Streetwise Professor

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.

Back in Houston after time in Geneva, and a quick day trip to Paris for a conference.  The conference was sponsored by the ECB, Banque de France, and the Bank of England.  It was an examination of the progress in OTC derivatives regulation since the G20 declaration in Pittsburgh in September, 2009.

For the most part, the audience was central bankers, and the theme was “Yay! Look what we’ve accomplished!”  And of course, I had to rain on that parade.  My paper was titled “Bill of Goods: CCPs and Systemic Risk”, and the themes were (a) most of the arguments about how clearing would reduce systemic risk (e.g., the effects of netting) are wrong, and (b) clearing and collateral mandates created new sources of systemic risk.  Meaning that the G20 sold us a bill of goods in Pittsburgh.

So call me Mr. Popular.

A good part of the rest of the program on Wednesday was the Craig show.  The next panel was chaired by someone from the ECB, who gave a rather injured defense of the Pittsburgh agenda: I wasn’t mentioned by name, but it was pretty clear that she was attempting-ineffectually, IMO-to rebut me.  Several of the panelists said “as someone said in the previous panel”-and then referred to something that I had said.

Then a representative from the BIS presented, to much fanfare, the results of the Macroeconomic Assessment that I criticized heavily before I left for Europe.  After presenting the results, he discussed criticisms and caveats, and spent most of the time attempting-even more ineffectually, IMO-to rebut the arguments I raised in my post.

Very flattering.  Thanks.

The next panel was another group of academics.  The authors of two of the three papers, Bruno Biais and Hector Perez-Saiz (from the Bank of Canada), stated that their papers were motivated/inspired by my earlier research (which Biais called “seminal”).

Even more flattering.

My panel generated some interesting discussion and questions.  Many related to Dale Rosenthal’s paper about the potential inefficiencies that can occur when defaulted positions are replaced (or hedged).

As I’ve written for 3-plus years, the one main benefit of CCPs is that a centralized mechanism (e.g., an auction) for replacing/hedging defaulted positions is likely to be more efficient than an uncoordinated scramble in a bilateral OTC market.  The question is whether this function can be unbundled from the other functions performed by CCPs, which may not reduce systemic risk, and may in fact increase it.

Indeed, since there will be massive quantities of non-cleared derivatives, many of them of the more complex variety, the clearing mandates will not eliminate the replacement/hedging problem.  Even if the cleared derivatives are handled in an orderly auction process, these massive quantities of non-cleared derivatives will not.  These positions will have to be dealt with, and there is a serious risk that the process of replacing them will be very chaotic and destabilizing.

I confess to amazement that in all of the post-Pittsburgh regulatory efforts, this issue has escaped attention.  The focus on clearing, margins, SEFs, etc., has apparently taken up all the oxygen.  This is truly unfortunate, because a centralized auction mechanism to replace or hedge defaulted positions is likely to be far more effective and efficient than a non-centralized mechanism.  Put the other way, the decentralized mechanism is likely to be chaotic and destabilizing and excessively volatile.

Again, the clearing mandate does not solve this problem because many derivatives, especially the most exotic and illiquid (and hence problematic) ones will be outside CCPs, and CCP auction processes.

Which got me thinking (during a conversation with Dale Rosenthal during a break) of how this issue could be addressed.  What popped into my head? The swap dealer designation.

For the most part this designation is all pain, no gain.  How could we make lemonade out of this lemon?  Well, the thought that comes to mind is that designated swap dealers could be required to participate in the auction/hedging of a positions defaulted on by another swap dealer (or dealers).

I am somewhat reluctant to advance this proposal, because I am usually skeptical about mandating anything.  But there is arguably a public good (in the technical sense of the term) element to the process of  replacing/hedging defaulted positions: as the Rosenthal paper suggests, there are potentially many coordination and strategic behavior problems when this process is decentralized.  Consequently, it is worth some further thought.  (The clearing and collateral and capital obligations of swap dealer designation do not have as compelling a public good justification.)

The details will be challenging. In particular, since not all swap dealers will trade all of the types of instruments in a defaulted portfolio, it is not immediately obvious how to determine, in advance, each designated dealer’s auction obligations: that is, it’s not obvious how to specify which auctions each dealer must participate in.  For instance, it makes little sense to require BP or Cargill to participate in auctions for interest rate swaptions.  So who has to participate in what auctions?  Given the plethora of categories (interest rates, credit, equity, FX, commodities) and currencies, there is likely to be a plethora of auctions, and thus it will be difficult to say who is obligated to participate in what auctions.

However it is specified, this obligation will arguably make the swap dealer designation more onerous, and firms will attempt to structure their businesses to avoid falling afoul of it.  But the biggest dealers will not be able to avoid it.  What’s more, if I am correct that a centralized mechanism for handling defaulted positions is a public good, the creation of such a mechanism will actually redound to the benefit of all market participants, including the swap dealers.  After all, they are likely to have the biggest positions to hedge and replace in the event of a major default, and would benefit from a reduction in the risk of this process, and an improvement in the efficiency of the pricing mechanism in the aftermath of a major default.

