Protecting the Subsidy

So the fight over leadership of the House Financial Services Committee has begun with an attack on Dodd-Frank, particularly with the claim from Spencer Bachus, one of men who would be chair, that Dodd-Frank would cost the US derivatives industry more than $1 trillion, and drive everyone to London and Zurich -- assuming the regulators in those jurisdictions are siting on their hands, which seems unlikely, but I digress.

The $1 trillion figure comes from ISDA, the industry group that is not particularly known for its measured, balanced approach to derivatives policy. But that's not really the issue -- after all, as long as we acknowledge what ISDA's goals are, they can't really be faulted for pursuing them with great vigor.

But if we're going to embrace ISDA propaganda press releases wholesale, we should at least get the facts straight and understand what is being asserted.

The actual press release states that Dodd-Frank could cause US companies to incur "$1 trillion in capital and liquidity requirements," which is somewhat different than incurring $1 trillion in cost or taking $1 trillion "out of the economy," which is what Representative Bachus is quoted as saying.

ISDA's $1 trillion figure includes $400 billion in additional collateral. There is some opportunity cost in tying up a company's money in a collateral account, but the cost is not equal to $400 billion. The remainder of the $1 trillion comes from $370 billion of additional credit capacity that companies will need to comply with the Dodd-Frank rules. Again, additional credit capacity has a cost. But $370 billion in extra capacity does not cost $370 billion, just like having a $100,000 credit limit on your Visa card does not cost you $100,000.

You may also notice that $400 billion plus $370 billion does not equal $1 trillion. The remainder comes from additional collateral that would have to be posted if the derivative markets were to return to their pre-Lehman size. If ISDA is somewhat hesitant about including this extra $230 billion, I'd suggest Representative Bachus proceed with caution.

But misstating the press release is only part of the problem. The other question is how much of this extra $770 billion in additional collateral and credit simply replaces an implicit subsidy from the US Treasury? For example, if financial institutions have heretofore avoided posting collateral because the Treasury implicitly stood behind these institutions, inflating their credit ratings and supporting their ability to perform on their swaps -- see, AIG -- then the overall cost of putting up collateral is actually less than the opportunity cost of tying up the money as collateral. Instead, the net social cost is the opportunity cost less the cost of the subsidy that the government will no longer provide.

Big financial institutions can bemoan the loss of this subsidy, but their cost in this regard is a net gain to the average taxpayer. And we should call a spade a spade.