Streetwise Professor

July 11, 2013

Doctors Warren and McCain: Screwing Up the Diagnosis and the Prescription

Filed under: Economics,Financial crisis,Financial Crisis II,Politics,Regulation — The Professor @ 6:39 pm

Today Elizabeth Warren and John McCain unveiled the “21st Century Glass-Steagall Act” that would restore the separation of investment banking and commercial banking, along with a few new restrictions on the things commercial banks with access to deposit insurance can invest in.

I really don’t get the nostalgia for Glass-Steagall.  I really don’t.  What’s next?  High Button Shoes for the 21st Century?  Radio tubes for the 21st Century?

Smarter people than McCain and Warren (a bar that a snail could jump, I admit) have pumped for the restoration of Glass-Steagall.  Luigi Zingales is a prominent example. I expressed my criticisms of Zingales’s advocacy of Glass-Steagall a little more than a year ago, and nothing I’ve seen since changes my mind.  Certainly the bloviations of Warren and McCain don’t.

The essence of the argument for a restoration of Glass-Steagall, as well as “ring fencing” regulations in Europe, appears to be that deposit insurance creates a moral hazard: banks with access to insured deposits take on too much risk.  Preventing such banks from engaging in risky investment banking activities supposedly improves the safety of the banking system, and limits taxpayer exposure, by reducing that moral hazard.

There are only two problems with that.

First, access to deposit insurance is obviously not a necessary condition to induce risk taking.  None of the stand-alone IBs that took on leverage out the wazoo in the 2000s, and took exposures to highly risky real-estate related securities-Bear, Lehman, Merrill, Morgan Stanley and even, yes, Goldman-had access to deposit insurance.  And that was in  fact the problem.  Nor did they have statutory access to Fed support in the same way banks do.  They all relied on very fragile wholesale funding that ran like Usain Bolt when things started to look dodgy.

Second, Glass-Steagall-like restrictions on permitted activities/investments are not sufficient, by a long shot, to prevent commercial banks from taking on risks that threaten their solvency, and the stability of the financial system.  Look at all the banking problems in the 70s, 80s, and 90s that occurred despite Glass-Steagall.  Sovereign lending to Latin America.  The S&L crisis.  Lending to Asia before its 1997-1998 crisis.  Commercial lending to the energy industry.  Need I remind everyone that the phrase “too big to fail” was coined to describe Continental Bank, which became insolvent the old fashioned way: engaging in high risk commercial lending in the era of Glass-Steagall?

The “quiet period” of US banking the 50s and 60s was the result of a dense nexus of costly restrictions on banking activity.  Glass-Steagall was a part of that, but not the entire story by a long shot.  It just gets the most press, and the best press.  The complex web of restrictions on banks and financial intermediation during that period-restrictions that imposed substantial costs-is too hard to explain.  So Glass-Steagall has become the poster child for that era. People like Warren and McCain think that Golden Age can be restored by reviving Glass-Steagall.  As if.

I am deeply skeptical of restrictions on the activities of financial intermediaries; I am also skeptical of mandated impositions of market structure (e.g., clearing mandates).  The underlying incentives remain the same, and these Byzantine restrictions induce attempts to circumvent them.  It is better to operate at the level of incentives, through capital requirements, for instance.  Yes, there will be attempts to circumvent these too, but at least they provide some incentive for those with the information to internalize the risk-return trade-offs.  Structural restrictions, not so much.  At all.

Yes, moral hazard induced by deposit insurance matters.  But it matters a lot less than other things.   Breaking up universal banks will still leave large investment banks reliant on wholesale funding with incentives to lever up, and large commercial banks who can blow themselves up just fine, thank you, by making loans.  So the revivification of Glass-Steagall won’t materially reduce systemic risk, but it will induce costly efforts to circumvent the separation, and will sacrifice the synergies between investment and commercial banking activities.

When your diagnosis is wrong, the prescription is likely to be wrong too.  And with financial doctors like Warren and McCain, we should have no illusions that they’ve screwed up both.

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July 8, 2013

The SWP Worldwide Personified Clearing Tour: Greatest Hits

Dealer banks and the CME squared off in the pages of the FT today, arguing over the systemic risks of CCPs.  Each made some good points; each whiffed on a few; both overlooked the real sources of systemic risk arising from clearing mandates.

First, the banks:

“We are losing track of the nominal risk,” warned Jean-Pierre Mustier, head of investment banking at UniCredit and a former board member at London-based LCH.Clearnet. “We’re moving from a set-up where banks were interconnected, because they had transactions between them, to a system where very lowly capitalised entities, the clearing houses, are supposed to protect the banks from a problem.”

. . . .

Banks have voiced concerns to regulators in Europe and the US that central clearing houses are providing insufficient data on their own risks and demanding lower-quality collateral for swaps transactions. They argue the risks are too opaque, and getting riskier.

“It’s going in the wrong direction,” said the head of credit trading at a large US bank. “The race to the bottom is on.” He and other executives were critical of the CME’s decision to accept corporate bonds as collateral, a step down from the safer instruments usually required for margin.

There are reasons to be concerned about the expansion of the collateral pool to include more risky assets.  This is especially true inasmuch as these assets are likely to become less liquid precisely when a CCP needs to liquidate them: during a systemic even that causes the failure of a large, or several large, clearing members.  This problem could be mitigated by giving CCPs access to central bank liquidity, collateralized by the corporate bonds, etc., they take in as initial margin.  But the fundamental driver here is that clearing mandates have dramatically increased the need for initial margin, and it was inevitable that this would result in expansion of eligible collateral.  It’s not a competitive race to the bottom, it’s facing reality: indeed, CCPs in individual product spaces face relatively little competition.