This is something that at least deserves some consideration.  And, of course, regulators appear to have ignored it altogether in their focus on clearing and margins.  Which is another reason why I am not a G20 cheerleader, 4 years after Pittsburgh.

I’m supposed to be in Geneva right now, but United Airlines decided that what I really wanted to do was to sit around Dulles for 5 hours waiting for them to figure out they couldn’t fix a mechanical problem, and then to sit around a hotel for a day waiting for today’s flight.  Luckily I was able to get the last seat on that plane, so I don’t have to do something like Dulles-Newark-Frankfort-Geneva like some of the other folks on the canceled flight.

So that gives me some time to catch up on reading (and blogging).  And it takes some time to read this loooonnnnggggg Bloomberg encomium to Gary Gensler, which describes his valiant St. George-like battles against the big, bad banking dragons.

The basic theme is that anything the banks don’t like must be good, and anything the banks do like must be bad. The profile confirms that’s Gensler’s view of the world, and Silla Brush and Robert Schmidt pretty much adopt that template.

If only the world were that simple.  Yes, regulatory capture by major financial institutions is a major danger, and happens.  Freddie and Fannie illustrate that in spades, for sure.  So one should always approach the lobbying efforts of large incumbent players, especially large financial institutions, with incredible skepticism.

But at the same time, one has to remember that regulators do stupid things, and adopt regulations that are grossly counterproductive and impose costs far in excess of any conceivable benefits.  Banks potentially subject to such regulations reasonably fight against those, which means that bank opposition to a regulation is not a sufficient statistic to determine whether it is a good or bad policy.

The two regulations that Gensler fought for that are covered extensively in the Bloomberg piece are definitely examples of bad regulations.  The article devotes the largest share of pixels to the battle over the request for quote battle.  You may recall that I named Gensler’s RFQ proposal as the Worst of the Worst of Frankendodd.  The SEF mandate itself is seriously misguided, and mandating how many quotes those wanting to buy or sell a swap must obtain is totally cracked: it is predicated on the paternalistic belief that those who are doing the trading don’t have the ability to make the appropriate trade-offs between information leakage and greater competition to get their business.

The article also details the battle over the de minimis level of trading activity that would determine who has to register as a swap dealer, and thereby incur the additional compliance, collateral, and capital burdens.  Gensler wanted the level set at a piddling $100 million, which would catch pretty much everyone of even modest size in the CFTC’s swap dealer web.

If the purpose of the swap dealer designation is to reduce systemic risk, the level of trading activity is a very poor means of determining which entities should be subject to the higher level of regulation and scrutiny.  And seriously, many firms that must register as swap dealers under the $3 billion level eventually settled upon-against Gensler’s furious opposition-are not systemically risky, either.

Relatedly, the article identifies futurization as an end run around regulation.  As I’ve written before, futurization is a predictable response to regulations that treat economically identical instruments differently.  Swaps are treated more punitively, due to more onerous collateral standards, and because swap trades count towards the de minimis swap dealer trading level but identical futures don’t.  So, duh, people will choose futures over swaps that are otherwise economically equivalent.  If this also allows firms that aren’t systemically important to escape the burdens of swap dealer registration, that’s all for the better.

Moreover, it should be noted that futurization has been over-hyped.  Its main effect has been in energy.  There is no way that the real swap dealers who are systemically important-the JP Morgans, Citis, etc.-are going to be able to avoid being designated as swap dealers by switching their business to futures.  (Don’t interpret that to mean that I believe that swap dealer designation will materially reduce systemic risk.)  A lot of their business is in instruments for which futures are not a viable substitute.  In contrast, in energy (and commodities generally) for the bulk of the business futures and swaps are close substitutes.

Indeed, there is an irony here.  Large quantities of energy swaps were “NYMEX lookalikes” virtually equivalent to futures traded on NYMEX (and then the CME after it acquired NYMEX): firms traded the swaps because under the CFMA, they were subject to a lighter regulatory touch than futures.  So the energy swaps business was largely a product of regulation, and when the regulation changed, the business changed.  The business went to where the regulatory burden was lowest.  Go figure.  Given that part of the premise of Frankendodd is that the futures regulatory structure was the right model that made an appropriate trade off between costs and benefits, the migration to futures should be considered an improvement even by Frankendodd supporters.  It brought the business back to where it should have been all along, according to the advocates of Frankendodd.

The article also writes a lot about extraterritoriality, a subject that makes my eyes glaze over.  The most revealing aspect of this battle is Gensler’s regulatory imperialism, and his stubborn resistance to near universal opposition.  In Gensler’s view-and in the article-everybody was out of step but Gary.

