Derivatives Are Inherently Destabilizing for the Financial System Because they Increase Interconnectivity

Many smart people have said that credit default swaps destabilize the financial system. See this and this.

But there is yet another reason – one perhaps even more fundamental – why CDS are inherently destabilizing to our economy.

Remember, one of the reasons that AIG, Goldman Sachs, JP Morgan, and Bank of America have been labeled “too big to fail” is that they are highly interconnected. In other words, mainstream economists believe that their interconnectivity means that a failure of any one of them could bring down the whole system.

For example, Paul Volcker told Congress last week that the approach proposed by the Treasury is to designate in advance financial institutions “whose size, leverage, and interconnection could pose a threat to financial stability if it failed.”

Systems expert Valdis Krebs points out (as does Frontline) that the higher the interconnectivity of financial institutions, the more vulnerable the financial system.

Stephen G. Cecchetti – Economic Adviser and Head of the Monetary and Economic Department for the Bank for International Settlements – agrees that interconnectivity is one of the factors which leads to financial instability.

And as the New York Times pointed out earlier this month, derivatives increase the interconnectivity of banks:

Derivatives drove the boom before 2008 by encouraging banks to make loans without adequate reserves. They also worsened the panic last fall because they inherently tie institutions together. Investors worried that the collapse of one bank would lead to big losses at others.

CDS tie the financial giants together with each other, with smaller banks, with other types of financial institutions, and with national, state and local governments. They therefore inherently destabilize the financial system.

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  • Charles D

    Perhaps the real danger does come from the interconnectedness of the TBTF financial institutions, but from the fact that they are also highly interconnected with the legislative and executive branches of the federal government. The more highly interconnected these institutions are with the government, the more vulnerable the government. They not only destabilize the financial system, they destroy what's left of our democracy.

  • Tom Hickey

    I don't think that the problem is as much with derivatives as with size and interconnectedness, which lead to system risk. Even without derivatives, this risk continues to exist with size and interconnectedness. There are a number of factors involved that others have pointed out that need to be addressed in addition to derivatives. Outlawing derivatives would not cure the problems of the financial system by itself. Derivatives are just one symptom of the excessive leverage that continues to infect the financial system. What is unsustainable cannot continue forever, and the boundary has been met.Should derivatives by banned outright? I am hardly literate in this field but from what I can determine, the problem is not so much with derivatives per se but with the way they are employed. It seems that derivatives have some useful financial functions that can offset risk concentration but only by creating other counter-party risk, just as insurance. For example, an insurance company distributes risk, but this is only useful to the degree that its actuarial strategy is competent and prudent to calculate risk correctly. Even this doesn't compensate for uncertainly (unknown unknowns) like natural disasters and wars. Therefore, insurance companies limited their liabilities with escape clauses.Certainly, action could be taken to limit the exposure created by derivates while preserving their useful aspects. Instead of outlawing derivatives completely, the authorities should be working to obviate system risk, which leads to moral hazard (and vice versa). This means limiting banking to fiduciary relationships, breaking up institutions too big to fail based on anti-trust legislation, ensuring transparency, enforcing best accounting practices, prosecuting fraud and misrepresentation, and the like. One of these reforms would be creating a proper marketplace and rules like capital requirements for derivative trading that would eliminate systemic risk through interconnectedness.

  • funkalunatic

    If I understand correctly, I think it would be more precise to describe it as "interdependence" than "interconnectedness".

  • Tom Hickey

    Cam Hui proposes an interesting solution — return to partnership banking. We need genuine market accountability if the regulators aren't going to do there job and the government is going to circumvent accountability when the chips are down.