Streetwise Professor

July 19, 2011

Backsliding in Basel

Filed under: Clearing,Economics,Financial crisis,Regulation — The Professor @ 4:55 pm

Laurie Carver of Risk passed along this BIS/Basel Committee on Banking Supervision Consultation Paper that proposes a methodology for measuring whether a bank is a “global systemically important bank” or G-SIB.  Laurie perceptively points out that a bank’s OTC derivatives exposure is included as one of the factors in the proposed index that will be used to determine systemic significance, but that cleared derivatives exposure is not. Since capital charges will depend, under the proposal, on the index score, this means that OTC derivatives exposures will affect capital requirements, but cleared exposures will not.

This is a major mistake.  A bank’s exposure to CCPs, and perhaps more importantly, CCP exposures to banks, are of major systemic importance.  The failure of a large bank with a large book of cleared derivatives, both proprietary and client, would pose a substantial risk to the CCP, the other banks that are members of the CCP, and to the broader financial system.  Moreover, via the liquidity channel, large cleared exposures can also be destabilizing, as when a big bank needs large sums of cash in a hurry to meet margin calls on cleared trades.  Indeed, due to the rigid timing deadlines of CCP margin payments, it is my belief that cleared exposures put more stress on the liquidity channel than OTC deals.

Put differently, CCPs are a channel of contagion, and a potential source of shocks that create contagion.  What’s more, they don’t internalize all the externalities that the BIS cites to justify stricter regulation of big banks.  Indeed, as I’ve argued repeatedly, CCPs actually create some perverse incentives (in particular, moral hazards) that can increase systemic risks.

It is particularly disappointing to see this glaring oversight at this late date.  Although the proper time to debate the clearing issue was over a year ago (the Frank-n-Dodd anniversary just passed), it did seem that serious people were coming to recognize that the idea that CCPs were a panacea for derivatives-driven systemic risk was an unrealistic dream, and were therefore thinking far more seriously about how to deal with the systemic risks arising from CCPs.  Even the Basel Committee had genuflected to this understanding, and incorporated a capital charge for cleared exposures into the Basel III proposal.  Hence, the Consultation Paper seems to be a retrograde step back to the unrealistically optimistic view of CCPs as safe.

This attitude is very dangerous.  The longer it persists, and the more widespread it remains, the higher the likelihood that cleared derivatives will play a major role in creating or exacerbating some future financial crisis.

Update: Laurie kindly pointed out that my description of the implications of the G-SIB index score was misleading.  The G-SIB score affects only the systemic risk capital surcharge; cleared derivatives are included in the standard capital calculations.  Bad drafting aside, the basic point stands: the proposal implicitly assumes that cleared derivatives do not contribute to systemic risk.  Danger, Will Robinson!

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