For once I agree with Nobel Laureate and New York Times columnist Paul Krugman. He writes that the bill sponsored by RPCV Senator Chris Dodd to put controls on previously unregulated parts of our financial system, principally trade in derivatives, now coursing its way through the Senate, errs in calling for an end to “too big to fail” financial institutions. This was the rationale used by the Feds to inject massive amounts of public funds into large banks and other financial institutions in 2008 whose collapse would bring down our entire financial system. The bill speaks of limiting the size of banks so that they cannot become “too big to fail,” i.e. their very size means that the Feds will be forced to salvage them again in the future.

Krugman says this is not necesary. He notes that the Great Depression came from many smaller banks failing, not from large banks collapsing. He says that no matter what the invidividual size of the bank in trouble, there can be cases again where the Feds will have to shore them up.

Krugman goes on to say that the focus of the new financial regulation bill should be on the nature of the investor (read bank) and the transaction itself. He says that the bill must extend current bank controls to “shadow banks” or the financial entities created to deal in derivatives. We must also control the transactions themselves, with a limit on “leverage” being the key concern. Leverage here means the ratio of the investor’s asset base to his borrowing to buy more assets.

I fully agree with Krugman on all his points. However, I would add that I believe the main goal should be to make trade in derivatives fully transparent, i.e. buyers know exactly what the derivative is with full details, prices offered and paid must be completely visibile on a market similar to those for stocks and bonds, the condition of the buyer and the seller will be known, as well as the amounts of credit used for the sale. Represenative Barney Frank, who already managed to get the House of Represenatives to adopt the companion bill as law, stated this goal elequently by saying, “we will make all trades in derivatives fully transparent.”

While we can debate what should or should not be in the Senate bill that, when adopted, will be blended with the House bill, the main question will not be directly addressed in the law itself. This key question is, “will the new controls act to kill trade in derivatives all together?” Will investors want to buy these assets with new rules in place?

One of the few people on this planet who can offer a valid answer to this key question is our loyal reader, Dennis Grubb, who has spent the last decade or so creating derivative markets in emerging economies. So Dennis, what say you?