Derivatives Are Inherently Destabilizing for the Financial System Because they Increase Interconnectivity

Many smart people have said that credit default swaps destabilize the financial system. See this and this.

But there is yet another reason – one perhaps even more fundamental – why CDS are inherently destabilizing to our economy.

Remember, one of the reasons that AIG, Goldman Sachs, JP Morgan, and Bank of America have been labeled “too big to fail” is that they are highly interconnected. In other words, mainstream economists believe that their interconnectivity means that a failure of any one of them could bring down the whole system.

For example, Paul Volcker told Congress last week that the approach proposed by the Treasury is to designate in advance financial institutions “whose size, leverage, and interconnection could pose a threat to financial stability if it failed.”

Systems expert Valdis Krebs points out (as does Frontline) that the higher the interconnectivity of financial institutions, the more vulnerable the financial system.

Stephen G. Cecchetti – Economic Adviser and Head of the Monetary and Economic Department for the Bank for International Settlements – agrees that interconnectivity is one of the factors which leads to financial instability.

And as the New York Times pointed out earlier this month, derivatives increase the interconnectivity of banks:

Derivatives drove the boom before 2008 by encouraging banks to make loans without adequate reserves. They also worsened the panic last fall because they inherently tie institutions together. Investors worried that the collapse of one bank would lead to big losses at others.

CDS tie the financial giants together with each other, with smaller banks, with other types of financial institutions, and with national, state and local governments. They therefore inherently destabilize the financial system.

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