Concern about initial margin methodology is also reasonable.  Under-margining leads to the mutualization of risk in excess of what CMs had anticipated: over-margining leads to inflated trading costs.  But the crucial problem with any CCP methodology is that it takes into account position risk only, and doesn’t vary margin with the balance sheet risk of the member firms.  This tends to lead to excessive trading by weaker clearing members, as they don’t have to post higher collateral, as their poorer credit would suggest they should.  This is pretty much an inherent feature of clearing, for informational and governance reasons, as I’ve discussed frequently here on SWP in the past.

Now to CME,  as represented by Chairman Terry Duffy:

Terry Duffy, executive chairman of CME Group, said the shift in moving more OTC derivatives transactions was more profound than just transferring the risk and exposure to a counterparty default from banks to clearing houses. “The difference is with a clearing house we do market-to-market [risk management], either twice daily or have the ability to do it much more often,” he said on a visit to London.

“What’s important is making certain the pays and collects are done on a risk basis and not a mark-to-myth or anything else. Because of that, we have a much easier time doing the pays and collects than the banks do if it was a bilateral transaction. In turn, I think some of the banks are just not used to the model of clearing.”

This relates to variation margin, which was/is often collected in OTC transactions (once exposure exceeds negotiated credit limits between the parties.)  Several points to make here.  First, variation margin is basically a way of keeping initial margin levels current.  This doesn’t really address the issue raised by the banks of whether initial margin levels are adequate, banks can determine that, and the quality of the collateral posted as initial margin (and whether the haircuts applied against this collateral are commensurate with the risks).  Second, you can go through the process of marking to market, but the protection provided by that process depends crucially on the quality of the prices.  That depends on market liquidity, trading activity, etc.  You need a market to mark to, and for many products that will be brought into clearing there are serious doubts about the reliability of the prices used for markets.  If there’s a liquid market, the prices it generates more accurate MTM in both bilateral and cleared trades: if there isn’t, both cleared and bilateral MTMs are dodgy.  Third, as I’ll discuss more in detail, the mechanical process of marking to market can actually create systemic risks.

The FT reporter, Phillip Stafford, also mentions that banks complain about the inadequacy of CCP capital, but notes that CCPs also have default/guarantee funds that they can call on to prevent a CCP default. But that’s exactly what the big banks are worried about.  Their exposure to CCPs comes first and foremost through their participation in these funds.   There’s only a thin layer of CCP capital separating a defaulter’s margin (and default fund contribution) from the non-defaulters’ contributions.  If the CCP under margins, that capital can be blown through very quickly, and expose banks to substantial losses.  These losses are most likely to occur, moreover, during stressed market conditions when banks are least able to afford the hit.  This wrong way risk is precisely what banks are complaining about.

Truth be told, although both the banks and the CCPs (to the extent Duffy is representing the clearing industry perspective) have some valid points, they miss the big systemic risks associated with clearing and clearing mandates.  I’m sort of in the middle of my Streetwise Professor Worldwide Personified Clearing Tour, in which I’ve given talks on the systemic risks of clearing in Chicago, Frankfurt, Osaka, Istanbul, DC, and the UK (London and Oxford), and will give another in Paris in September.  (Rough duty, I know, but somebody has to do it.)  Here are some of the greatest hits I play at each stop.

  • Clearing, and in particular multilateral netting, basically redistributes credit risk from derivatives counterparties to other creditors of defaulting CCP members.  These other creditors may be as systemically important and vulnerable, or even more systemically important and vulnerable, than CCP members.  For instance, moving to clearing is likely to make runs on money market funds more likely even if it makes runs on dealer banks less likely.  It is not evident that this is a desirable trade-off.
  • The variation margining mechanism in clearing is particularly rigid, and can create substantial demand for liquidity precisely when funding liquidity dries up.  This is what almost brought down the CME clearinghouse on the Day After Black Monday in 1987.  This is why rigid marking-to-market and variation margining can be a systemically destabilizing bug, not a stabilizing feature.
  • Clearing does not eliminate interconnections between big financial firms: it reconfigures the network of connections.  Moreover, it does so in a way that is rife with wrong way risk.  As noted before, CCP members-mainly big banks-are connected via CCP default funds, and are most likely to incur losses during periods of market stress, when they are least able to afford it.

Regulators are becoming increasingly aware of these problems, and are responding by attempting to make CCPs virtually immune to failure.  But this brings me to another of my greatest hits: beware the fallacy of composition.  Yes, failure of a CCP would be catastrophic, but making one part of the financial system stronger-a CCP, for instance-does not necessarily make the system stronger.  One of the main effects of increasing the financial resources of a CCP is to redistribute credit losses from derivatives counterparties to other creditors of defaulting firms, and to redistribute scarce liquidity.   It is not necessarily the case that this redistribution makes the system stronger.

The analogy that I’ve made here, and that I make on tour, is that of the levee.  Building up the levee around a CCP reduces the likelihood that it will be inundated, but forces the financial flood elsewhere.  Again, it is not evident that it’s better for systemic stability to redistribute the water from CCP members to other parts of the financial system.

My closing number is that CCPs have been vastly oversold as a means of reducing systemic risk.  It’s virtually impossible to know what the net effects are, but it’s likely that CCP mandates reduce systemic risk under some scenarios, but increase it under others.  What’s more, the main systemic risk is not necessarily the failure of a CCP, as bad as that would be, but the spillover effects from clearing to other parts of the financial system.

