In addition to their normal uses in portfolio diversification or risk reduction, derivatives can be used to increase risk—one side of the deal may be speculating. In weakly regulated, undercapitalized financial systems, derivatives provide a perfect opportunity for financial intermediaries to acquire risky positions in attempts to recover capital. This section will show how derivatives such as those in the examples developed earlier can be used to escape prudential regulation and capital controls.
Evading Prudential Regulation
Prudential regulations of varying stringency are well-accepted across different financial systems, but they are especially important in the presence of large capital inflows. Such inflows, in particular, increase the potential to have systemic failures in the financial sector because of the rapid expansion of bank balance sheets into unfamiliar business. If capital suddenly flows into a country in quantity, there will be a general expansion of the financial system and investment projects; and it is not clear that a large fraction of the investments will be placed in “good” projects.
There is a belief among regulators and academics that the inflows are often the results of various investment fads-ultimately, investor disappointment over the payoffs from these investments will lead to an attempt to withdraw them. Therefore, regulations are imposed— such as reserve requirements, limits on lending to individuals, firms, or sectors, liquidity requirements against domestic or foreign exchange liabilities, net foreign currency exposure limits, capital requirements, etc.—which aim at channeling inflows away from banks and risky projects. Similarly, a ban on holding securities on margin or on short sales will mean that equities holders will not be forced to join the general scramble for cash in a liquidity crisis and thereby reduce the potential magnitude of the demand for cash. Nevertheless, bans on margin buying tends to push such activity offshore, through over-the-counter derivative markets. payday loan consolidation
Banks can readily avoid regulations either in a straightforward manner or by going offshore or engaging in off-balance sheet activities, which violate the intent, if not the letter, of regulations. We will examine how structured notes and equity swaps can be used to avoid such regulation.