It's not owners, but counterparties that keep banks in line

Alan Blinder has an op-ed up at the WSJ asking what to do about crazy Wall Street compensation schemes. He misses a key point: No one ever expected financial institution shareholders to be sophisticated and coordinated enough to properly monitor management decisions. The question is not why owners didn't keep managers from blowing up their firms, the question is why counterparties -- who undoubtedly understood how the game was being played and who was likely to end up eating their risky bets -- were willing to trade with ticking time bombs.

The latest straw man argument against a clearinghouse

Here's the latest argument against a clearinghouse for derivatives. From the wsj:

"It's counter to the goal of reducing systemic risk to put all the risk in one place, if that concentrates the risk of trades in clearinghouse institutions that would be 'too big to fail,'" suggests Mark Brickell, a longtime swaps banker now with an online derivatives platform called Blackbird. "It's also unnecessary. With today's ability to gather information electronically, we don't need to put all the risk in one place. We can just aggregate all the bank information in one place, so that regulators know the exposures of all the firms."

Notice what Mark Brickell is arguing: he states directly that goal is for regulators to have enough information to monitor systemic risk and presumably to use that information to impose capital controls. Earlier in the column, Gordon Crovitz argued:

Derivatives traders would have to report their trades and overall positions to regulators and could have their capital requirements adjusted. This makes sense, though regulators already had access to key derivatives information through banking regulations, with the ability to track cash flow at every bank.

In other words, Brickell and Crovitz are arguing that the goal of policy should be to have a top-down government controlled financial system even though this system has already failed us once.

Crovitz has created a straw man to knock down:

it's surprising that Treasury would create more systemic risk by putting hundreds of billions of dollars in derivatives into concentrated positions at a few clearinghouses. The rationale is that this would make it easier for regulators to gather information, but there are ways to centralize information without centralizing trading risk.

Well, no. The rationale for a clearinghouse is not to make it easier for regulators to gather information. As Crovitz has already remarked, "information" didn't help us in the past and nobody who believes in free markets would expect government regulators to be able to manage the problem of systemic risk -- especially after the current crisis.

The rationale for a clearinghouse is to create liabilities that are the joint obligation of all the members of the clearinghouse. In other words, the purpose of a clearinghouse is to place the responsibility for managing systemic risk where it belongs in a free market system -- in the hands of the banks that are in a position to create and control systemic risk.

Since a troubled clearinghouse can issue a capital call that draws resources from the member banks, the shareholders of all of the member banks can be wiped out before the government steps in to support the clearing house. In other words, while a clearinghouse is indeed “too big to fail”, because its debt is the joint responsibility of the member banks a clearinghouse is an excellent means of aligning incentives, so that regulators don’t actually need to be very attentive. The bank members of the clearinghouse will do their own policing of their fellow members, because the banks themselves will be subject to resolution if they allow the clearinghouse to get into trouble.

It hardly needs to be stated that this is precisely the kind of incentive structure to which we need to return – one where regulators can be sloppy and allow free market incentives to do their work for them.

There's another valuable piece of information that is generated by forcing market makers to jointly guarantee the markets in which they trade: Whenever the banks are unwilling to set up such a joint guarantee, it is a clear indicator that they know there is something rotten in the market. It is precisely for this reason that it is so important to force the derivatives markets into clearinghouses -- because the banks will choose to clean up the markets. The banks will dictate the terms that will make them willing to jointly guarantee the debt.

We need clearinghouses in derivatives markets, because setting them up will align incentives so that the banks choose to clean up their own market practices and do the regulators' work for them. That's what used to be called a free market economy. What Mark Brickell and Gordon Crovitz are advocating for is a socialized bastardization of the free market economy, where banks just run crying to Papa and tell him it's all his fault whenever something goes wrong.