Books

Derivatives The Wild Beast of Finance

Alfred Steinherr

Wiley, New York, 1998, xvii + 430 pp., $79.95 (cloth).

Alfred Steinherr's book is a well-written, clear, and nontechnical treatment of derivatives markets. It grew out of a paper he co-authored with David Folkerts-Landau (the former head of the IMF's capital markets group), which won first prize in the 1994 AMEX Bank Review competition. The book focuses on the rapid growth of the derivatives markets (particularly the over-the-counter segment), episodes of financial distress caused by misuse of derivatives, the systemic risks that such episodes can raise, and the associated policy implications. Steinherr's book is timely, in view of the role of derivatives and off-balance-sheet activities in the mature markets turbulence experienced in September-October 1998 (described in Chapter III of the IMF's World Economic Outlook and International Capital Markets Report: Interim Assessment, December 1998) and the recent focus by policymakers on the activities of institutions that use such instruments. While derivatives markets are one of the more technical areas of finance, the boxes, glossary, and extensive footnotes and references make the book accessible to general readers.

The book, which has four major sections, begins with some historical perspective and background, including a discussion of the key functions of financial markets, the "Americanization" of finance (that is, increased reliance on liquidity and trading of credit), and a description of some well-known episodes of financial distress associated with derivatives (such as the collapse of Barings). It then describes derivatives markets in detail, including their use in risk management, their economic functions, and the different mechanisms for trading derivatives (over the counter versus exchange traded). The third section discusses policy issues, including systemic risks from derivatives and whether the current policy structure is adequate to manage such risks, and suggests some policy options to deal with gaps in the current policy structure. The final section makes some predictions about the future evolution of derivatives markets.

The centerpiece of the book is the third section, which covers public policy issues. Steinherr argues that the growth in derivatives activities and the concentration of such activities in a relatively small number of institutions have heightened systemic risk. In his view, traditional financial regulation-oriented toward institutions and balance sheets, rather than functions and risks-has not kept pace with these developments. In addition, alternative approaches (the "internal models" approach, which employs banks' own estimates of their risk profile to set capital, and the "precommitment approach," under which a bank faces a penalty if its capital falls below a target level) have their own shortcomings.

Steinherr offers an alternative approach, which would combine improvements to the financial infrastructure-in particular, the use of clearinghouses or organized exchanges to handle the risks that are now traded in over-the-counter contracts-and a new regulatory framework covering all financial institutions and focusing on functions rather than institutions. This new framework would also rely more heavily than the current one on private risk management and measures to encourage financial intermediaries to internalize risks.

Steinherr makes a strong argument that his proposals would reduce systemic risk and limit moral hazard. Some readers may disagree, however, about the extent to which private risk management and measures to enhance the internalization of risks can substitute for the existing framework of official supervision and regulation. Even the best risk managers acknowledge that there are still important shortcomings in risk management; the current consensus is that internal risk models-particularly models of credit risk-need to be...