That is, it’s necessary to analyze the systemic risks of clearing by analyzing the financial system as a whole.  Regulators haven’t done that, for the most part, and the debate between the banks and Terry Duffy doesn’t really do that either.  Their’s is a CCP-centric debate, and although that’s not irrelevant, it doesn’t get at the nub of the matter.  Meaning that the show must go on.

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July 1, 2013

Deleveraging is Devilish Hard: Just Ask the PBOC

Filed under: China,Economics,Financial Crisis II — The Professor @ 8:19 pm

The WSJ has a very long and interesting article about the PBOC’s ham-fisted handling of the liquidity crunch of the past weeks.  The central bank was trying to send a signal that it wanted to restrain credit growth, especially in the shadow banking sector, but things got out of hand:

Since early June, the PBOC has sought to force Chinese banks to redirect their lending away from shadow bankers—a mélange of trust companies, pawnbrokers, leasing companies and others—whose lending is putting further stress on an economy already slowing, economists say.

To achieve this, the central bank withheld cash from the interbank market, essentially twisting the arms of traditional bankers to force them to change their lending practices.

On June 20, China’s leaders feared the credit squeeze was getting out of hand. Overnight interest rates at which banks borrow from each other spiked to as high as 30% that day. A rumor circulating in Shanghai that Bank of China had defaulted on an interbank payment was given more credence when a Chinese newspaper, the 21st Century Business Herald, reported the alleged default on its website around 6 p.m. According to the newspaper, Bank of China defaulted during that afternoon, “deferring transactions for half an hour due to a fund shortage.”

But shadow banks are holding a large amount of assets.  How are those assets going to be funded?  Does the PBOC want banks to bring them on their balance sheets?  Really?  If not, where will they go?  Another reason that the PBOC’s crackdown was not credible last month, and hence will be unlikely to have disciplinary effects going forward.

Deleveraging is hard, because leverage funds assets.  To reduce leverage, you have to reduce the assets, or find equity to finance them.  How?  Dump them, leading to fire sales and substantial declines in asset prices that spill over and harm the balance sheets of banks and other institutions?  If not, where is the equity going to come from to hold these assets?

The PBOC is probably right in its diagnosis that China is over-leveraged and that the leverage is particularly fragile.  But making the diagnosis is one thing.  Finding the cure is something different altogether.  The PBOC has found that cutting off funding to shadow banking isn’t feasible, because the assets it holds have to go somewhere.  And if a lot of those assets are bad-which is likely the case here-it’s truly a challenge.  Extend and pretend is the path of least resistance, meaning that the problem is deferred, and likely to matastasize. Meaning that even the most clever central banker is likely to find it very difficult to wean the financial system off cheap credit.  There is a path dependence here that makes that task very, very difficult.  So it’s likely that we haven’t read the last story about a liquidity crisis in China.

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June 29, 2013

The Fed Plays a Global Game, and Loses

Filed under: Economics,Financial Crisis II,Politics,Regulation — The Professor @ 7:21 pm

The Fed is reeling at the violent market response to Bernanke’s statements regarding the eventual taper of Quantitative Easing.  High level Fed officials flooded the zone last week, making soothing noises and arguing that the market had overreacted to Bernanke’s words.

There is some solid economic theory that predicts that the public release of “small” pieces of information can lead to big changes in behavior and market outcomes.  Specifically, the theory of Global Games (see a variety of paper written by Morris and Shin, in particular) predicts that the release of objectively trivial information can lead to a discontinuous jump from one equilibrium to another in coordination games.  The Fed is quite consciously playing a coordination game: it is trying to coordinate the expectations of market participants with the understanding that market outcomes depend quite crucially on consensus beliefs and expectations that tend to be self-fulfilling This is precisely why the market hangs on every Fed statement, every Bernanke utterance.  And this is precisely why a seemingly benign public statement with little information content can lead to a big market move.  It’s inherent in the game the Fed is playing.  They really shouldn’t be all that surprised.

The game the Fed is playing is actually even more complicated than those analyzed in the Global Games literature.  Specifically, there is a reflexivity and endogeneity in the Fed expectations game.  That is, in the real world game game, the Fed responds to the market’s response to the Fed’s actions, and on and on.   That’s not taken into account in the Global Games models, makes things even more complicated, and adds another level of beliefs on which the players of the game (which includes the Fed, prominently) must coordinate.

This is why QE and other exceptional monetary policies are so fraught with danger and risk.  This makes chess look like checkers.  Mistakes will be made.  You will pay for them.

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June 27, 2013

Did the PBOC Blink? Uhm, Yes.

Filed under: China,Economics,Financial Crisis II,Politics — The Professor @ 6:36 pm

The WSJ’s ChinaRealTime blog asks that question.  The answer is fairly obvious.

Recall about a week ago that China was experiencing an acute liquidity shortage, resulting in the spiking of repo rates to 25 percent intraday.  The PBOC remained aloof.  Then it intervened, providing liquidity and making soothing noises.  Interbank rates (SHIBOR) and repo came back down, though they still remained at elevated levels.

The narrative is that the PBOC was trying to teach banks and shadow banks (trust companies, marketers of wealth management products and the like) a lesson: cut down on the extension of dodgy credit, or else!

But as I noted in my post last week, the PBOC was in a bind.  It could refuse to supply liquidity, and watch the system blow up.  Or it could supply liquidity, and undermine the credibility of its “or else” threat.  Not surprisingly, PBOC chose the latter course.

