Wall Street's derivatives casino: is today's eerily tranquil scene an illusion?

• Author: Whalen, Christopher

In the dog days of August, the House Committee on Financial Services tentatively announced hearings regarding the long-delayed implementation of the New Basel Capital Accord or Basel II. In a letter, some legislators asked that U.S. bank regulators hold off on issuing a new rule for public comment regarding Basel II until after the hearings, but the Federal Deposit Insurance Corporation board did the right thing, ignored the request, and approved the proposal for public comment.

In the hearings on Basel II on September 14, 2006, various representatives from regulatory agencies and the banking industry held forth on the pros and cons of the proposal. Though the regulators tried to present at least the appearance of a united front, the differences in their recommendations for implementing Basel II made clear that the New Capital Accord still has a long way to go before it will be adopted in the United States. FDIC Chairman Sheila Bait summarized the situation:

"As the U.S. banking and thrift agencies proceed with the deliberative process for implementing Basel II, it is important that the new capital framework does not produce unintended consequences, such as significant reductions in overall capital levels or the creation of substantial new competitive inequities between certain categories of insured depository institutions. In this regard, there clearly remain several outstanding issues with the proposed rule."

One of the "unintended consequences" Bair probably was not thinking about when she made that statement was the extent to which the easy money policy followed by the Federal Open Market Committee between 2000 and 2003 has created a vast speculative bubble in markets from real estate to credit derivatives. Fact is, regulators, legislators, and even bankers themselves feel an increasing sense of urgency regarding Basel II, if for no other reason than there are so many other pressing issues requiring attention--issues which the delay of Basel II implementation in the United States has effectively blocked.

Important as Basel II may be to the banking industry and to the U.S. national interest, the approaching trough in the U.S. economic cycle is stoking concerns about credit quality and collateral values. Among the issues which top of the list for the financial services industry is the generic question of how to get better counterparty risk data, especially for hedge funds and other organizations involved in Complex Structured Financial Transactions (CSFF) and Over-the-Counter (OTC) derivatives.

In September, a principal from one of the largest hedge funds involved in credit derivatives told an audience of professional risk managers that in 2007 and 2008 there will be a serious shakeout among hedge funds, broker dealers, and banks involved in creating credit derivatives and CSFFs. The reasons cited for this grim view: poor credit risk practices by the major derivatives dealers and even more deplorable deficiencies in valuation methods. The...