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Note justifying ban on financial derivatives to fix the global economic crisis (2011)

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Note justifying ban on financial derivatives to fix the global economic crisis (2011) - S. Kalyanaraman

The global economic and financial system of the world is broke, principally due to the use of financial derivatives during the last three decades. The broken global economic and financial system can be fixed by banning financial derivatives (euphemistically called securitizations).

US Financial Crisis Inquiry Commission (FCIC) (2008 to 2011) notes in its report (2011) that FCIC was not charged with making policy recommendations but were only required to inquire into the causes of the economic and financial crisis of 2008 in USA. 

It is about time that policy makers of G-8 revisit the Commission's report and draw at least one policy imperative to fix the broken economic and financial system: ban financial derivatives.

Financial derivaties lead only to financial destruction because the quants' work consist of mathematical games. The games are not based on a reality of the need for trading in markets by a study of the underlying assets and because the quants' models do not subject themselves to a clear evaluation by the investor in the marketplace -- of the true value of underlying assets which had been used to create multi-trillion dollars worth of trades on 'financial derivatives' which are clearly bogus mathematical games.

Let us hope that the G-8 political and economic pundits will see the value of the FCIC report and draw the lessons for policy: to ban financial derivatives including puts and calls (called options) in the marketplace.

S. Kalyanaraman, Ph.D.,
Former Sr. Exec., Asian Development Bank,
Director, Sarasvati Research Center
Sept. 10, 2011


Final report of the National Commission on the causes of the financial and economic crisis in the United States was submitted in January 2011 by Financial Crisis Inquiry Commission (FCIC) Chairman Phil Angelides (including 9 other Commissioners)-- (Pursuant to Public Law 111-21) to President Obama. The report also includes the dissenting views of four Commissioners.
http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf Full Report 
http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_conclusions.pdf

From the Preface

...The Financial Crisis Inquiry Commission was created to "examine the causes of the current inancial and economic crisis in the United States." In this report, the Commission presents to the President, the Congress, and the American people the results of its examination and its conclusions as to the causes of the crisis...This report is intended to provide a historical accounting of what brought our financial system and economy to a precipice and to help policy makers and the public better understand how this calamity came to be.

CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION
How did it come to pass that in 2008 our nation was forced to choose between two stark and painful alternatives -- either risk the collapse of our financial system and economy, or commit trillions of taxpayer dollars to rescue major corporations and our financial markets, as millions of Americans still lost their jobs, their savings, and their homes?

The Commission concluded that this crisis was avoidable. It found widespread failures in financial regulation; dramatic breakdowns in corporate governance; excessive borrowing and risk-taking by households and Wall Street; policy makers who were ill prepared for the crisis; and systemic breaches in accountability and ethics at all levels. Here we present what we found so readers can reach their own conclusions, even as the comprehensive historical record of this crisis continues to be written.

...In this report, we detail the events of the crisis. But a simple summary, as we see it, is useful at the outset. While the vulnerabilities that created the potential for crisis were years in the making, it was the collapse of the housing bubble fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008. Trillions of dollars in risky mortgages had become embedded throughout the financial system, as mortgage-related securities were packaged, repackaged, and sold to investors around the world. When the bubble burst, hundreds of billions of dollars in losses in mortgages and mortgage-related securities shook markets as well as financial institutions that had significant exposures to those mortgages and had borrowed heavily against them. This happened not just in the United States but around the world. The losses were magnified by derivatives such as synthetic securities.

The crisis reched seismic proportions in September 2008 with the failure of Lehman Brothers and the impending collapse of the insurance giant American International Group (AIG). Panic fanned by a lack of transparency of the balance sheets of major financial institutions, coupled with a tangle of interconnections among institutions perceived to be 'too big to fail', caused the credit markets to seize up. Trading ground to a halt. The stock market plummeted. The economy plunged into a deep recession.

The financial system we examined bears little resemblance to that of our parents' generation. The changes in the past three decades alone have been remarkable. The financial markets have become increasingly globalized. Technology has transformed the efficiency, speed, and complexity of financing than ever before. And the financial sector itself has become a much more dominant force in our economy.

From 1978 to 2007, the amount of debt held by the financial sector soared from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product. The very nature of many Wall Street firms changed--from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By 2005, the 10 largest U.S. commercial banks held 55% of the industry's assets, more than double the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted 27% of all corporate profits in the United States, up from 15% in 1980. Understanding this transformation has been critical to the Commission's analysis.

... • We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation's financial markets. The sentries were not at their posts, in no small part due to the widely accepted faith in the selfcorrecting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor. 

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Director, Sarasvati Research Center. Former Sr. Exec., Asian Development Bank. Ph.D. in Public Administration.
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