Streetwise Professor

November 9, 2011

Basel Still Faulty: CCP Capital Charge Edition

Last week the Basel Committee released its revised proposal on capital requirements for exposures to CCPs.  It made a few tweaks to its earlier proposal, which had attracted considerable criticism.  The critics are not mollified, and some new criticisms have been directed at the new version.

I won’t deconstruct the new proposal in detail.  I’ll just focus on a few of the high level issues, all in the way of reiterating a broader point that I’ve raised previously.

One criticism of the new proposal is that it imposes punitive burdens on client clearing, and is therefore inconsistent with the stated goal of encouraging the movement of more derivatives transactions to CCPs.  Against this, it is claimed that the new rules facilitate portability of client accounts between clearing firms.  So, you won’t be able to find someone willing to clear for you in the first place, but you’ll be able to move your account easily.  Or something.

The allegedly punitive treatment of client clearing, combined with the capital and margin burdens placed on non-cleared trades, will tend to reduce end user hedging with derivatives.  This is clearly an undesirable outcome, and will induce end users to devise alternative means (and in particular, to adjust their capital structures) in order to achieve the same objectives as they currently do through derivatives.  These alternatives  are likely to be more costly than derivatives.  Moreover, they will still result in the creation of counterparty risk (or credit risk).  From a systemic perspective, it is not clear that the ultimate effect will be to reduce the amount of credit risk, or improve its allocation.

The new draft reduces slightly the capital charges for default fund contributions, but the treatment is still sufficiently tough to make it likely that CCPs will jack up margins to avoid incurring the high capital charges associated with exposures in excess of the CCPs “hypothetical capital.”  Maybe this is precisely the intent, because the idea that derivatives trades should be massively collateralized is a matter of faith among many regulators.  But demanding high collateral can lead to many adverse effects, including less hedging, the utilization of riskier assets to pay initial margins, the substitution of other forms of leverage, including fragile repo-based collateral transformation services, and the engineering of securities that can be used as collateral (either directly with a CCP or indirectly via a collateral transformation) but which are loaded with systematic tail risk.

The proposals retain the very crude distinctions between risk exposures.  Capital charges across exposures do not vary sufficiently to account for their different risk characteristics.

All of these issues point out the basic problem with Basel capital requirements.  These rules are essentially price controls.  They cannot–metaphysically–get the prices right.  The way the risks are priced via capital charges will affect resource and risk allocation decisions.  Those subject to the rules will have the information and incentive to figure out how to minimize their impact, and will tend to load up on risks that are underpriced and take too few of the overpriced risks.  Many of the endogenous responses to the capital charges will occur in unexpected ways and places, and the connection between these responses and the rules will often be highly indirect and difficult to identify.

But the big problem is that since everybody is facing the same distorted price signals, they will tend to make correlated mistakes.  This increases the vulnerability of the system.  That’s why Basel is faulty generally.  The CCP capital charges are just a particular example of that.  They are intended to reduce systemic risk, but they largely ignore how the system will respond to the rules, thereby creating new vulnerabilities.

Just step back and look at what is going on now in Europe.  One of the basic principles of Basel II was that sovereign debt was safe.  Another was that mortgages were safe.  Financial Crisis I exploded the latter belief.  Financial Crisis II is demolishing the former.  But the favorable capital charges accorded these investments encouraged the supply and demand for both.

If you haven’t noticed, this is not working out well.  The CCP capital charges will have far reaching effects on how much risk there is in the system, and where it resides. The necessary crudeness of the capital rules, their inability to price different risks in a discriminating way, and the endogenous behavioral responses that they induce not just in clearing but throughout the interconnected financial markets, will create new systematic errors and vulnerabilities that won’t work out to well either.

The conceit of these rules is that they are pricing systemic risk.  How is that even possible when those formulating rules do not–and realistically, cannot–consider fully the systemic responses to them?  Charging a price can make things worse if the price is wrong.  A financial Gosplan hardly inspires confidence, and methinks that’s exactly what Basel is.

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    As ‘a’ would say, it is simply unconsciable that $10B in profits in one quarter should go to a but of Asiatic primitives in a state-owned company with 400,000 employees that should rightfully go to Government Sachs, Morgan Stanley and JP Morgan Chase.

    Comment by Mr. X — November 9, 2011 @ 4:30 pm


    On the other hand, to be fair and balanced, Gazprom will have plenty of competition soon, even if they finally buy into the Eagle Ford shale and thereby cause SWP’s head to explode by putting royalty payments into the pockets of his South Texas friends and acquaintances. No doubt the Obama Admin will soon be lending money to Argentine banks so we can be their best customer when they tap their shale oil while his administration keeps the biggest oil shale deposits possibly in the world offline underneath federal naval reserve lands in Utah, Colorado and Wyoming.

