from the traditionally conservative deposit-taking and lending institutions, whose safety and soundness were guarded through statutory and regulatory restrictions on potentially risky activities, into a new breed of financial \u201csuper-intermediaries,\u201d or wholesale dealers in pure financial risk. \u2026\u00a0<\/em><\/p>\n

Moreover, some of the most influential of those decisions escaped public scrutiny because they were made in the subterranean world of administrative action invisible to the public, through agency interpretation and policy guidance.\u00a0<\/em><\/p><\/blockquote>\n

The OCC\u2019s authority to regulate banks dates back to the National Bank Act of 1863, which grants national banks general authority to engage in activities necessary to carry on the \u201cbusiness of banking,\u201d including \u201csuch incidental powers as shall be necessary to carry on the business of banking.\u201d The \u201cbusiness of banking\u201d is not defined in the statute. Omarova writes:<\/p>\n

Section 24 (Seventh) of the National Bank Act grants national banks the power to exercise all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes.\u00a0<\/em><\/p><\/blockquote>\n

No mention is made of derivatives trading or dealing.<\/p>\n

The powers of banks were further limited by Congress in the Glass-Steagall Act of 1933, which explicitly prohibited banks from dealing in corporate equity securities, and by other statutes passed thereafter. However, the portion of the Glass-Steagall Act separating depository from investment banking was reversed in the\u00a0Commodity Futures Modernization Act<\/a>\u00a0in 2000. Omarova writes that this allowed the OCC to articulate \u201can overly expansive definition of the \u2018business of banking\u2019 as financial intermediation and dealing in financial risk, in all of its forms, and \u2026 this pattern of analysis allowed the OCC to expand the range of bank-permissible activities virtually without any statutory constraint.\u201d<\/p>\n

What Then Can Be Done?<\/strong><\/p>\n

The 2008 financial crisis is now acknowledged to have been largely a derivatives crisis. But massive efforts at financial reform in the following years have failed to fix the underlying problem. In a\u00a0Forbes<\/em>\u00a0article titled \u201cBig Banks and Derivatives: Why Another Financial Crisis Is Inevitable<\/a>,\u201d Steve Denning writes:<\/p>\n

Banks today are bigger and more opaque than ever, and they continue to trade in derivatives in many of the same ways they did before the crash, but on a larger scale and with precisely the same unknown risks.<\/em><\/p><\/blockquote>\n

Most of this derivative trading is conducted through the biggest banks. A commonly held assumption is that the real derivative risk is much smaller than the \u201cnotional amount\u201d stated on the banks\u2019 balance sheets, but Denning observes:<\/p>\n

[A]s we learned in 2008, it is possible to lose a large portion of the \u201cnotional amount\u201d of a derivatives trade if the bet goes terribly wrong, particularly if the bet is linked to other bets, resulting in losses by other organizations occurring at the same time. The ripple effects can be massive and unpredictable.<\/em><\/p>\n

In 2008, governments had enough resources to avert total calamity. Today\u2019s cash-\u200bstrapped governments are in no position to cope with another massive bailout.\u00a0<\/em><\/p><\/blockquote>\n

He concludes:<\/p>\n

Regulation and enforcement will only work if it is accompanied by a paradigm shift in the banking sector that changes the context in which banks operate and the way they are run, so that banks shift their goal from making money to adding value to stakeholders, particularly customers. This would require action from the legislature, the SEC, the stock market and the business schools, as well as of course the banks themselves.<\/em><\/p><\/blockquote>\n

A Paradigm Shift in \u201cthe Business of Banking\u201d<\/strong><\/p>\n

In a September 2023 paper titled \u201cRebuilding Banking Law: Banks as Public Utilities<\/a>,\u201d Yale law professor Lev Menand and Vanderbilt law professor Morgan Ricks propose shifting the goal of banking so that chartered private banks are \u201cnot mere for-profit businesses; they have affirmative obligations to the public.\u201d The authors observe that under the New Deal framework, which was rooted in the National Bank Act of 1864, banks were largely governed as public utilities. Charters were granted only where consistent with public convenience and need, and only chartered banks could expand the money supply by extending loans.<\/p>\n

The Menand\/Ricks proposal is quite detailed and includes much more than regulating derivatives, but on that specific issue they propose:<\/p>\n

While member banks are permitted to enter into interest-rate swaps to hedge rate risk, they are not allowed to engage in derivatives dealing\u00a0(intermediation or market making) or take directional bets in the derivatives markets. Derivatives dealing and speculation do not advance member banks\u2019 monetary function. Apart from loan commitments, member banks would not be in the business of offering guarantees or other forms of insurance.\u00a0<\/em><\/p><\/blockquote>\n