One interesting omission (as if you think anything could be omitted in a 20 page article) is anything related to position limits, another Gensler hobby horse.  Perhaps this is because he eventually prevailed in the Commission, and got it to pass a rule to his liking, so it doesn’t fall into the category of where Gensler’s views lost out to intense political opposition.  But it does fall into the category of a regulation that was opposed vigorously by the banks, who prevailed-at least for now-in getting the regulation stopped.  The difference is that they fought and won that battle in court (though appeals are ongoing).

The article does devote some coverage to the systemic risk of clearinghouses.  Ironically, it indicates that Gensler is aware that CCPs concentrate counterparty risk, which can be problematic.  This is quite contrary to many of his public statements on the issue, including in an FT oped mentioned in the Bloomberg piece, in which Gensler suggests that CCPs are a magic box that makes risk disappear.  So was he misinformed before, and has he come to a better understanding of the way things really work?  Or was he deceptive in his earlier advocacy?

It’s good to know that there is some recognition of this issue, but sadly, the diagnosis of how CCPs contribute to systemic risk is cramped and simplistic.  Yes, the failure of a CCP is a major worry, but as I point out in the paper I will present in Paris next week (assuming UA cooperates!) measures to keep CCPs immune from failure can create systemic risks too.  There is too little systematic thinking about systemic risk.

In politics and journalism, good versus evil narratives are easy and comforting.  The problem with that is that when you are talking about something as complicated as derivatives regulation, the world isn’t that simple.  Rent seeking and capture happen, resulting in industry-friendly regulations that may create or perpetuate systemic risks, or fail to mitigate real problems.  But regulatory stupidity happens too.  This is especially likely when you have a regulatory crusader who believes that he is on the side of good fighting evil, and who approaches complicated markets with a very narrow set of simple beliefs, rigidly held: Transparency good! More transparency better! (Ironic, given that SEFs reduce transparency about the identity of counterparties, even if they increase pre- and post-trade price transparency).  Clearing good!  Banks bad and anti-competitive!

As you know, I believe that the intellectual assumptions underlying Frankendodd are fundamentally flawed.  The adverse consequences of those fundamental bugs are only exacerbated when the individual with the primary responsibility for implementing the law believes the bugs are actually features, and approaches his task with a Jesuitical zeal that treats any opposition as the result of malign and self-interested motivations.  Gensler’s rigidity and self-righteousness, and apparent unwillingness to contemplate the possibility that people were opposing him because, he was, you know, actually wrong, have made the process costlier and more contentious, and made the resulting regulations more costly and less beneficial.  Consequently, Gensler’s defeats on these issues-which are minor in the scheme of things, really-are to be welcomed, not lamented.

This article by Chris Whittal in International Financing Review does a good job at summarizing my beef with the BIS’s Macroeconomic Assessment Group on Derivatives.  I appreciate Chris taking the time to speak with me and broadcasting my analysis to a broader audience.

A couple of people have expressed interest in my paper on clearing mandates and systemic risk.  So here it is.

In a nutshell: the arguments that clearing (and non-cleared derivatives) collateral mandates will reduce systemic risk are fundamentally flawed.  Ironically, this is because the analyses do not take a truly systemic approach.

My counterarguments will be familiar to those reading my posts on clearing over the past five years (!) but this piece lays them out in one place.  One stop shopping, as it were.  Or maybe one stop slashing.  (One of my lawyer clients remarked to his partner yesterday that I wrote “slashing” blog posts.  I said “Don’t leave out the burning!”)

The BIS has released a report titled “Macroeconomic impact assessment of OTC derivatives regulatory reforms.” It concludes that the benefits of these reforms-including Frankendodd-will greatly exceed the costs, because (a) financial costs of a financial crisis are immense, and (b) the reforms will greatly reduce the probability of a financial crisis.  Specifically:

In its report, the MAGD focuses on the effects of (i) mandatory central clearing of standardised OTC derivatives, (ii) margin requirements for non-centrally-cleared OTC derivatives and (iii) bank capital requirements for derivatives-related exposures. In its preferred scenario, the group found economic benefits worth 0.16% of GDP per year from avoiding financial crises. It also found economic costs of 0.04% of GDP per year from institutions passing on the expense of holding more capital and collateral to the broader economy. This results in net benefits of 0.12% of GDP per year. These are estimates of the long-run consequences of the reforms, which are expected to apply once they have been fully implemented and had their full economic effects.

Don’t believe it for a minute.  The methodology of the analysis is irretrievably flawed.  The net benefits are the free-est of lunches, because the report does not take into account the redistributive aspects of the collateralization and netting that results from clearing, capital, and uncleared derivatives collateral mandates.  That is, it fails to recognize that the reduction in counterparty credit losses on derivatives that result from the “reforms” are accompanied by an increase in losses suffered by somebody else.  It accounts for a transfer as a social gain.