The ultimate result is likely to be quite different than the PBOC had hoped for.  Banks and shadow banks will likely conclude that the PBOC will always come to the rescue.  The “or else!” threat is incredible.

Meaning that Chinese credit will continue to grow, and the ultimate reckoning-which must occur-has been merely delayed.

I have read some reports questioning where money invested in WMPs will go at the end of the quarter, when they mature.  Well that’s the problem, isn’t it?  If the WMPs can’t roll over, if the money invested in them goes somewhere else, the rather dicey assets they hold can’t be funded, with the following consequences: (a) some WMPs will default, (b) others will call on the (implicit) liquidity puts extended by banks, thereby communicating the contagion to the banks, and/or (c) WMPs will dump assets on the market, depressing prices, with deleterious consequences for others holding similar assets.

The PBOC is riding the tiger. Its relenting at the last minute makes it clear that it is loath to dismount.  Market participants will note this, and respond accordingly.  Meaning that the supposed teaching moment will not provide the lesson that the PBOC intended.  It will instead convince market participants that they will be rescued if it looks like the system is about to crack.

Again: the reckoning with China’s extreme financial imbalances and malinvestment has merely been deferred.

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June 20, 2013

Crisis=Danger+Opportunity? The PBOC Seems to Think So

Filed under: China,Economics,Financial crisis,Financial Crisis II,Politics,Regulation — The Professor @ 8:30 am

I have written for some time about my doubts about the sustainability of Chinese growth (driven by massive credit expansion that is delivering progressively less and less bang for the renminbi), and my concerns about the stability of the Chinese financial system, especially the shadow banking system.  So far these prognostications have not been realized, but events over the last few days relate directly to these doubts and concerns.

Specifically, China is in the grips of a full-blown liquidity crisis, with overnight repo rates approaching 30 percent, and one week rates well over 10 percent.  The Chinese yield curve has become steeply inverted, which is never a good sign.  The word “panic” is being bandied about quite freely.

News accounts make it seem that the liquidity shortage is the deliberate  policy of the People’s Bank of China.  Indeed, these accounts suggest that the PBOC is withholding liquidity from the market precisely because it too believes that credit-fueled growth is unsustainable, and that the banking and shadow banking sectors have over expanded and need to be cut down to size:

China’s interbank funding costs surged again on Thursday, with the two shortest-term rates hitting record highs, as the central bank again ignored market pressure to inject funds into the market, despite fresh evidence that the economy is slowing.

The People’s Bank of China (PBOC) told the market that it would not conduct repo business in its regular open market operations on Thursday, frustrating widespread expectations that it would use reverse repos to inject cash to ease an acute market squeeze over the last two weeks.

. . . .

“The central bank appears to be determined to force banks and other financial institutions, such as funds, brokerages and asset managers, to de-leverage,” said a trader at a major Chinese state-owned bank in Shanghai.

“That hardline stance suits the recent government policy of clamping down on non-essential businesses by financial institutions, such as shadow banking, wealth management, trust operations and even arbitrage.”

Yes, deleveraging is probably a good idea: the economy had become over leveraged as the result of previous stimulus policies that fed a credit boom. The question is: how to deleverage?  Quite often system-wide deleveraging is a chaotic process, beset with externalities.  Companies that can’t fund dump assets in fire sales, which puts pressure on other institutions holding the same or similar assets: they often join the fire sale stampede.  Institutions start hoarding credit and liquidity, which drives up rates and puts yet further pressure on financial institutions.

In other words, system-wide deleveraging often occurs through a financial panic that causes massive economic damage.  Usually central banks try to stem this process by flooding the system with liquidity.  Bizarrely, China, it appears, seems to be trying to start the process by starving the system of liquidity.  Central banking with Chinese characteristics, as it were.

One interpretation is that the PBOC has found that jawboning and other less drastic policies have failed to stem the growth in credit and shadow banking, so it feels obliged to take stern measures to curb these activities.  But this is a dangerous way to do it, and I am not sure that it is the optimal strategy in the game between the PBOC and other market participants.

Let’s say the PBOC relents and says “You’ve been warned: don’t let it happen again.”  Many market participants will infer that the PBOC’s threats are not credible, and that it will supply liquidity if the system appears on the verge of failure.  The will therefore have little incentive to curb their activities, viewing the PBOC as a paper tiger.  The economy will continue to be over leveraged.

Conversely, let’s say to demonstrate its credibility the PBOC sticks to its guns and refuses to supply liquidity: then there is a risk of a full-blown panic and crisis-and right now.

China is having an episode not unlike the one that hit world markets in August, 2007, when funding markets signaled the onset of the crisis, with the difference being-and it is a big difference-that this appears to be a crisis of choice, and one that could morph from onset to a Lehman moment in days or weeks, not months.

Perhaps the PBOC believes that the situation is so dire that a purgative crisis now is preferable to a worse one that chooses its own time to appear.  If so, it has no one else to blame.  If China’s financial system was hurtling down the road too rapidly, it was because the PBOC (and the Chinese government) had jammed down the accelerator with its credit-driven stimulus measures.  Now it is responding by jamming on the brakes.  A policy of alternating extremes seldom works out well.

There is an apocryphal belief that in Chinese the word “crisis” is represented by the characters for “danger” and “opportunity”.  (JFK is responsible for popularizing this belief.) The most charitable interpretation of the PBOC’s starving the market of liquidity is that it doesn’t view that belief as apocryphal, but as gospel.  That it is running a great danger to seize an opportunity to put the Chinese financial system on a firmer foundation.

