Role of regulators

Q: The banks which went bankrupt were not operating in isolation. If they were meddling in instruments as complex as derivatives then why the banking regulators didn't intervene when they could have made a difference?

A: First, these were no ordinary banks. Lehmann Brothers e.g is more than 150 years old. Nobody expected them to fail. Second, if it were ordinary lending-borrowing type banking. Then there are strict Basel regulations to govern them. So, even though use of derivatives has recently become widespread. They are still in nascent stage and hence not strictly regulated.

Q: But how can a bank incur such huge losses by trading in derivatives? Isn't it a known fact that derivatives have limited downside for loss while retaining unlimited upside potential for profits. 

A: Derivatives are used for the purpose of reducing your risk, i.e. a bank's exposure to market uncertainties, also known as hedging. But since there is also a possibility that one can reap profits by entering into such a derivatives contract, the counterparties cross the line from hedging to speculation. An activity a good banker should strictly avoid.