In broad strokes, the BIS analysis goes as follows.  Financial institutions are connected to one another by OTC derivatives trades.  One way of measuring this interconnection is the CVA-the credit value adjustment on derivatives trades.  The CVA is (roughly speaking) loss given default per dollar of exposure times credit exposure times the probability of default.  If a given bank, B say, takes a hit of X to its balance sheet, due to a bad investment, or a rogue trader loss, or whatever, its probability of default goes up.  This raises the CVA.  This is immediately recognized as a mark-to-market loss, dollar for dollar, by its counterparties.  These counterparties tend to be systemically important banks, and the loss makes them more leveraged.  The greater leverage makes them riskier, and more subject to default.  This raises their probability of default, which imposes CVA losses on their counterparties, and on and on.  In this way, a shock to one bank propagates throughout the system, and feedback effects intensify the original effect.  The end result is that major financial institutions become more leveraged, and the more leveraged the system, the more prone it is to a very costly crisis.

But Frankendodd lurches to the rescue!  By collateralizing and increasing netting*, Frankendodd reforms reduce credit exposure in derivatives.  Therefore, the CVA hit from a given rise in the probability of default is smaller.  The leverage in the system doesn’t rise nearly as much when bank B takes the hit of X to its balance sheet.  So a given shock has a substantially smaller impact on systemic leverage, and hence systemic risk.  Yay!

Not so fast, people.  Notice the flaw in the logic?  Remember what started the cascading effect in the pre-Frankendodd world: an increase in the probability of default at B due to some adverse shock to its balance sheet.  Collateral and clearing mandates reduce the exposure of derivatives counterparties to this shock.  But a default doesn’t just affect derivatives counterparties: it hurts all of B’s creditors.  Roughly speaking, the total cost incurred by B’s creditors as a result of an increase in the probability of default due to the loss of X is loss given default times total liabilities times the change in the probability of default.  Given total liabilities, this does not change when derivatives are collateralized or netted more extensively.  This, in turn, means that the decline in derivatives CVA that results from more derivatives collateral and netting is matched by an increase in losses suffered by other creditors.  The “reforms” shift around the losses: they do not reduce them in aggregate.

That is, the “reforms” don’t reduce the losses that result from the balance sheet shock that raises B’s probability of default: they redistribute them.  Note, moreover, that many of the same big financial institutions that benefit from the decline in derivatives CVA are hurt by the loss on B’s other liabilities, because these institutions are exposed to one another through a variety of claims, not just derivatives.  Moreover, some of the others (non-bank creditors) that suffer from the redistribution may be systemically important too: money market funds that invest in the short term debt of financial institutions (including B) are one example.  Repo is another example.  Thus, the overall effect of Frankendodd and EMIR on systemic risk is quite equivocal.  It shifts around losses, and there is no guarantee that the shift in losses improves the stability of the financial system.

But the BIS study does not treat the redistributive effects of the derivatives reforms.   It treats them has a net gain.  This is fundamentally, basically, and irredeemably wrong.  Wrong, wrong, wrong.  When evaluating systemic risk, it ignores the systemic redistribution of losses.  As a result, it overestimates the gains of the regulatory changes.

To a first approximation, given the redistributive nature of their effects, the benefits of the reforms is zero.  The BIS recognizes that they involve costs.  Meaning that to a first approximation, Frankendodd and EMIR reduce wealth, rather than increase it.

But that’s just a first approximation.  To understand fully the effects, you’d have to know how losses are redistributed, and the systemic importance of those who suffer bigger losses and of those who realize smaller ones.  You’d also have to understand how financial contracts will change in response to the new set of creditor priorities inherent in the Frankendodd and EMIR rules.   Financial contracts-capital structures, if you will-will change in response to the new rules.  Claims will be repriced.  There is going to be a new, different equilibrium structure of financial contracts.  Maybe this new structure is less fragile.  Maybe it is more so.  I don’t know: the system is so complex that it will respond to this big shock in surprising ways.  All I do know is that this where you need to look to figure out the effects of the so-called reforms on systemic risk, and this ain’t where the BIS looks.  It counts benefits conferred on some subset of claimants, while ignoring the costs imposed on others (that are approximately equal in magnitude).

In other words, the BIS is hawking a free lunch, and as Friedman said, there ain’t no such thing.

The BIS study also has a particular model of systemic risk: the counterparty credit contagion model.  B takes a hit, that spreads to C, D, and E, which then spreads to F, G, and H, and on and on, until most everyone drops dead like Aztecs fell to the smallpox.  This is a common way of formalizing systemic risk, but reminds me of the story of the drunk looking for his keys under the lamppost because the light is better there, not because he lost them there.  If you look at the history of financial crises, they almost never look like the systemic crises in these contagion models.  An idiosyncratic shock at one institution doesn’t bring a house of cards crashing down.  The collapses of individual institutions (Bear, Lehman) are symptoms of a deeper-and systemic-rot.

In sum, the BIS analysis is fundamentally flawed, and hence gives a wildly misleading estimate of the social benefits of the clearing and collateral mandates embedded in Frankendodd and EMIR and regulations adopted by other G20 nations.  It is a sad, sad example of a reputable institution falling prey to free lunch fallacies.

