The Federal Reserve Bank of Texas has come out with a robust challenge to Warren Buffett's recent claim that derivatives are weapons of mass destruction, deeming them instead "instruments of financial reconstruction." Thomas Siems, senior economist and policy advisor in Dallas, who co-authored the study into banks use of derivatives, argues free market policies instituted in the 1990s have promoted innovation and effective risk management systems among banks and derivatives have played a vital role within these systems. "Rather than being financial weapons of mass destruction, derivatives instead may be viewed as instruments of financial reconstruction," Siems quipped, rephrasing Buffett's statement in Berkshire Hathaway's annual report last month.
The banking sector's resilience to the current economic downturn is a tribute to the success of risk management systems, which when partnered with better disclosure as is being encouraged by the Basel Committee, shows greater government control over derivatives is unnecessary, according to Siems. While many banks use derivatives as a means of risk mitigation, provincial banks in areas such as Texas remain shy of the instruments and are concerned by negative press. It is important that the ability to use derivatives not be taken away by reactions to failed institutions who have made bad bets, he stated.
While previous recessions have been marked by widespread fear of large banks heading into receivership, the current downturn has not yet provoked similar fears, observed one New York-based derivatives attorney. The use of derivatives in distributing bank balance sheet risk may have played some part in this, he observed. It is, however, not yet fully transparent where the risk has been transferred, or how concentrated the risk holders are.
Henry Hu, in the Allan Shivers chair in the law of banking and finance at the University of Texas at Austin School of Law in Austin, Texas, said that any evaluation of derivatives should look at their benefit for the financial system rather than for individual end users.