    Comment by Mr. X — November 9, 2011 @ 4:32 pm

  3. @Mr. X: Right on topic as usual! Well played.

    South Texas friends and acquaintances? Name one–I sure as hell can’t. But hey, if Gazprom wants to make Texans rich, I have no problem with that. Why could you possibly think that my head would explode?

    But here’s the reality, Senor Equis: Gazprom can spend money, but it can’t compete. Note how the Russian government protects Gazprom from competition. As Pahoben showed definitively in a comment some months back, by every metric Gazprom is a bloated, inefficient dinosaur. And Gazprom is going to face increasing competition from LNG produced from places like Eagle Ford and Marcellus. Trying to play the same game is just an admission that its entire legacy model is shot. It’s just another firm in an already crowded field, with no comparative or strategic advantage whatsoever.

    So, some Texans will take Gazprom’s money. Helluva lot of good that will do Gazprom.

    Savor the irony: it went whole-hog into Shtokman with the grand plan of producing LNG to sell to the US. It’s unlikely that even with the help of Total that Shtokman would have ever really come to reality given the technical challenges and Gazprom’s dysfunctionality, but now the economics upon which the entire project were predicated have been turned completely upside down. The US doesn’t need to import gas, and will be exporting it in large quantities (unless the US government screws that up too–as it well might, if hearings in the Senate are any indication). Gazprom will just be tagging along in that game.

    Sucks to be them. Big time.

    The ProfessorComment by The Professor — November 9, 2011 @ 5:15 pm

  4. The one market specifically set up to price idiosyncratic risk vis-a-vis credit — the CDS market — just now suffered a stealth regulatory-taking event unimagined in the history of markets: The “voluntary” haircuts agreed among banks on their Greek debt, aka the Private-sector Involvement (PSI in the FT’s usage) initiative hammered out by the banks that wrote CDS protection on that very debt. Those at the highest risk for paying on CDS used to hedge Greek default — i.e., the banks that populate all the relevant ISDA panels with any say on things things like events of default under CDS CONTRACTs — orchestrated a non-default default that allowed them to escape contractual obligations. It is frightening in its own that a cabal of bankers such as this can, sub rosa, destroy the foundation of an entire market and the concept of contract law that underpins derivatives. Obviously, this market-based solution to the pricing of risk failed. The far more complicated issue is how can a CDS ever be margined with such precedent? What exactly is the risk in this case? The banks will again agree not to declare an event of default? Italy will destroy the. What’s the probability space we’re dealing with?

    Oh, DB’s ceo thinks this could be a problem …

    He engineers the event then warns against it. Is the whole world high?

    Comment by markets.aurelius — November 9, 2011 @ 5:32 pm

  5. @markets.aurelius. It is becoming clear that the entire idea of credit protection on sovereign risk is doomed. Economically, the wrong way risks are immense. What bank is going to be able to pay out if a major country goes down? And there is a huge political risk that means that even if the protection sellers could pay out, the contracts will be abrogated for political reasons.

    And yes. The world is eight miles high, but falling fast.

    The ProfessorComment by The Professor — November 9, 2011 @ 5:47 pm

  6. “South Texas friends and acquaintances? Name one–I sure as hell can’t.” Well, I’m not a stalker or a not-so-anonymous Google bombing libeler, which is more than I can say for a certain Ekaterina in Manhattan…ah you get the idea.

    Comment by Mr. X — November 9, 2011 @ 9:17 pm

  7. “It’s just another firm in an already crowded field, with no comparative or strategic advantage whatsoever.” Ah, but you forgot about the St. Herman of Alaska bridge/pipeline to create the largest integrated oil and gas, electric and highway/rail network in the world. Getting a bridge between Alaska and Chuhotak beats dumping another $60 billion down the megabanks rathole. Wayne Madsen may be a LaRouchie but at least with David P. Goldman (aka Spengler’s) former cult buddies running the show we’d be printing money for real infrastructure instead of taking the trash off the megabanks books.

    Comment by Mr. X — November 9, 2011 @ 9:20 pm

  8. “Note how the Russian government protects Gazprom from competition.” Yes, and of course the megabanks have to compete with a VTB or a Brazilian bank branch opening in Manhattan offering consumers storage in rubles, real, gold bars, silver eagles or two headed Russian gold eagles, you name it. What’s that you say? The Fed doesn’t allow that? Why not Mr. Free Market? Banksterism is only for the West?

    Comment by Mr. X — November 9, 2011 @ 9:21 pm

  9. Mr. X–The discussion was about Gazprom. If you think that I believe that the US does not restrict competition, and protect some companies/industries, or that I am fine with said restrictions, you aren’t paying attention, and have no clue about what I think. Whataboutism is tedious.

    The ProfessorComment by The Professor — November 9, 2011 @ 9:36 pm

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