In October, 2011 I was in a group of academics invited to meet the Board of Governors of the Fed to discuss our research. The theme was network industries, and I was to make a presentation on the network aspects of clearing and its implications for systemic risk.
My most vivid memory of the meeting has little to do with my presentation. Instead, it relates to Ben Bernanke, who sat facing me, directly across the massive boardroom table. Bernanke obviously had a headache. He was rubbing his temples, and he asked a staffer to bring him a cold can of Diet Mountain Dew, which he held against his forehead while closing his eyes. Figuring that a Bernanke headache would portend bad financial news, I was sorely tempted to excuse myself to call my broker to sell the hell out of the S&P.
Sitting next to me was Governor Daniel Tarullo. Truth be told, I was not impressed by his questions, which seemed superficial, or his mien, which was rather brusque, not to say grouchy.
He was definitely not sympathetic to my warning about the potential systemic risks of clearing: he made some skeptical, and in fact dismissive, comments. It was quite evident that he was a believer in clearing mandates.
It appears that Tarullo is still struggling with the idea that CCPs are a risk, but at least he’s open to the possibility:
JPMorgan Chase & Co. and BlackRock Inc. have argued for years that a key response to the last financial crisis could help fuel the next one. [What? No mention of SWP? I was way ahead of them!] Global regulators are starting to heed their warnings.
At issue is the role of clearinghouses — platforms that regulators turned to following the 2008 meltdown to shed more light on the $700 trillion swaps market. A pivotal goal was ensuring that losses at one bank don’t imperil a wide swath of companies, and the broader economy.
Now, Federal Reserve Governor Daniel Tarullo is quizzing Wall Street after big lenders and asset managers said clearinghouses pose their own threats, said three people with knowledge of the discussions who weren’t authorized to speak publicly. Among the concerns raised by financial firms: Relying on clearinghouses shifts risk to just a handful of entities, and the collapse of one could lead to uncapped losses for banks.
. . . .
Tarullo, the Fed’s point man on financial regulation and oversight, has publicly conceded that it’s hard for banks to determine their own market risks if they can’t evaluate how badly they would be hit by the failure of a clearinghouse. It’s “worth considering” whether clearinghouses have enough funds to handle major defaults, he said in a Jan. 30 speech.
Tarullo’s speech is here. Although he is still obviously a clearing fan, at least he is starting to recognize some of the problems. In particular, he acknowledges that it necessary to consider the interaction between CCPs and the broader financial system. Though I must say that since he mentions multilateral netting as the primary reason why CCPs contribute to financial stability, and margins as the second, it’s painfully evident that he doesn’t grasp the fundamental nature of clearing. In the first instance, netting and collateral just redistribute losses, and it is not clear that this redistribution enhances stability. In the second instance, although he acknowledges the problems with margin pro cyclicality, he doesn’t explicitly recognize the strains that large margin flows put on liquidity supply, and the destabilizing effect of these strains.
So it’s a start, but there’s a long way to go.
Tarullo pays most attention to the implications of CCP failure, and to measures to reduce the likelihood of this failure. Yes, failure of a large CCP would be catastrophic, but as I’ve oft written, the measures designed to save them can be catastrophic too.
Tarullo would be well-advised to read this short piece by Michael Beaton, which summarizes many of the issues quite well. The last few paragraphs are worth quoting in full:
In general, I think what we need to take away from all of this is that systemic risk can be transferred – it’s arguable whether or not it can be reduced – but it certainly can’t be eliminated, and the clearing model that we are working towards is a hub and spoke which concentrates risk on a very, very small number of names.
A decentralised network is arguably stronger than a hub and spoke model, mainly because open systems are generally regarded as more robust than closed ones. The latter is what the clearing model operates on and you have that single, glaring point of failure, and there’s really no escape from that.
So, going back to the original questions – do I think the proposals are enough? I think it goes a long way, but fundamentally I don’t think it will ever resolve the problem of ‘too big to fail’. I’m just not convinced it’s a problem that is capable of resolution. [Emphasis added.]
Exactly. (The comparison of open vs. closed systems is particularly important.)
Since clearing mandates create their own systemic risks, the Fed, and other central banks, and other macroprudential regulators, must grasp the nettle and determine what central bank support will be extended to CCPs in a crisis. Greenspan extemporized a response in the Crash of ’87, and it worked. But the task will be orders of magnitude greater in the next crisis, given the massively increased scope of clearing. It’s good that Tarullo and the Fed are starting to address these issues, but the mandates are almost 5 years old and too little progress has been made. Faster, please.