It is particularly sad because it’s not as if this hasn’t been pointed out before.  I raised the problem five years ago.  So you may say-well, who are you anyways?  Well, Harvard’s Mark Roe, one of the most accomplished bankruptcy scholars in the legal academy, has made the same point (and graciously cited my work).  And, truth be told, it is a staple of the bankruptcy literature.  And it’s also sad because I hear such “logic” over and over from regulators (e.g., scholars and policymakers at the Fed).  They presume to identify systemic benefits based on analyses that look at only a portion of the system.

And speaking of sad.  Could the BIS please spring for a typesetting program like LaTeX that prints readable equations?  Please?

* It is by no means clear that moving more trades to clearing will reduce credit exposures in derivatives via netting, especially given the fragmentation of CCPs by product and jurisdiction.  CCPs permit multilateral netting, but (a) bilateral trades can be compressed multilaterally, and (b) cross-product netting of exposures within dealer books can be larger than multilateral netting in single-category CCPs.  But that’s really a secondary issue.  The most important thing to remember is that the primary effect of netting is to redistribute default losses from derivatives counterparties to non-derivatives creditors.

Earlier in the year I wrote about the obscure, but very important, regulation of futures commissions merchants that essentially requires them to hold enough of their own money to cover shortfalls in customer margin accounts.  This “residual interest” rule has caused a wholesale freakout among FCMs and market participants, and for good reason, as I pointed out in that post.  The rule would not have prevented an MF Global or Peregrine situation-those involved fraud and/or numerous rule violations.  Moreover, the rule puts further strains on the funding liquidity of the futures markets.  There are already new strains aplenty, and liquidity shortages are a major source of systemic risk.  A rule ostensibly designed to protects customers puts the entire system at greater risk.

The near universal opposition of the industry is leaving the CFTC unmoved.  But the CFTC’s response is purely legalistic, and does not even attempt to address the fundamental economic issues:

But on Thursday, at an open meeting of the Agricultural Advisory Committee to the CFTC, regulators were unmoved by the criticism.

The proposed rules, said Ananda Radhakrishnan, director of the CFTC’s division of clearing and risk, merely clarify what the law already says: funds from one customer must not be used to pay for the position or deficit of another customer

“Nobody’s been able to make the argument, with all due respect, that what we are suggesting is not what the law says it is,” Radhakrishnan said. “The arguments we’ve heard … (are) that it’s going to be expensive, the earth is going to fall and so on and so forth. But nobody has done, to my view, a legal analysis saying, ‘your analysis is wrong.'”

Translation: “The law may well be an ass, but we’re rolling with it.”

I have some sympathy, because Congress has handed the CFTC many legislative directives that are at odds with economic common sense, and which are actually contrary to the purposes of the legislation (notably, the reduction of systemic risk).  But where there’s a will, there’s a way.  I get the sense that the CFTC is just hiding behind the legalisms in order to force through a proposal that it-and most likely Gensler-wants.  If it had the will, it could likely find a way to adhere to the law as written but substantially mitigate the negative impacts of the regulation on liquidity, costs, and systemic risk.  The failure to do so, and the appeal to the “Congress made me do it” defense (seen so clearly in the position limits regulation, and repeated in its appeal briefs) strongly suggests that the CFTC doesn’t have a strong economic justification for its regulation, can’t rebut the arguments of the critics, and is playing legal rope-a-dope in order to force through one of Gensler’s (and perhaps the staff’s) bright ideas/obsessions.

In 2009 I called China the “Michael Jackson economy,” meaning that it was kept going by artificial stimulants, but that inevitably their cumulative effects would cause  serious, and perhaps fatal problems.  They mask the effect of the underlying ailment, and have severe side effects.   China responded to the 2008 financial crisis by engaging in massive stimulus, and has inflated credit bubbles whenever growth stuttered in the past several years.  Moreover, allocation of credit and investment in the economy is subject to substantial direct and indirect government control.  Local governments invest massive amounts in infrastructure and housing projects, and the banking system is tilted to direct credit to large state enterprises that invest primarily in heavy industry-steel manufacture and shipbuilding, for instance.

This “investment” can prop up GDP statistics, but they are recorded at cost, not value.  (I recommend this David Henderson piece about the perversity of GDP fetishism, and how GDP can grossly mis-measure well-being.)

If the investments are ill-conceived, they will not pay for themselves in the future, and economic output and consumption will suffer.  And investments guided primarily by the visible hand in an authoritarian state are almost certainly ill-conceived.  They are driven by considerations like political connections, prestige, and the imperative to maintain employment in existing enterprises and regions to buy labor-and political-peace.  This latter effect is particularly deleterious, as it means that rather than there being a natural corrective mechanism for past mistakes, mistakes tend to be self-perpetuating.