Maybe.  But that suggests a conceit on the behalf of policymakers: it presumes that once a panic is sparked, they can control it, and the panic will make financiers more prudent in the future by putting the fear of God into them today.

That’s a very, very risky bet that has a very, very high probability of turning out very, very badly.

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June 12, 2013

Two SWP Themes Going Mainstream

As changes in financial market regulation like Frankendodd lurch into effect (with phase two of the clearing mandate becoming effective a couple of days ago), it’s interesting to see the dawning realization about some of the implications.  Implications that I’ve discussed for several years here, or in my academic work.

One of these is the tension between the micro-prudential and macro-prudential roles of collateral.  Micro-prudentially, collateral makes sense for a lender: it increases recoveries in the event the borrower goes bust.  But collateral is much more problematic macro-prudentially, for a variety of reasons.  It can be a highly pro cyclical mechanism that intensifies the effects of financial shocks.  It can be a crisis accelerator.

Andrew Hauser of the Bank of England focuses on this tension in this speech.  Unfortunately, despite this and other evidence of growing attention to this issue, I still think it’s under appreciated and that will lead to problems down the road.

Another issue is one that I raised in my more cynical moments.  Scary thought, I know.  Specifically, I mused that one reason for the broad political support for clearing and collateral mandates, especially among government treasuries (e.g., Timmy!), is that these were a form of financial repression.  That is, a means of increasing the demand for government securities, in order to reduce interest rates and borrowing costs.  The mandates effectively require market participants to hold more government debt in their portfolios.

Bloomberg just noticed this:

New collateral rules for hedge funds, insurers and others in the $633 trillion over-the-counter derivatives market are poised to boost demand for U.S. Treasuries, potentially slowing rising yields as the Federal Reserve considers scaling back unprecedented stimulus.

Swaps traders will need to come up with $800 billion to $4.6 trillion to meet Dodd-Frank Act regulations requiring that the derivatives be backed by clearinghouses that collect upfront collateral such as cash or Treasuries, according to estimates from the Treasury Borrowing Advisory Committee. The regulations take effect today for the second group of firms designated by the Commodity Futures Trading Commission in the market for interest-rate and credit-default swaps.

“This is going to be a new, very powerful engine that drives demand for Treasuries, so you have to expect it will impact yields,” said Ted Leveroni, executive director of derivatives strategy at New York-based trade-processer Omgeo LLC. “There are a lot of firms out there — I know because they’ve told me — that are concerned about having the available collateral.”

The rush for collateral may be an unintended benefit from swaps rules designed to protect against a cascade of bank failures

Um, unintended benefit for whom?  And who says its unintended?  I think it might have been quite intentional-just not acknowledged.

Now that the regulatory changes are being put into place, we’ll see how good my forecasting performance is.  Since I’ve predicted many unintended consequences, most of which are not good, y’all should hope that it’s not very good at all.  But it appears that others are making similar predictions now, at least on these two issues.

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April 30, 2013

Gary Dunn of HSBC Meets Wrongway Peachfuzz

HSBC’s Gary Dunn said something at the ISDA AGM that I think is very important:

Dunn pointed out the risk characteristics of a CCP are very similar to that of collateralised debt obligations, the tranched credit products that were prevalent in the run-up to the 2008 financial crisis.

In the CCPs default waterfall, the initial margin payments from clients and default fund contributions from clearing members are comparable to the equity or first loss and mezzanine tranches of a CDO. In other words, these are the first sources of funds that get eaten into to cover any losses.

According to Dunn, the super senior tranche (which in the case of CDOs tended to attract Triple A ratings, but often subsequently sustained losses during the credit crisis) is the additional steps the clearing house might take when all other funds are exhausted, whether it is haircutting, asking for more capitalisation from clearing members of possibly even a government bailout.

“If you start modelling the risks of a CCP as a CDO, you realise the correlation risks in a CCP aren’t at the moment fully appreciated, very much like they weren’t when we had CDOs and CDO squareds,” said Dunn.

“The probability of a CCP failing is still relatively low, but there is a reasonable probability that people or banks lose money even if a CCP doesn’t fail,” he added.

I can hear you saying: “Where have I read that before?”  Or: “When have you said that before?”  In January, 2011, now that you ask 😛

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

This is a big deal. Wrong way risk is particularly poisonous, and a source of systemic risk in systemically important institutions like big CCPs. Policymakers have been largely oblivious to this very important problem.  I’ve been on about it for over two years, but we see how that matters.  Maybe if people like Gary Dunn start raising the alarm this issue will get the attention it deserves.

But, of course, Anat Admati, etc., will dismiss this as self-interested scaremongering by banks, and will criticize me as being some sort of tool (which she has, by the way).

I understand perfectly that such self-interested scaremongering occurs.  But I also understand that sometimes there is a wolf.  This is one of those times.

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April 28, 2013

CCPs: Models and Reality

Pre-Crisis, there was very little academic writing on clearing.  Post-Crisis, with questions about the role of derivatives in creating systemic risk, and the mandating of clearing of derivatives as a means of mitigating this problem, this is changing.  This is a good thing, but unfortunately, this burgeoning academic literature is at risk of irrelevance, and worse, of being misleading, because the theoretical models of clearing are nothing like clearing as it actually is.  These models tend to focus on the mutualization of risk within CCPs.  That’s important, but as I’ll discuss in more detail below, mutualization is not the most important feature of CCPs.  Collateralization is.

