Law Limiting Bank Use of Derivatives Must Be Carefully Thought Out
April 22, 2010
Derivatives are contracts that are meant to help banks and other financially interested parties mitigate risk, and make money. The classic derivatives contract is when an airline--or a bank that makes lots of loans to airlines--buys a derivative that pays off if oil prices go lower the day after you buy your supply for the next six months.
The new financial reform bill being proposed by Senator Christopher Dodd includes talk of restricting bank use of derivatives, as it should--there can be no doubt that bank foolishness with contracts has been a plague upon the land.
However, savings investors who are concerned about CD rates and savings accounts may not want to cheer too loudly if severe restrictions are placed upon bank use of derivatives. In a global financial system where everything connects to everything else, derivatives can serve as a net underneath the tightrope in certain situations.
If oil prices go up, if gold prices go down, if Goldman Sachs gets sued and that leads to other, more widespread charges against banks--well, suffice it to say that derivative contracts can allow banks to soften the blow of unfavorable events such as these (and a million others).
In that respect, when properly used, banks can use derivatives to actually protect bank deposits from danger.