The Wall Street Journal has a fascinating article about one major malinvestment that fits this story almost perfectly.  Yes, it is likely an extreme case, but there are enough similar stories to suggest that that the malivinestment problem in China is severe.  Moreover, the bloated fraction of investment to GDP, and the falling delta between changes in credit and changes in income provide some quantitative support for these anecdotes.  Add in the dodginess of Chinese economic data, and there is serious reason to believe that China is heading for a very rocky period.  When the interactions with the financial system are considered, the prospects look even more dire: when the investments don’t generate sufficient return to pay back the loans, realistic outcomes range from a Japan-like zombie-fication of the banks to a full-blown financial crisis.

China’s new premier is promising 7+ percent GDP growth.  That could be the problem: the only way to get it is to double down on the artificial stimulants, thereby exacerbating the malinvestment problem.  Living with lower GDP growth, and permitting Chinese businesses and individuals to reallocate resources to those that generate value rather than statistics, would be far preferable in the short, medium, and especially long run.

A major adjustment is needed, but I would have little confidence in the Party and the system that created the mess in the first place to manage this adjustment effectively or efficiently.  The political economy suggests that incumbent industries, firms, and interests, all of which have strong political influence, will disproportionately influence government economic policy.  This impedes adjustment, and substantially increases the odds of zombie-fication, of the financial system and entire industries.  China could use some creative destruction, but I do not believe this is politically feasible.

China is one of those few matters on which Krugman and I agree.  Krugman mentions that this could be bad for commodity prices, and that would definitely be true if China goes cold turkey and stops trying to perpetuate its old growth model.  That will lead to a substantial decline in the demand for commodities such as industrial metals, iron ore, coal, and oil.  But if the political economy story is correct, it will attempt to support the existing commodity-intensive structure of production and delay the adjustment process.  In the event, commodity prices will likely fall, because a reprise of 2009’s extreme dosage of stimulants is likely infeasible.  But government attempts to cushion the adjustment process will cushion the impact on commodity prices too.

But it is true that the course of commodity prices will depend crucially on how the Chinese government handles the painful withdrawal from its past stimulus binge.  Cold turkey would be very bearish (how’s that for a mixed metaphor!?!) Hair of the dog far less so.  This implies that a crucial fundamental in commodity markets in coming months and even years, and perhaps the crucial fundamental, will be Chinese politics.

Who woulda thunk that commodities-especially ones like aluminum-would become such a huge story.  Maybe it’s the summer news doldrums, but in the last week there have been two major, related stories using up loads of ink and pixels.  The stories are: (1) the Federal Reserve’s announcement that it is evaluating whether to continue permitting banks it regulates trade physical commodities, and own physical assets like storage facilities and power plants used to transform commodities in space, time, or form, and (2) the role of banks like Goldman and Morgan in the industrial metals storage business.  The latter story was the subject of an extensive piece in the NYT on Sunday.  The stories are related because the metals warehouse controversy is Exhibit A in the case against allowing banks to be involved in physical commodities.

First the warehouse story.  I wrote about this issue back in January.  There is smoke here.  The premiums in physical aluminum above the LME in-store price is an indication of a bottleneck in getting material out of warehouses.  The question is whether this bottleneck is being artificially exacerbated by game playing-manipulation, perhaps-by the warehouse operators.  The NYT article does cast some light on some mysterious practices, but it does not seal the deal in my mind.  Not to say that manipulation is not occurring, just that the NYT piece doesn’t convince me.

One puzzle is that the operators of warehouses, who cannot own physical metal in them, pay third parties a bonus over the LME price approximately equal to the cash market premium in order to put their material in store, and thereby put themselves at the mercy of the loadout queue.  Presumably, those taking these deals only do so because they are compensated for the higher storage expenses they incur once their metal gets stuck in the roach motels.  If Goldman (or any other warehouseman) paid everyone these premiums, Goldman couldn’t make any money by running the roach motel: it would pay in premium what it collects in storage fees.  It would compensate the roaches for the costs of getting stuck in the motel.  Which suggests that they only pay some customers the premium to attract metal.  What would be interesting to know is how this would permit the warehousemen to collect storage for a longer period from others whose metal is in the warehouses, but who don’t get paid the bonus.  Are there side deals with the storers who receive the premiums?   Does the mere fact that there is more metal in the warehouses increase the ability of the operators to slow down load-out, and thereby collect storage for a longer period?    This seems to be the most curious practice, but the articles I’ve read don’t shed enough light on how they could be part of a manipulative scheme.

Tom Maguire of Just One Minute does a good job at debunking the math in the Times piece: the profits accruing to Goldman and the costs imposed on soda and beer quaffing consumers alleged by the Times don’t withstand scrutiny.  To which I would add another point.  Namely, these calculations assume that the cash premiums reflect an inflation in price.  Any uneconomic act that exacerbates the bottleneck in the transformation of metal in store to metal outside LME warehouses has effects on prices on both sides of the bottleneck: it reduces the price of metal in store, and increases the price at the Coca Cola or Budweiser facility.  So even if the premium is inflated, this does not mean that the price paid by consumers (directly or indirectly) is inflated by the same amount because part of the inflation is due to a depression of the in-store price.  Those with metal in store, or producers who put their metal into store, bear some of the cost.

