Actually, the solution to the derivatives dilemma is easy to find and easy to administer. This solution was proposed in 1994 by David Folkerts-Landau, then director of capital markets research at the International Monetary Fund, and Alfred Steinherr of the European Investment Bank. Their essay on the subject won the annual American Express Bank Review brilliancy prize. In terms of the various risks generated by OTC derivative activity, credit risk would be reduced by marking to market with margining, transparency of price discovery would increase, liquidity risk would be reduced by the fungibility of contracts, legal risks would be eliminated under existing laws, and operational risk would be reduced. What is actually happening, unfortunately, is that the central banks, the Bank for International Settlements, and the private-sector Group of Thirty are all looking for ways to reduce the capital that banks must allocate against their derivatives positions.
Central banks are the source of the moral hazard in cross-border banking.
Concerned by the diminishing franchise value of a banking charter, they are virtually without exception eager to help banks try new things that promise higher rewards. To the extent that these rewards are bought by greater risks, they are not real. But like the money illusion at the beginning of inflation, profits from taking positions in derivatives look good early on. It is because the large banks know that the central banks will take care of their liabilities, especially in an international context, that they engage in risky behavior. The violence of the break when trouble occurs is because the market loses faith in the central banks.