I’ll just talk about a couple of papers in detail, Adam Zawadowski’s Entangled Financial Systems in the most recent RFS, and Clearing, Counterparty Risk, and Aggregate Risk by Biais, Heider, and Hoerova.

These papers have some important insights, and I don’t want to seem overly critical.  I just want to persuade scholars that the focus of these papers, and many others, is misdirected, and to suggest where they should direct their attention.

“Entangled Financial Systems” presents a model of the periodic collapse of the financial system through the channel of inter-bank derivatives exposures.  The paper is rough sledding, in part because it tackles a complicated issue, and in part because the exposition and especially the proofs are hardly paragons of clarity: I have my doubts about some of the proofs.  That said, the story is a plausible one.  Banks use fragile capital structures (short maturity debt to fund long-lived assets) to solve an agency problem.  They use derivatives to manage risk in order to protect non-pledgeable income.  Banks are at risk of blowing up due to an idiosyncratic, exogenous shock: perhaps an operational risk, like a rogue trader.  If a bank blows up, its counterparties don’t get paid in full on their derivatives.  If these counterparties don’t insure against this risk, they may fail, and so on, with the result being a daisy chain of failures.  Thus, one idiosyncratic failure can lead to the collapse of the entire system.

In the model, the original risk of a blowup is idiosyncratic and insurable.  But in equilibrium, banks don’t buy insurance against a counterparty failing because they don’t internalize the impact of their failure on their other counterparties.  Thus, there is a “market failure”: the system blows up periodically because it is privately efficient but socially inefficient not to buy counterparty insurance.

One crucial issue with the paper is that most things are, laudably, endogenized, but one crucial thing is not: each bank can trade with only two counterparties located adjacently on a circle.  The choice of counterparties is exogenously specified. This concentration of counterparty exposure is crucial in making the system vulnerable to collapse.

Zawadowski recognizes that greater diversification of exposures across counterparties reduces the fragility of the system.  Although the externality may induce insufficient diversification across counterparties (because the systemic benefits of this aren’t internalized), market participants in reality have a variety of reasons to spread their trades across many counterparties.  Meaning that real financial systems may be less fragile than in the model, with its exogenously imposed concentration of exposures.

I’m also skeptical that an idiosyncratic risk at a single institution can bring down the entire financial system.  Look at some of the rogue trader losses-Kerviel at SocGen, Adoboli at UBS.  These guys cost their banks billions-but even such huge losses didn’t lead to a financial system meltdown via any channel, including a derivatives channel.  Instead, the 2007-2008 Crisis was related to a systemic shock-a decline in US real estate prices-that hit multiple financial institutions and investors.  It’s hard to identify an actual episode where the channel analyzed in the model-an idiosyncratic shock at a single financial institution-led to a financial meltdown.  The idiosyncratic nature of the risk is important: that’s what makes the risk insurable.  The paper therefore has little to say about non-insurable risks.

Where does clearing come in?  In the paper, clearing is a form of counterparty insurance.  Mandating clearing internalizes the externality.

There are several problems here.  The first is that in the model, counterparty insurance is supplied by a continuum of investors who can diversify away the risk.  A CCP in theory can also diversify the idiosyncratic risk by mutualizing it.  But note that CCPs are voluntary cooperative arrangements among financial institutions.  If there is a gain from collective action-internalizing the externality through cooperation-why don’t financial institutions voluntarily cooperate to form CCPs?   (Though in the context of the model, sharing the risk among financial institutions is more costly than passing the risk to investors.  Still, there is a collective benefit from cooperation among the financial institutions.)  Such cooperation increases joint wealth: why don’t market participants cooperate to internalize the externality?  What stands in the way of consummating such mutually beneficial bargains?   Moreover, why does it happen in some markets, not in others?

But the mutualization issue generally is the bigger problem, and the root of my qualms about the developing literature on CCPs.  Most of the models, including the Biais et al paper, formalize CCPs as a mutual risk sharing/insurance mechanism.  (Hell, I’ve done that myself.)

But mutualization is only one of the functions of CCPs As We Know Them.  Indeed, I am increasingly leaning to the view that it is the most problematic of their functions.

CCPs operate on the “defaulter pays” principle.  That is, real world CCPs attempt to choose margins (collateral) and default fund contributions so that they almost always cover a defaulter’s losses, and that non-defaulters’ default fund contributions are seldom used to make good a defaulter’s losses.  That is, default funds are tapped-and risk mutualized-only in rare, and arguably extreme, situations.

Put differently, only tail risk is mutualized in real world CCPs, and the primary function of CCPs is to set margins so that default losses are NOT mutualized, except in extreme circumstances.  CCPs are like monoline insurance of supersenior positions well down on the default waterfall.

In the context of the _ paper, this is particularly problematic, as he shows that collateralization is an inefficient way to address the externality problem.  It ties up valuable resources that could be used to fund positive NPV projects.   This is just one problem with collateral: the “initial margin problem”, if you will.  There’s also the variation margin problem that I’ve written about over the years.

I consider the tail-risk mutualization aspect of CCPs highly problematic because of the wrong way risk problem.  Like super-senior tranches of a CDO, losses hit the default fund during systemic episodes when those exposed to the default fund (the members of the CCP) are under stress.

This all means that the academic literature, which is modeling CCPs as mutual insurers, has two big problems.