Would that mean the end of the derivatives casino? No \u2013 it would just be moved out of the banks charged with protecting our deposits:<\/p>\n

The blueprint above says nothing about what activities can take place outside the member banking system. It says only that those activities can\u2019t be financed with run-prone debt [meaning chiefly deposits]. In principle, we could imagine a very wide degree of latitude for non bank firms, subject of course to appropriate standards of disclosure, antifraud, and consumer and investor protection. So securities firms and other nonbanks might be given free rein to engage in structured finance, derivatives, proprietary trading, and so forth. But they would not be allowed to \u201cfund short.\u201d\u00a0\u00a0<\/em><\/p><\/blockquote>\n

By \u201cfunding short,\u201d the authors mean basically \u201ccreating money,\u201d for example through repo trades in which short-term loans are rolled over and over. In their proposal, only chartered banks are delegated the power to create money as loans.<\/p>\n

Expanding the Model<\/strong><\/p>\n

University of Southampton business school professor Richard Werner, who has written extensively on this subject,\u00a0adds<\/a>\u00a0that banks should be required to concentrate their lending on productive ventures that create new goods and services and avoid inflating existing assets such as housing and corporate stock.<\/p>\n

Speculative derivatives are a form of \u201cfinancialization\u201d \u2013 money making money without producing anything. The winners just take money from the losers. Gambling is not illegal under federal law, but the chips in the casino should not be our deposits or loans made with the backing of our deposits.<\/p>\n

The Menand\/Ricks proposal is for private banks, but banks can also be made \u201cpublic utilities\u201d through direct ownership by the government. The stellar model is the Bank of North Dakota, which does not speculate in derivatives, cannot go bankrupt, makes productive loans, and has been highly successful. (See earlier article\u00a0here<\/a>.) The public utility model could also include\u00a0a national infrastructure bank<\/a>, as proposed in\u00a0H.R. 4052<\/a>, which currently has 37 co-sponsors.<\/p>\n

The \u201cbusiness of banking\u201d can include making money for private shareholders and executives, but that business should be junior to the public interest, which would prevail when they conflict.<\/p>\n

Unfortunately, only Congress can change the language of the controlling statute; and Congress has been motivated historically to make major changes in the banking system only in response to a Great Depression or Great Recession that exposes the fatal flaws in the existing system. With the\u00a0reversal of \u201cChevron deference<\/a>,\u201d however, the OCC\u2019s rules can now be challenged in court. A powerful citizen\u2019s movement might be able to catalyze needed changes before the next Great Depression strikes.<\/p>\n

A financialized economy is not sustainable and not competitive. The emphasis should be on investment in the real economy. That is the sort of paradigm shift that is necessary if the U.S. is to survive and prosper.<\/p>\n

________________________________________<\/em><\/p>\n

\"\"<\/a> Ellen Brown is a member of the <\/em>TRANSCEND Network for Peace Development Environment<\/a>, an attorney, founder\/chairperson of the\u00a0<\/em>Public Banking Institute<\/a>, and author of thirteen books including\u00a0<\/em>Web of Debt<\/a>,\u00a0The Public Bank Solution<\/a>, and\u00a0<\/em>Banking on the People: Democratizing Money in the Digital Age<\/a>.\u00a0Her articles are at\u00a0<\/em>ellenbrown.com<\/em><\/a><\/p>\n

 <\/p>\n

Go to Original \u2013 ellenbrown.com<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

4 Aug 2024 – While the world is absorbed in the U.S. election drama, the derivatives time bomb continues to tick menacingly backstage. Warren Buffet famously labeled derivatives \u201cfinancial weapons of mass destruction\u201d in 2002. Twenty years later, financial commentators have put it\u00a0as high as $3.7 quadrillion.<\/p>\n","protected":false},"author":4,"featured_media":179118,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[40],"tags":[232,354,562,645,176],"class_list":["post-270963","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-transcend-members","tag-capitalism","tag-economics","tag-finance","tag-international-trade","tag-money"],"_links":{"self":[{"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/posts\/270963","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/users\/4"}],"replies":[{"embeddable":true,"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/comments?post=270963"}],"version-history":[{"count":1,"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/posts\/270963\/revisions"}],"predecessor-version":[{"id":270965,"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/posts\/270963\/revisions\/270965"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/media\/179118"}],"wp:attachment":[{"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/media?parent=270963"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/categories?post=270963"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.transcend.org\/tms\/wp-json\/wp\/v2\/tags?post=270963"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}