Now on to the bigger issue, which the hue and cry over bankers owning metals warehouses is intended to illustrate: namely, whether banks should be involved in physical commodity markets.  This is the subject of a Senate hearing today, where one of the main anti-bankers, Ohio Senator Sherrod Brown, is leading the charge to get the banker-squids’ tentacles off our commodities.

I find most of the reasons advanced for keeping banks out of physical commodities, and the ownership of commodity transformation assets, to be unpersuasive.  What’s so special about commodities?  Are they uniquely risky?

I think not, and believe that there are good economic reasons for banks to enter into the commodities business.

In addressing this issue, it’s important to be specific about the kinds of risk involved.  Price risk, spread risk, and operational and reputational risks are perhaps the most important to consider.

The conventional view is that commodity prices are extraordinarily volatile, and hence pose extraordinary risks on those who hold them.  One thing to note is that for a leveraged investor like a bank it is possible to transform a relatively low volatility flat price exposure into a much riskier exposure.  So one thing that matters is whether, taking leverage into account, bank positions in commodities are riskier than their positions in more traditional lines of business.  Moreover, it is risk at the portfolio level that matters, and the correlation between the price exposures and other elements of the banks’ portfolios.  A highly volatile position may not increase portfolio risk substantially if it is uncorrelated with other exposures, or negatively correlated.

But there’s a more important point.  Most commodity trading by commodity trading firms and banks does not consist of punts on the flat price, on whether the price of oil or copper is going to rise or fall.  Instead, most commodity trading is a margin business or a fee business.  Money is made on margins or fees in transportation, storage, and processing.  These margins-spreads-tend to be much more stable than flat prices.  Asset ownership, or contractual control of physical assets (of the type that JP Morgan has over California power plants that have attracted FERC’s ire), is a position on the value and cost of transformation, and spreads and margins measure these values and costs.  The riskiness in these spreads/margins, and the ability to manage spread/margin risk through paper trades, is what drives the risk of bank commodity plays.  My reading of the coverage has turned up virtually no understanding of this issue.

Moreover, the profitability of physical assets can provide a natural hedge for other bank businesses.  Most banking his highly pro-cyclical: it profits when the economy booms, and does badly when the economy tanks.  Some commodity assets are countercyclical.  Storage is a classic example.  The amount of oil or metal in storage-and revenues from storing these things-goes up when the economy weakens.  This is basic economics.  So metal or oil storage-a fee business-is a natural hedge against the strongly procyclical traditional banking and dealing businesses.

Taking these factors into consideration, it is wrong to believe that commodity businesses are unduly risky, compared to other banking activities.

Operational risks are perhaps more problematic.  A major oil spill, for instance, leads to substantial costs on the operator of the ship or pipeline or terminal that spills it.  A bank that owns or charters a tanker that ends up on a reef is potentially exposed to a substantial risk of loss.  But much of this risk can be passed on to insurance companies via the insurance market.  What’s more, the risk doesn’t go away if banks can’t touch physical oil: someone has to bear it.  The question is whether banks are less efficient bearers of this risk than others (where others include insurance companies).

Many of the stories that have come out in recent days focus on the reputational and legal risks associated with commodity trading.  For instance, JP Morgan’s impending settlement with FERC of allegations that it manipulated the California electricity markets has received considerable play.  Well, this is not a problem unique to commodities.  Traditional banking businesses, and other less traditional activities now widely considered to be legitimate activities for banks, have huge reputational and legal risks.  Consider Libor.  Or the Toure trial.  Or mis-selling.  Or mortgage servicing/foreclosures.

I could go on. And on. And on.  If you think that keeping banks out of commodities you’ll reduce their rep or legal risks, I have a bridge to sell you.

Furthermore, even if it is shown that banks have engaged in dodgy activity in commodities, that doesn’t mean that getting banks out of commodities will eliminate the dodgy activities.  Consider the warehouse issue.  If LME rules and cash market frictions make it profitable for warehouse operators to manipulate markets, forcing banks to sell off these assets won’t reduce the manipulation: the new owners will take ownership of the strategies along with the storage sheds.  Note that Glencore-not a bank!-has been accused of playing similar games.   Keeping banks out of commodities may affect who plays dodgy games, and profits therefrom, but won’t have much of an impact on the amount of dodginess in the markets.  That dodginess ultimately derives from economic opportunity (which is driven by frictions in the market) and regulation (flawed rules and rule enforcement mean that market participants calculate there’s a substantial probability of escaping punishment for misdeeds).  Barring banks from the market won’t change either of these things.  If crime pays, someone will commit it.  If you care about reducing the deadweight losses from manipulative activities, you shouldn’t really care about who profits from them.  You need to fix the problem at the level of incentives and enforcement of rules: keeping banks out of the market doesn’t do that.  Period.

