Monday, November 29, 2010

CFTC Chair Says No Going Back to Originate and Hold World of It's a Wonderful Life

Referencing the holiday movie It's A Wonderful Live, CFTC Chair Gary Gensler said that in passing the Dodd-Frank Act, Congress determined that it is incumbent upon regulators to update to the reality that we no longer live in George Bailey’s pre-derivatives originate and hold time. Rather, federal financial regulators must oversee a banking system, shadow banking system composed of mutual funds and hedge funds, a complex derivatives marketplace and a Wall Street that continue to change and pose new risks. In remarks at the Woodrow Wilson School of Public and International Affairs, he emphasized that the CFTC and SEC don’t have the luxury to turn back the clock, but rather have the responsibility to update their oversight for the financial system of the time.

Chairman Gensler joins a growing and by now overwhelmong consensus that we have ``crossed the Rubicon’’ into originate and distribute securitization and there is no turning back to originate and hold. Indeed, restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis and to the withdrawal of central bank and government interventions. However, no one wants policies that would take markets back to their high octane levels of 2005–07. Thus, the Dodd-Frank legislation aims to put securitization on a solid and sustainable footing and provide for transparency and accountability of the derivatives markets.

When the movie was filmed in 1946, the CFTC Chair noted, 98 percent of bank liabilities were made up of deposits. But today, there are many alternative ways for money and credit to flow through the economy other than banking. There has been explosive growth in shadow or alternative banking, including money market funds, asset backed and mortgage securitizations, government sponsored enterprises, repo and securities lending and open market paper, such as commercial paper. This has all grown to $16.4 trillion, he noted, larger than bank liabilities. That figure does not even include the $1.6 trillion with finance companies, the $1.9 trillion with securities brokers, the $1.8 trillion with hedge funds or the $1.5 trillion in private equity and venture capital, all of which might also be considered part of, up until Dodd-Frank, the largely unregulated shadow banking system that former Fed Chair Paul Volcker warned about.

The changes in how the financial system intermediates money is only part of the story, he continued, as there also have been significant changes in how it intermediates risk. Though risk is intermediated as part of the intermediation of money and credit, it also is done so with the use of derivative contracts. The CFTC Chair explained that derivatives are used by banks and by the alternative banking sector, as well as throughout the economy. Derivatives, and in particular currency swaps, interest rate swaps and credit default swaps, have come to serve important roles in the credit markets as well. Today they are intertwined with many of the client relationships and risks of a bank. Based upon figures compiled by the Office of the Comptroller of the Currency, the largest 25 bank holding companies currently have $277 trillion notional amount of over-the-counter derivatives, he observed, representing more than 20 times these bank holding companies’ combined total assets.

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