BUSINESS
01/21/2014 03:45 pm ET Updated Jan 25, 2014

Banks Could Still Blow Up The World

Big banks are perfectly safe these days, unless you count all those weapons of mass financial destruction they've got lying around. And who's counting those? Certainly not the banks.

Some in Washington are doing a premature victory dance over the relatively gentle new regulations that have been applied to Wall Street since the financial crisis. But the job of regulating one of the of central causes of that crisis -- the trading of derivatives -- is far from finished.

The world's biggest banks still can't fully account for all the risks they're taking when they trade derivatives, according to a report last week by a group of 10 of the world's financial watchodgs, including the Federal Reserve.

Derivatives, in case you don't know, are essentially side-bets that banks and hedge funds and other investors make with each other on the prices of things trading in other markets. These other things include everything from corn prices to subprime mortgages. Sometimes derivatives are helpful ways to buy insurance against wild price swings (see corn futures, for example). Sometimes they're dangerous ways to feed Wall Street's addiction to obscene bonuses (see subprime mortgage-backed securities, for example). Sometimes they're both!

Though banks these days aren't trading too many subprime mortgage-backed securities -- the derivatives that blew up the world last time -- they're still trading plenty of other such stuff, including the credit-default swaps that recently cost JPMorgan Chase $6 billion in the London Whale debacle. Even years after the crisis, JPMorgan didn't see that one coming.

And JPMorgan is probably not alone, according to this new regulatory report. Heck, banks can't even always identify who's on the other side of their trades -- which, as you can imagine, is somewhat vital information.

"Five years after the financial crisis, firms' progress toward consistent, timely and accurate reporting of top counterparty exposures fails to meet supervisory expectations as well as industry self-identified best practices," the regulators wrote.

English translation: Banks still aren't doing a good job of understanding what could happen to them when derivatives -- what Warren Buffett once called "weapons of mass financial destruction" -- go horribly wrong. In fact, they're doing such a bad job of it that they don't even live up to the lax standards the banks have set for themselves.

Why do we care about this? Because the financial crisis got really ugly during the Lehman Brothers meltdown when banks suddenly realized they didn't understand just how exposed they were to huge losses on derivatives trades with Lehman and others. That led to a panic that caused global financial markets to basically shut down for a little while, in what was the worst crisis since the Great Depression.

And it could happen again, given that the problems still have not been solved.

"On derivatives, the global financial system was flying blind," Francesco Guerrera, financial editor of The Wall Street Journal, wrote on Monday. "It still is, albeit less so, according to the 10 regulators."

As Guerrera pointed out, the same regulators that Politico recently declared won a "blowout" victory over Wall Street are still "fairly toothless" when it comes to making banks keep track of their derivatives trades. Banks, in what has become a standard refrain, moan that it is too costly to keep up with all the pesky paperwork required.

And yet banks have spared no expense in trying to keep derivatives trading as hard-to-follow as possible. That's because banks find it easier to make money in opaque markets -- even if it means risking the occasional financial crisis.

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