US Senator's plan key to reducing derivatives risk-Stiglitz

NEW YORK, June 9 (Reuters) - U.S. Senator Blanche Lincoln’s proposal to require banks to spin off their derivatives units is key to reducing risk in the $450 trillion, privately traded derivatives markets, Nobel Prize winning economist Joseph Stiglitz said on Wednesday.

The proposal by Lincoln, an Arkansas Democrat, that banks that have access to the Federal Reserve’s emergency lending window be blocked from dealing derivatives, is one of the most controversial elements of a financial regulation reform bill that will be negotiated in Congress this week.

Opposition to the proposal from industry players and some lawmakers has led Democrats to instead discuss toughening a proposal from economist Paul Volcker to limit proprietary trading by banks as a means of also reducing the risk of derivatives.

However, the Volcker rule, though important, addresses different issues and risks to Lincoln’s proposal, and will not remove risks banks dealing derivatives pose to taxpayers, Stiglitz said in a call with reporters.

“Both are needed and that is even true if the Volcker rule is strengthened.”

Privately traded derivatives were blamed for exacerbating the credit crisis due to the web of connections the contracts create between systemically important banks. Derivatives are based on assets such as commodities, bonds or equities or are used to hedge against or bet on changes in foreign exchange or interest rates.

Removing the federal backstop from banks dealing opaque derivatives is key to imposing fiscal discipline on actors in the market, Stiglitz said.

“Because these risky products are effectively being underwritten by the U.S. government they are being provided at a lower price,” he said. “And that makes absolutely no sense.”

The option to access federal funds allows banks to extend greater leverage than they may otherwise offer, and subsidizes pricing on the contracts, said Rob Johnson, director of the economic policy initiative at the Franklin and Eleanor Roosevelt Institute and member of the UN Commission of experts on finance and international monetary reform, who was speaking on the same call.

“Market makers become risk free because of taxpayer subsidies,” causing significant overuse of these instruments, he said. And, “taxpayers bear the risk of the downside, while the private sector benefits from the upside.”

Stiglitz also took issue with arguments that separating derivatives operations from a bank’s backstopped business would curtail their ability to offer clients the ability to hedge exposures, saying banks could offer the same products from separately capitalized derivatives subsidiaries.

Fears that regulations would shift derivative operations from regulated banks to more risky, unregulated players are also unfounded as it assumes the reforms will fail to adequately supervise market players and require enough collateral to back the contracts, he said.

Stiglitz added that lawmakers should ensure that exemptions to companies required to route eligible derivatives contracts into central clearinghouses and onto electronic trading platforms be narrowly applied.

Some industrial companies have sought exemptions from derivatives rules arguing that the cost of clearing contracts they use to hedge business risks would damage their operations.

Around 10 percent of contracts may be exempt under laws currently being proposed, though firms that are not subject to the exemption may seek to expand this to allow around 40 percent of the market to bypass clearing, Stiglitz said. (Reporting by Karen Brettell))