The foregoing is basically a rebuttal-or at least a skeptical questioning-of the case against bank ownership of commodity assets, or participation in physical commodity markets.  What about the affirmative case for such participation?

For several years, in response to shrieks about the evil effects of the “financialization” of commodity markets, I’ve made the following basic point: a good deal of commodity trading is about allocating commodities over time, and allocating risk.  Both of these are fundamental financial functions: finance is about trading off the future and the present, and allocating risks.  Banks are linchpins of the financial system, and engage in intermediation of risk and of resources over time.  Why should we exclude them from a sector where the allocation of resources over time and the allocation of risk are vitally important?  That is the comparative advantage of banks: why keep them out?

Indeed, banks have gained market share in commodities in large part because they can perform the time- and risk-allocation functions more efficiently than others.  If banks have the lowest funding costs, it makes sense that they fund some inventories.  Banks have expertise in risk management and hedging, making it sensible that they utilize this expertise in the management of commodity price risks.  In other words, the success of banks in commodities is a feature, not a bug, because it reflects their comparative advantages in allocating risks and resources over time.

Moreover, there is often a synergy between financing and risk management activities, and banks can exploit these synergies.  For instance, one physical market activity that banks engage in is offtake agreements, whereby they provide say crude oil to a refinery, and receive the refinery’s output which they market.  This bundle of transactions involves a funding element-the bank is basically providing working capital to the refinery.  It also involves a risk management element: the bank is managing the price risks on the crude and refined product side (as well as the logistical/operational risks).

Crucially, by taking on the risk, the bank is reducing the moral hazard that would be involved if it was providing working capital financing to the refinery.  Yes, if it just extended loans or credit lines to the refinery, the bank would presumably impose requirements on the refinery to hedge its risks, but there are inherent agency problems associated with such an arrangement that can be avoided by putting the price risks on the bank.   Moreover, the operational and logistical risks cannot be hedged, and pose a potential moral hazard.

The most telling objection that might be raised against these arguments is that banks have gained market share in commodities because they are subsidized as a result of too big to fail.  I would note that the investment banks that made the first and biggest forays into commodities-Morgan Stanley, Goldman, Bear-did so when they did not have access to insured deposits for funding or to the Fed window, though one could argue that they still were subsidized by the belief that they were too big for the Fed to allow to fail.

But even if you buy into the subsidy argument, that’s no reason to single out commodities.  The subsidy leads to an excessive expansion of big banks generally, across all lines of business.   Meaning that keeping them out of commodities will not materially reduce the perverse effect of the subsidies.  Implicitly or explicitly subsidized banks will exploit that subsidy to the hilt, and if they can’t do it in commodities, they’ll do it somewhere else.  TBTF has to be tackled at the roots, not the branches or the leaves-and particular lines of business like commodities are the latter.

One last point.  It is beyond ironic that the banks are under attack for their commodity dealings.  GFMA wanted to hamstring banks’ competitors in commodity trading-namely, the commodity trading firms.  Perhaps they should have paid more attention to making the affirmative case for their participation in these markets, than they did attempting to raise their non-bank rivals’ costs.

The word karma comes to mind.

Marco Dialosa of the Pension Insurance Corporation echoes some SWP clearing themes in an interview on Derivsource.com (sorry we didn’t connect in London last month, Julia):

Q. Given the liquidity squeeze that will result from CCP clearing, where do you see the liquidity coming from?

A. We believe that the amount of high quality liquid assets on balance sheets will increase. We see the repo market as a mean to provide liquidity for cash variation margins. What is less clear at this stage is whether the repo market is the right place for collateral transformation and how this market will behave in times of stress. One of the unintended consequences of the clearing initiative is that it may be transferring systemic risk away from the OTC world into the repo market.

Q. Does the movement of systemic risk away from OTC world and into the repo market an unintended consequence concern you or do you view it as just inevitability?

A. It is an unintended consequence in our view. The OTC market is akin to an ecosystem, it is in a stable equilibrium. A small change in a particular parameter (i.e. central clearing) will be corrected by some negative feedback that will bring the parameter back to its original point of balance. It is extremely difficult to eliminate systemic risk in practice without disrupting the balance of the whole system.

Just so.  Most of the effects of clearing mandate are to redistribute risk, not to reduce it.  Moreover, the equilibrium in the system will adjust in response to an exogenous policy shift: the “negative feedback” will attempt to find a way to replicate the old equilibrium as closely as possible, given the constraints imposed by the new rule or regulation.

In other words: you need to take a systemic approach to analyzing systemic risk.  You have to understand how a change imposed on one part of the system is going to be transmitted to other parts of the system, and how those other parts are going to respond to this impulse.   Systems achieve a particular configuration for particular reasons, and it is very difficult to change these configurations fundamentally.  The particular reasons that led to its particular configuration lead to the negative feedbacks that Dialosa mentions.  And a good thing too.  Negative feedback is a stabilizing force.