The BIS has been one of the major advocates for mandated clearing. They have produced an analysis claiming that mandated clearing will increase GDP growth by .1 percent or more per annum. I criticized this calculation claiming that it was predicated on a fallacy: namely, that multilateral netting and collateralization, result in a reduction in the costs of OTC derivatives borne by banks, and thereby reduce the risk that they will become dangerously leveraged. In fact, these measures redistribute losses, and will not affect the overall leverage of a financial institution in the event of an adverse shock to its balance sheet.
Stephen Cecchetti, the head of the BIS’s Monetary and Economics Department has responded to this sort of criticism. Here’s his argument regarding multilateral netting:
Before turning to the costs, I think it is worth responding to criticism of this approach. First, some critics have argued that, by focusing on derivatives exposures, the Group has ignored the impact of multilateral netting on other unsecured creditors. The main claim is that multilateral netting dilutes other unsecured creditors.
This is correct. Multilateral netting does dilute non-derivatives-related claims to some extent. However, this is neither new, nor is it unique to derivatives. In fact, repos, covered bonds and any other secured loans result in dilution and subordination. For repos, that counterparties can close out a position and seize collateral in default has led to comment and worry for some time. Given that this is all well known, I would think that it is already reflected in the pricing of the instruments involved. Presumably no one will be terribly surprised by this when it is applied to derivatives, and so the impact will be muted. It is a stretch to see how this redistribution of a part of the risk associated with OTC derivatives transactions increases systemic risk.
This argument totally fails to meet the criticism.
First, there has been some repricing, but it is incomplete. Repricing only takes place to the extent that adoption of mandated clearing occurs, or is at least anticipated, and does not occur for derivatives contracts and other liabilities until they mature. Since many derivatives and other liabilities have maturities extending well beyond the clearing implementation dates, these have yet to be repriced.
Yes, the most run-prone liabilities, such as short term debt, have been repriced, but that’s not all that important. Even if banks adjust their capital structures to reflect the repricing, they will still have large quantities of such liabilities which are now more junior and which will pay off less in states of the world when a bank is insolvent. The higher yield received in normal times compensates the creditors for the lower returns that they get in bad states of the world, and most notably in crisis times. And it is exactly during these crisis times that these liabilities are a problem. Due to repricing, there may be a lower quantity of such short term debt, but this debt will be more vulnerable to runs as a result of the subordination inherent in multilateral netting. Excuse me if I don’t consider that a clear win for reduced systemic risk, and fear that it in fact represents an increased systemic risk. That is no stretch at all. None. Cecchetti’s belief that it is a stretch reflects a cramped and incomplete analysis of the implications of subordination.
In terms of the BIS’s claim that will boost economic growth, Cecchetti’s argument does not rebut in any way what I have been saying. The BIS argument is based on a belief that netting makes the pie bigger. My argument is that it does not make the pie bigger, but just resizes the pieces, making some smaller and others bigger. Nothing in what Cecchetti writes demonstrates the opposite, and in fact, his acknowledgement that netting dilutes other creditors is an admission that the effects of netting are redististributive.
Once that is recognized, the entire premise behind the BIS macroeconomic analysis of the OTC derivative reforms collapses, and the conclusions collapse right along with it.
Cicchetti mischaracterizes the critique when he insinuates that it means that netting increases systemic risk. I’ve said that’s one possible outcome, but mainly have used the redistribution point to refute the claim (made by the BIS and others) that netting reduces systemic risk. The channel by which the BIS claims it will is predicated on the belief that netting reduces default losses rather than reallocates them. If they only reallocate them-which Cicchetti effectively acknowledges-this channel is closed, and the asserted benefit does not exist. It’s very simple.
Therefore, Cicchetti may “remain convinced that the Group’s analysis accurately captures the benefits of the proposed reforms,” but his conviction is based on faith rather than economic reasoning: his attempted defense notwithstanding, the Group’s analysis is contrary to the economics.
Here’s what Cicchetti says about collateral:
A second concern that has been raised is that the regulatory insistence on increased collateralisation will simply redistribute counterparty credit risk, not reduce it. To see the point, take the simple example of an interest rate swap. The primary purpose of the swap is to transfer interest rate risk. But the mechanics of the swap mean that there is always a risk that the parties involved will not pay. This is a credit risk. In the case where the swap is completely uncollateralised, it is clear that the instrument combines these two risks: interest rate (or market) risk, and credit risk.
Now think of what happens if there is collateralisation. At first it appears that the credit risk disappears, especially if there is both initial margin to cover unexpected market movements and variation margin to cover realised ones. But the collateral has to come from somewhere. Getting hold of it by borrowing, for example, will once again create credit risk.
The point is that, by collateralising the transaction, the market and credit risk are unbundled. I would argue fairly strenuously that unbundling is the right thing to do. Unbundling forces both the buyer and the seller to manage both the interest rate and the counterparty credit risks embedded in a swap contract. In the past, some parties seem to have simply ignored the credit component. Unbundling sheds light on the pricing of the two components of the contract. A more transparent market structure with more competitive pricing will almost surely result in better decisions and hence better risk management, risk allocation and ultimately lower systemic risk. The AIG example is a cautionary tale that leads us in this direction.
I agree completely that clearing unbundles price and credit risks. This is particularly true under a defaulter pays model, in which the CCP members bear very little default risk. In fact, this is the focus of a chapter I’m writing for my next book.
But Cicchetti’s assertion that unbundling is a good thing begs a huge question: why were risks bundled in the first place? By way of explanation, sort of, Cicchetti asserts, without a shred of evidence, that market participants often ignored credit risk bundled in derivatives trades. Even if that’s true, why would they necessarily take it into consideration merely because it’s unbundled? I think the most that can be said is that ex post it appears that market participants underestimated credit risk prior to the crisis. And if they did this with derivatives, they did it with unbundled credits too: look at the massive repricing of corporate paper and the virtual disappearance of unsecured interbank lending starting in August 2007.
But more substantively, there can be good reasons for bundling market risk and credit risk. I explore these reasons in detail in my Rocket Science paper, which has been around for years. In particular, there can be informational synergies. These are quite ubiquitous in banking, and explain a variety of phenomena, such as compensating balances which require firms that borrow from a bank to hold some portion of the loan in deposits at the same bank: this is a form of bundling. Moreover, bundling can be a way of controlling a form of moral hazard, namely asset substitution/diversion.
At the very least, bundling is so ubiquitous in banking (and finance generally, e.g., trade credit) that it is extremely plausible that there are good economic reasons for it. The reasons for this practice should be understood before implementing massive policy changes that forcibly eliminate it for massive quantities of contracts. It is rather frightening, actually, that Cicchetti/the BIS are so cavalier about this issue, and are so confident that they know better than market participants.
And again, even if credit risk is priced more accurately in an unbundled world (which Cicchetti asserts rather than demonstrates), bank capital structures in an unbundled world can be fragile and a source of systemic risk. For instance, collateral transformation trades used to acquire collateral to post as CCP margin are arguably very fragile and systemically risky even if they are priced correctly.
What’s needed is a comparative analysis of the fragility/systemic riskiness of the bundled and unbundled structures, and this BIS/Cicchetti do not provide.
Cicchetti’s speech suggests that BIS has heard the criticisms of clearing mandates, but doesn’t really understand them, or is so invested in clearing mandates that it refuses to take them seriously. Regardless of the reasons, one thing is clear. The BIS has taken a big swing at a rebuttal, and missed badly.