To address the systemic risks caused by collateralized interbank lending, it is important to discourage large financial institutions from borrowing on a collateralized basis. For example, if large financial institutions are prohibited from entering into over the counter derivative contracts that require them to post collateral, then their counterparties will be forced to evaluate the credit risk of being exposed to them. Since every counterparty will favor the more creditworthy financial institutions, market forces will once again function to encourage the growth of conservatively run firms.
Collateral is intrinsic to the market for repurchase agreements and this market is far too large to disrupt by prohibiting the participation of large financial institutions. On the other hand after the recent turmoil, it should not be difficult to remove the safe harbor protection for repos of less liquid assets – effectively, it is advisable to repeal those sections of the 2005 Bankruptcy Act that apply to repurchase agreements. The repo market functioned reasonably well for a quarter of a century and imploded shortly after it was enlarged to included riskier assets. As the riskier assets were the first to be rejected by repo counterparties, the presumption must be that we are better off with the narrower privileges granted to repurchase agreements in 1984.
To those who would argue that collateralization is necessary in order for derivative markets to function, I observe that this claim is simply false. Collateralization of over the counter derivative contracts was introduced in the early 1990s. Thus, the market for interest rate and currency swaps grew to more than $10 trillion in notional value before collateralization of derivatives became common. Clearly, collateralization is not necessary to the operation of derivative markets.
In fact, financial markets are likely to be healthier when uncollateralized contracts are the norm. In an environment where the credit risk inherent in every contract is obvious, there will be very few participants who are willing to do business with an unsound counterparty. When unsound counterparties are shunned, the business of well-managed firms grows and the business of poorly managed firms shrinks. Thus in an environment with uncollateralized contracts the natural dynamics of the financial system will tend to reduce leverage and promote stability. This stands in stark contrast to the dynamics generated by a financial system that relies on collateral.
While unsecured interbank lending plays an important role in financial stability, it is appropriate to require collateral when dealing with an unreliable or an unproven business partner. As long as some derivative contracts continue to require that collateral be posted, financial statements need to give the user an idea of how the collateral situation may change over the quarter. For example firms could be required to report the maximum amount of collateral that could be called in two scenarios (i) the most adverse pricing environment and (ii) the most adverse pricing environment that was actually experienced over the past twenty-five years.
Furthermore, if Congress were interested in more thorough reform of over the counter derivatives markets, it could repeal the derivative and repo related bankruptcy amendments of 1984, 1990 and 2005, redefine repurchase agreements and swaps as securities and rely on the 1982 bankruptcy amendment to protect the interests of repo and swaps traders. For this reform to work repo traders would have to form a Repo Trader’s Association and register with the SEC as a self regulatory organization. Similarly, the ISDA – or an American offshoot of it – would have to act as a self regulatory organization subject to the supervision of the SEC. Under this scenario repos and swaps would become regulated contracts like futures and options and receive the same protections – including safe harbor under the bankruptcy code – that other regulated derivatives receive.
 1999 ISDA Collateral Review, p. 1 http://www.isda.org/press/pdf/colrev99.pdf
 The ISDA reports that by the end of 1994 there $11.3 trillion of currency and interest rate swaps outstanding.