The first problem is one of positive economics.  Existing models are not able to predict (a) why clearinghouses form, and (b) why they are primarily mechanisms to net and collateralize exposures, and only mutualize extreme risks.  They do not predict why market participants sometimes cooperate to implement a “defaulter pays” model, and sometimes don’t-and why they have never implemented a fully mutualized insurance scheme.

We need models that help us understand why market participants sometimes cooperate to implement a defaulter pays mechanism, supplemented by mutualization of the extreme risks; why they sometimes don’t; and why they never fully mutualize.  That is, we need to understand why so few risks are mutualized, even when market participants choose to form CCPs.

With all due modesty, I think the answers will will be found in my original analysis from the 90s: that the usual bugbears of insurance-adverse selection and moral hazard-make it uneconomically costly to mutualize risk, and that these problems also make centralized/delegated setting of collateral levels more costly than bilateral arrangements for doing so, depending on the characteristics of the traded instruments and those trading them.

The second problem is one of normative economics and policy prescriptions derived from models.  Policy recommendations based on models of CCPs that are flatly contrary to the way CCPs really operate are highly misleading, and dangerous.  Eliding from a model that says “mutualization of risk is socially efficient but privately unprofitable” to prescribing a policy of mandating CCPs is deeply flawed, when in practice CCPs won’t mutualize risk as in the models, but will instead implement a defaulter pays model.  (NB: of late regulators are telling CCPs that their main source of concern is that CCPs will set margins too low.  That is, regulators want to make sure that CCPs really make defaulters pay.  So in practice, mandated CCPs will mutualize only extreme risks, and collateralize the rest.  Nothing like what’s in the models.)   It’s a sort of bait-and-switch.

Prudent normative policy recommendations need to be based on a model with good positive content. We need to understand much better why market participants eschew implementing the defaulter pay model before mandating it.  For that’s what clearing mandates do: they impose the implementation of defaulter pays, NOT the implementation of the kinds of mutualization in many formal models of clearing.   Given the costliness of collateral (IM-not to mention the destabilizing effects of VM), it is particularly misleading to advocate policy measures that will lead to increased collateralization based on models in which collateral plays no role whatsoever.  Again-a bait-and-switch.

In sum, I’m pleased that many talented scholars are turning their attention to clearing. Especially when they cite me 😛 But it will be a shame if these scholars go on a wild goose chase, and construct models of CCPs that are completely disjoint from real world CCPs.  This goes double when they make policy prescriptions based on their models.

We need to understand the costs and benefits of defaulter pays, with the mutualization of only extreme risks.  For that’s what CCPs are really about.  We need models that are based on an understanding of collective action issues-because non-mandated CCPs are institutions that arise from collective action.  Only when we understand these issues should we have much confidence about making policy recommendations.

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April 25, 2013

Fools Rush In: CCP Mandate Edition

I was invited to participate in a panel on clearing at ISDA’s Annual General Meeting in Singapore, but unfortunately I had to decline on account of my teaching obligations.  I therefore have to nod (vigorously0 in agreement from afar, because much of the discussion there has focused on the unintended consequences of the clearing and collateral mandates.  Consequences that I have been warning about for over four years.

One of the things that infuriated me about the advocacy for clearing (and yeah, I’m looking at you GiGi) was the claim that clearing would reduce the interconnectedness of the financial system.  I said this was patently false.  Clearing mandates would reconfigure the topology of the network of connections among financial institutions, but they would remain interconnected.  I noted that: CCPs would be vital interconnecting nodes in this new network: failure of these nodes would be catastrophic: and perhaps most importantly, CCPs could be vectors of contagion precisely during periods of financial stress.  I pointed out very early on that CCPs were repositories of wrong way risk because losses would hit default funds precisely during periods of extreme financial stress, and via that channel would bring that stress right back to the balance sheets of the banks with exposure to the default funds.  You know, when they were least able to stand the shock.  The CCP circuit connecting banks would be closed precisely when they were least able to stand the shock.

In retrospect, I seem like a Pollyanna.  Compared to people like HSBC’s Gary Dunn, anyways (Risk link-requires a subscription).  Gary went all Jeremiah at the AGM, warning of an apocalypse emanating from the clearing system.  Actually, his word was “Armageddon”:

Mandatory clearing of over-the-counter derivatives could jeopardise policy-makers’ hopes of a no-bailout financial system, according to Gary Dunn, senior manager for regulatory and risk analytics at HSBC.

Speaking at the annual general meeting of the International Swaps and Derivatives Association in Singapore today, Dunn sketched out an “Armageddon scenario” resulting from the fact that the same group of international banks are all members of the majority of central counterparties (CCPs) – so, a big bank default would simultaneously hit all CCPs of which it is a member.

“What happens when one bank defaults across six CCPs? The remaining members will have to pick up the bill. Given that they are almost certainly members of the other CCPs, this will result in a default contribution bill so large it could potentially lead to their failure also,” he said.

Given the key role CCPs will play in the future financial system, Dunn argued this would ultimately result in a taxpayer bailout amounting to trillions of dollars. In his Armageddon scenario, that bailout would be preceded by the complete liquidation of CCP initial margin stocks – much of which would likely be held in the form of government debt.

The wrong-way risk in the current CCP system is so large it could potentially lead to a sovereign default,” he said. [Emphasis added.]

Interconnections between SIFIs via clearinghouses, with the fragility of these connections perhaps exacerbated by the fragmentation of CCPs (due to fragmentation along jurisdictional lines, perhaps).  Where have you seen that before?  Hint: Not in a Gensler speech.

