Streetwise Professor

Commentor Matt asked my views about the clearing portion of the Squam Lake Report on Fixing the Financial Crisis, which was written by a group of distinguished finance academics.  Since I know that the rest of you were waiting with bated breath but were just to shy to ask, here it goes.

In a nutshell: superficial, question begging, and at times contradictory.

The superficiality is perhaps understandable, because the report was intended to be a high-level overview understandable by policy makers and the public.  But it does undermine the persuasiveness of the report.  Indeed, it makes it potentially dangerous if policy makers aren’t fully aware of the limitations of the analysis.

The Report identifies “two important advantages of clearinghouses” (p. 113): netting and “by standing between counterparties and requiring each of them to post appropriate collateral, a well-capitalized clearinghouse prevents counterparty defaults from propagating.”

Many problems here.  First, as the Report itself acknowledges (pp. 116-117), although clearing has the potential to exploit more completely netting economies, if CCPs are fragmented, adoption of clearing can actually result in a loss of netting economies.

Second, netting benefits are largely private, and if counterparty risk is costly and collateral is a costly way to mitigate it (propositions that the Report accepts), why don’t market participants organize their transactions and create institutions to exploit efficiently these netting economies?  Indeed, mightn’t the growth of large dealers and the failure to implement clearing more comprehensively be the best way to exploit netting economies across the full range of derivatives products (and other scope economies between derivatives and non-derivatives businesses)?  The survivorship principle would suggest so.  These are important, but begged, questions that bear directly on the relative merits of cleared and bilateral markets.

Third, the Report veers into Steve Martinesque How to Make a Million Dollars Without Paying Taxes territory in assuming that CCPs will (or enjoining them to) choose “appropriate” collateral and are “well-capitalized.”  Define “appropriate.”  Define “well-capitalized.”  What are the informational requirements to make these determinations?  Who has the information?  Do the CCPs?  Will regulators?  What are the incentives of CCPs (and their members) to choose “appropriate” margins and be “well-capitalized”?  How do those incentives compare to those in place in a bilateral OTC market?  If negative externalities from default propagation among systemically important financial institutions are a flaw in the existing financial infrastructure, why would one expect a CCP whose residual risk bearers are systemically important financial institutions to choose margin levels and capitalization to internalize that externality?  More begged questions.

Fourth, the statement that CCPs “prevent counterparty defaults from propagating” is not necessarily correct.  Clearinghouses can fail, and lead to the propagation of defaults.  Indeed, one of the self-contradictory parts of the Report acknowledges this: “even a well-capitalized clearinghouse can fail.  The failure of a clearinghouse for all OTC derivatives is likely to have enormous systemic consequences” (p. 117).  Once you recognize this, you need to take seriously the issue of whether CCPs are more or less vulnerable to this propagation than bilateral structures.  The Report fails to address this crucial issue.

The Report is similarly schizophrenic on AIG.  In the chapter on clearing, it states that clearing would not have been sufficient to prevent “the AIG catastrophe” (p. 114).  But in its conclusions, it states “[f]inally, by giving AIG an incentive to use and clear standardized CDS contracts, our recommendations would have reduced AIG’s systemic importance” (p. 149).  Well, which is it?

The former judgment is correct; the latter, not.  Even based on the limited and rather one-sided characterization of the virtues of clearing, it is plain that clearing would not have made much of a difference in the AIG case.  Netting wouldn’t have made a damn bit of difference, because AIG wasn’t a dealer with a lot of offsetting positions.  It had a huge net position on one side of the market.  The same financial firms that would have been harmed by an AIG failure in September, 2008 would have been on the hook in an alternative world where the AIG deals had been cleared, either as members of the CCP, or as counterparties with large net positions that would have been owed money by the CCP, or likely both.  “Appropriate collateral” probably wouldn’t have made a whit of difference either.  The conventional wisdom at the time was that the instruments AIG traded were of very low risk, and hence it is highly likely that original margin amounts wouldn’t have been so large as to dissuade AIG from taking big positions.  Indeed, AIG’s creditworthiness and the low perceived risks of the positions led its counterparties to enter into big trades without demanding independent amounts; if a CCP had demanded cash collateral up-front, AIG could have used that creditworthiness and low perceived risk to borrow to fund the margin.  Moreover, the Report fails to analyze the full implications of a reduction in AIG’s positions resulting from clearing, or higher capital requirements, or whatever.  Since the AIG trades essentially transferred risks, how would hampering AIG’s ability to take on that risk have affected the amount of that risk in the financial system and the efficiency of the distribution of that risk?  The answers to those questions aren’t obvious, nor are they self-evidently that a reduction in AIG’s positions would have mitigated the effect of a real estate price collapse on the financial system.

