Editor's note: Joseph E. Stiglitz, the 2001 Nobel Prize winner in economics, is a professor of economics at Columbia University and former chairman of the Council of Economic Advisers during the Clinton administration. He is the author most recently of "Freefall: America, Free Markets, and the Sinking of the Global Economy."
(CNN) -- As legislators continue to trade loud barbs over the details of the bill that seeks to overhaul our financial system, we risk losing a crucial aspect of reform in the din.
We now have an important opportunity to fix the regulation of derivatives -- those controversial mechanisms that played a central role in the downfall of insurance giant AIG, and helped spark the Great Recession.
The current finance bill contains reasonable proposals, developed by the Senate agriculture committee, under the leadership of Blanche Lincoln, that would rein in the most egregious abuses of these instruments.
The AIG experience should have made clear that derivatives can create enormous risks -- risks that ended up being borne by taxpayers. In addition, derivatives have played an important role in all kinds of nefarious activities -- from trying to obfuscate Greece's real financial position, to vast tax evasion.
Derivatives are not inherently bad. They can play a positive role in risk management, but they are only likely to do that if there is the right regulatory framework.
Without the appropriate legal and regulatory framework, they will almost surely contribute, on balance, to the creation of risk -- as they did in this crisis, and as they did a decade ago in the infamous Long-Term Capital Management bailout.
The provisions reported out of the agriculture committee are an important step in the right direction. But derivatives have been an enormous profit center for a few big banks (about $20 billion last year), so we should not be surprised that there is resistance to anything that is a real change to the status quo.
Derivatives have been advertised as an "insurance product," insuring bondholders, for instance, against the risk of a loss. But if they were really insurance products, they should have been regulated as insurance, with insurance regulators making sure that there was adequate capital to meet their obligations.
In reality, in many cases derivatives are more accurately described as gambling instruments. But gambling should be subject to gaming laws, and derivatives aren't.
Remarkably, in fact, derivatives have been left totally unregulated -- a mistake that President Clinton, who failed to introduce regulations when he had the chance, now acknowledges. Congress's current proposal is the opportunity to rectify that mistake.
One provision holds particular promise -- and has the banks especially riled up. This is the idea that the government should not be responsible for the "counterparty risk" -- the risk that a derivatives contract not be fulfilled. It was AIG's inability to fulfill its obligations that led the U.S. government to step into the breach, to the tune of some $182 billion.
The modest proposal of the agriculture committee is that the U.S. government (the Federal Deposit Insurance Corporation) stop underwriting these risks. If banks wish to write derivatives, they would have to do so through a separate affiliate within the holding company. And if the bank made bad gambles, the taxpayer wouldn't have to pick up the tab.
This change would help fix the current system, where those who buy this so-called "insurance" enjoy the subsidy of the essential, free government guarantee; and where competition among the few issuers of these risky products is sufficiently weak that they enjoy high profits.
This arrangement is economically inefficient -- firms should pay for the costs of their insurance. If the government guarantee is removed, the banks might have to put more money into their derivatives subsidiaries. This will reduce the banks' profitability, and it might force up prices of this "insurance." But that is as it should be. The government shouldn't be subsidizing "insurance" -- and it certainly shouldn't be in the business of subsidizing gambling.
The Fed and the Treasury seem to object to the agriculture committee's proposals. These objections show once again the extent to which the Fed and the Treasury have been captured by the institutions that they are supposed to regulate, and reemphasize the need for deeper governance reforms of the Fed than those on the table.
To be sure, banks' high profits from derivatives would help with recapitalization, offsetting the losses they incurred from the risky gambles of the past. But that doesn't mean that the policy of allowing banks to issue derivatives -- and laying the risk of failure onto the taxpayer -- is right.
Bank recapitalization should be done in an open and transparent way, consistent with sound economic principles. Abusive credit card practices could also help recapitalize the banks, but fortunately we have curtailed some of these. We should now do the same for derivatives.
We should recognize that the agriculture committee provision is already a compromise. Many worry that if the affiliate within the holding company that writes the derivatives gets into trouble, Uncle Sam will still come to the rescue.
The bill, for instance, includes a "strong presumption" of losses for creditors and shareholders. What should be required is that creditors (other than depositors) and shareholders bear all the losses before the government is asked to pony up any money. But ultimately, in a crisis, worries about the consequences of such strong medicine will almost surely mean a bailout for the bank holding companies as well as the banks -- as happened in this crisis.
In a crisis, the government will not only bail out the banks, but also the bankers, their shareholders, and their bondholders -- if not totally, at least partially.
So if we are to protect American taxpayers, we must also bar any too-big-to-fail institutions from writing derivatives. But right now, the institutions who write the vast majority of these derivatives are too big to fail. Ideally, responsibility for writing derivatives should be spun out to a totally independent entity. The agriculture committee bill does not go this far; rather, it strikes a reasoned compromise between political expediency and economic good sense.
It would be a major mistake to walk away from this compromise by allowing FDIC-insured institutions to continue to write these risky products. To allow them to do so would simply generate more political cynicism: It would show that the big banks have succeeded in their ambition of returning to the world nearly as it was before the crash.
The opinions expressed in this commentary are solely those of Joseph Stiglitz.
