Friday, December 04, 2009

Credit-Default Swaps Solution For Too Big To Fail?

"Too Big to Fail" refers to the idea that our government cannot allow the large, highly interconnected financial institutions to fail because as one goes, so do the rest. This would result in economic disaster.

The most dangerous legacy of the financial crisis is the perception that some institutions are too big to fail. This perception distorts competition and the allocation of capital, favoring risk-taking and incubating the conditions for the next crisis. Ignoring the problem will only make it bigger. Intelligent regulation is essential. We have proposed a new market-based capital requirement system that we believe is superior to current regulatory proposals.
Well, what if the "tools for the fix" can be found inside the banks themselves? The following article, How the Tricks That Crashed Wall Street Can Save the World propose the following:
There is a way forward, beyond new regulators, new requirements, and new rules, for the banks to figure out how to skirt. An intervention mechanism centered within banks and reliant on market signals will work much better than a Washington edict. And we believe such a system is possible to create and put in place.

The way to do it, contrary though it might seem, lies in the much-maligned credit-default swaps (CDSs), which are like insurance policies against a loan defaulting and whose value rises as the chance of failure increases. When these contracts are traded on an exchange that ensures that they are properly collateralized, they provide a daily assessment of the risk of a loan's default. Our idea is to use this timely information to monitor banks.


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