The clearing panel also fretted abou the possibility that in its attempt to eliminate TBTF, the G-20 has just created new TBTF institutions.  Too big, and too interconnected:

Central counterparty clearers stand to be the next “too-big-to-fail” institutions and could pose an acute threat to the financial system if regulators stall on plans to manage the potential failure of a clearing entity.

At the annual general meeting of the International Swaps and Derivatives Association in Singapore today, a group of panelists highlighted the lack of clarity over resolution for failed CCPs as a significant concern for the G20 objectives of eliminating systemic risk.

“There are still no resolution plans for CCPs and it is murkier now that clearing houses have moved away from the utility model,” said Athanassios Diplas, senior adviser to the ISDA board, speaking at the event earlier today.

The G20 objectives agreed in 2009 deem that no financial institution should be considered too big to fail and that taxpayers should not bear the costs of resolution for any institution that does fail

While regulators have been busy penning rules to deal with the problem of too-big-to-fail banks, concerns are shifting to clearing houses, and the increased concentration of risk held in them as the Dodd-Frank Act in the US and the European Market Infrastructure Regulation push an increasing number of standardised over-the-counter swaps through central counterparties.

“We’re getting very close to solving too big to fail globally for banks, but I worry that this risk could move to CCPs. I’m not convinced that we have made CCPs deeply resolvable yet – we have to do that to address systemic risk issue in a thorough way,” Wilson Ervin, vice-chairman of the group executive office at Credit Suisse told IFR.

All of which was perfectly foreseeable in 2009 when the G-20 blessed clearing as the silver bullet solution.  Foreseeable-and foreseen by some.

And the late start on addressing this issue before CCP mandates went into effect has left the world financial system in highly exposed:

While the Financial Stability Board addressed basic principals for clearing house resolution in June 2012, the issue remains on the back burner with many regulators as they continue to get to grips with a workable bank resolution regime

CCPs are the solution.  So in their wisdom governments decided to load risk onto them.  But dealing with the failure of these government-mandated SIFIs “remains on the back burner.”

Great.  That will turn out well.

Fools rush in where angels fear to tread.  Governments have rushed into prescribing the Clearinghouse Cure, but have relegated addressing the very dangerous potential side-effect of that cure “to the back burner.”

But we’re not done!  The panel also fretted about the potentially destabilizing effects of increasing collateral and margins-both initial and variation margin (can’t find a link to this Mary Childs story: I think it is only available on Bloomberg terminals):

The numbers are large enough to be very worrisome,” Athanassios Diplas, principal at Diplas Advisors LLC and a senior adviser to the ISDA board, said on the panel. “I don’t

think anyone has trillions lying around the couch cushions.” Regulators should be careful in setting the collateral requirements given that margin calls contributed to the escalation of the financial crisis in 2008, according to Kim Taylor, president of CME Group Inc.’s clearinghouse.

Spiraling Losses

“Margin calls triggered liquidation of assets for positions, which triggered mark to market losses for other parties. It contributed to the spiral, and I think there’s the  potential for threshold-based margin” to help avoid a repeat, she said on the panel.

Margin calls exacerbating a crisis.  Whoever heard of such a thing?  Only anyone who has studied past financial panics and market crashes.  But Gensler and Timmy! and so many others assured us that collateral is only good: the more collateral the better.  Just another item on the bill of goods they sold the world-and for which we may have to pay dearly later.

Scary addendum.  At a recent Chicago Fed conference, I told someone from a major central bank that although the initial margin issue was important, it worried me that central banks and regulators seemed to be ignoring how variation margin could destabilize the system, especially with an expansion of clearing, which creates a very tightly coupled system of margin payments that must operate on a very tight and rigid time schedule.  He told me that there wasn’t as much concern about variation margin because it netted out to zero.

Seriously.  I kid you not.   It’s as stupid as the Krugman “we owe national debt to ourselves” mantra.  The payers have to find the liquidity to make the payment to the receivers.  In stress situations, they have to find a lot of liquidity precisely when liquidity dries up.  In response, they do things that impose additional stress on the system, and can break it.  Money is not transferred instantaneously and frictionlessly between those who owe and those who receive.  Those frictions-and just the timing required to recycle the payments-can cause the system to freeze up during periods of stress.

The “what, me worry?” approach to variation margin is very worrisome indeed.

But don’t worry!  Regulators will ensure that CCPs don’t engage in a race to the bottom when setting margins:

Britain’s new regulator for market operators warned clearers of tougher policing of fees to stamp out cut-throat competition that risks undermining financial stability.

. . . .

“We are not in the business of preventing competition but what’s important is the terms of that competition,” Britain’s new clearing supervisor, Edwin Schooling Latter, told Reuters in an interview.

The Bank of England became the regulator for clearing houses this month and Schooling Latter said in his first media interview he will not tolerate “a race to the bottom” such as clearers allowing banks to post too low margins against trades.

Margins refer to traders of derivatives posting government bonds or other high quality collateral to help cover any losses and the level of margins is determined by the clearing house.

“We want a world where the clearing houses compete on the quality of their risk management and not on how low their margins are,” Schooling Latter said.

Because regulators, of course, are so skilled at pricing risks.  They did such a bang-up job of it when setting capital requirements under Basel.  And by “bang-up” I mean like a train wreck.

The Sorcerer’s Apprentice metaphor seems more apt by the day.  Regulators and legislators have cast the spell to bring massive CCPs to life, but cannot control the consequences-which can be dangerous indeed.  They intended to solve one problem, but they have created others, and are scrambling to deal with them.

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