The Report repeatedly assumes away crucial problems of implementation of its recommendations.  For instance, it recommends “appropriate differences between capital requirements that are cleared and not cleared.”  Again: What is appropriate?  What information do you need to make that determination?  Who has the information?  Do they have the incentive to use it?  Can such price controls–and that’s what they are–be gamed by parties better informed than those who set them?  Could the systemic consequence of such gaming be worse than the disease that the capital requirement differentials are designed to cure?

Relatedly, it recommends that due to the systemic importance of CCPs, regulators require “appropriate collateral” (there’s that “A” word again); “strong operational controls”; and “sufficient capital.”  All of the questions raised in the previous paragraph are begged on these issues as well.

The authors of the Report mimic Goldilocks on the issue of the structure of the clearing sector (pp. 116-117).  Too many CCPs are bad, because this fragmentation can impede exploitation of netting economies.  Too few CCPs are bad, because that makes the financial system too vulnerable to the failure of one of these behemoths.  So how many is just right, Goldilocks?  And how are we going to get there?

The answer:

[r]egulators and lawmakers should not intentionally or unintentionally promote the proliferation of redundant or specialized clearinghouses.  The proliferation of clearinghouses would create unnecessary systemic risk by eliminating opportunities to reduce counterparty risk (p. 117).

Thanks a lot.

Indeed, the evolution of this industry going forward will determine the effects of clearing mandates, or other measures to favor clearing.  For far more reasons than the Report mentions, it is quite possible that the industry will evolve in a way that worsens the stability of the financial system.  And there are strong reasons to believe that the industry will not necessarily evolve in a salutary way.

First, the pervasive scale and scope economies mean that the industry is unlikely to evolve in an efficient, competitive fashion, or that the resulting structure will be systemically more robust.  These economies tend to favor consolidation into a relatively small number of systemically vital, and vulnerable, CCPs.  Moreover, this structure can impede competition (a point that the Report acknowledges).

Second, the Report’s rather naive injunction to regulators and lawmakers aside, jurisdictional considerations will tend to induce fragmentation.  Every major jurisdiction wants a piece of the clearing pie, for economic reasons, and for reasons of political control.  It is also likely that governance and control issues will also lead some market participants to favor specialized  (by product or geographically) CCPs (over which they can exert influence) over broader ones.

Third, political economy considerations completely ignored in the Report–but not in the real world–will also affect the evolution of the infrastructure.  Market participants will attempt to influence legislators and regulators on capital levels, margin levels, operational risk controls, the numbers of CCPs, etc.  We are already seeing industry pressure regarding membership requirements for CCPs–an issue that has both competitive and systemic risk implications.

Just who knows what kind of structure will evolve from these cross-currents of economic and political forces (with the politics rooted, of course, in economics and rents)?  I don’t know for sure, but am deeply concerned that the political economy dynamics will seriously distort the process in a way that reduces the efficiency of the market during normal times, but doesn’t reduce–and may increase–its vulnerability to crises in abnormal ones.  The Olympian, and superficial, analysis of the Report doesn’t come to grips–at all–with these weighty matters.

In brief, the clearing chapter (and related material) in the Squam Lake Report is too incomplete, and sometimes flawed on those issues that it does address, to provide actionable policy guidance.  And since that’s the purpose of the Report, it it is unsuccessful on its own terms.