Capital Markets, Derivatives and the Law

capmbookEvolution After Crisis

By Alan N. Rechtschaffen

496 pages

Oxford University Press

Early on in his new book, Alan Rechtschaffen makes the standard observation that although the provision/creation by a central bank of liquidity in times of crisis can get the system through the darkest days, it does raise the issue of moral hazard.

He then illustrates that point with a long quotation from Ben Bernanke, delivered at a conference sponsored by the FRB of Atlanta in May 2008: just after the shotgun marriage of JPMorgan Chase and Bear Stearns, but well ahead of the even more dramatic episodes of that autumn.

If, Bernanke said, “market participants come to believe that the Federal Reserve or other central banks will take such measures whenever financial stress develops, financial institutions and their creditors … have less incentive to pursue suitable strategies for managing liquidity risk and more incentive to take such risks.”

Actually, that (and the rest of the Bernanke passage in which Rechtschaffen preserves it) strikes me as a much understated way of expressing the hazard at issue. Nor am I just saying this because the words came from Bernanke’s mouth and we now view his tenure at the Fed with a certain inevitable hindsight.

An Autobiographical Reflection

Rechtschaffen himself offers a better definition of moral hazard much later in the book, near the end of his chapter 11. Here, too, he defines it not in his own voice but by a quotation. He cites Zachary Gubler, an associate professor at the Sandra Day O’Connor College of Law at Arizona State University, defining moral hazard as the risk observed when “insurance coverage causes a party to engage in behavior that actually increases the likelihood of incurring losses.” Now that sounds like a really ubiquitous phenomenon.

To be blunt, there have been times in my life when, due to my own cash-flow difficulties, I have driven an automobile on public roads without proper insurance for said vehicle, or for my own liability. (Tsk tsk, I know.) And, frankly, I do think I have driven more carefully during those periods than during others when I’ve been properly and lawfully insured.

You might well characterize my own impression of my level of care as subjective. But if I am right on this, then ordinary and state-mandated auto insurance itself imposes a moral hazard, in that I am not now exerting that extra level of care. That is not, by the way, by itself an argument against owning auto insurance. It isn’t even an argument against mandating ownership of auto insurance. It is simply an instance of the general fact that trade-offs are ubiquitous in human existence.

Bernanke’s circumscribed definition of moral hard, the banking-world-only definition that Rechtschaffen uses in his first chapter, doesn’t convey the ubiquity of the phenomenon, and rather circumscribes its importance even where it can’t be denied.

Anyway: Rechtschaffen’s book gets a high-prestige welcome to the marketplace by Jean-Claude Trichet, the former president of the European Central Bank. In a preface, Trichet describes this book as “a remarkable and extremely useful instrument in the hands of professionals.”

Much of the book as a whole is an outstanding example of how the central bankers of the world, the Bernankes and Trichets, view their own recent past, and of the lessons they want the rest of us to draw from it.

Unobjectionable Stuff

There are other portions of the book that are in fact helpful, and that without special pleading set forth the system in place in the U.S. as a consequence of the Dodd-Frank Act and its slowly rolled-out implementation.

In one chapter Rechtschaffen goes into some detail in a lucid explanation of the end-user exception that frees certain swaps from the clearing and exchange requirements of the Dodd-Frank Act, observing in the process that Congress was worried “that American consumers would face higher prices if the cost of hedging for non-financial firms increased.”

Related to this, and possessing a similar rationale, there is the physical settlement exclusion. That is: swaps based on wheat or coal, and settled by actual delivery of the wheat or coal, are generally not used for speculative purposes, but as hedges for market risks, and the legislators didn’t want to punish that, either. This book’s discussion of such points is unobjectionable.

 

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