Streetwise Professor

A tag-team of my favorite blogs-the wonderfully sardonic (and insightful) Rhymes With Cars and Girls and the less sardonic (but equally insightful) Deus ex Macchiato-discuss the fact that model-based risk-weighted capital calculations on the same assets differ substantially between models/banks.

From this, DEM concludes the need to centralize capital calculations:

he answer is clear. Centralize and standardise capital calculation. Throw all those internal models away, and use one common, regulator developed approach. Now that a lot of progress has been made on trade reporting, the data infrastructure exists to do this — or least it wouldn’t be too hard to extend what does exist to do it. Developing the models would be a huge undertaking, but compared to having each large bank do it individually, a central infrastructure would be cheaper and more reliable, and anyway you could pick the best of individual banks’ methodologies. You could even spin out the var teams from four or five leading banks into the new central body — just don’t pick the bank whose IRC is less than 10% of the average answer…

Crimson Reach at Rhymes is more cautious, repeating his theme that All Large Calculations are Wrong.  He concludes:

In other words, it’s a Large Calculation. But as RWCG readers know, all large calculations are wrong. So, I’m skeptical that the answer to this is to ‘centralise’ the calculation – i.e., make it even larger.

I’m on Crimson’s side on this one.  (Sorry, David.)

Centralize capital calculations?  No. No. No. No. No fucking no.

Crimson is right: all Large Calculations Are Wrong.  Including those-and I would suggest, especially those-undertaken by some Centralized Authority, e.g., The Wizard of Financial Oz.

What would you rather have?  Randomly distributed mistakes, or perfectly correlated ones?

The answer, it seems to me, is gob-smackingly obvious.  Randomly distributed.  Perfectly correlated errors are a recipe for systemic risk.  All banks will crowd the risks that the model underprices and avoid the risks that it overprices.  If an adverse shock hits the crowded investment, every bank is screwed simultaneously.  All will need to liquidate their positions in that asset, or in other assets.  Every bank will have fire sales at the same time.

That’s what we want to avoid.  That’s what creates a systemic risk.

We want to diversify model risk, not concentrate it.  Centralized calculation concentrates it.  I actually see an evolutionary benefit in the wide range of model risk weights that DEM bewails.  That represents a diverse ecosystem of entities with divergent views that is less vulnerable to a single shock.  Yeah, that shock will crater some banks, but not all of them. When I think of any-ANY-centralized calculation, I think of the Socialist Calculation Debate.  I also think of monocultures that are dangerously vulnerable-systemically vulnerable-to a single shock.  Think of the devastation that smallpox wreaked on native American populations.  A single shock can crater everybody all at once.

If that happens, who is the buyer in the fire sale?  If there are no buyers in the fire sale, how low can prices go? Pretty damn low.

Crimson is right.  All Large Calculations Are Wrong.  The answer to this problem is exactly the opposite that DEM suggests.  Diversify this risk.  Don’t concentrate it.  Don’t sort on it.

We need less centralized control-freakishness.  Not more.  A lot less.  Mistakes are inevitable.  Create a system that induces them to make uncorrelated mistakes (or at least, mistakes with low correlation).  Don’t induce perfect correlation in errors.  I say again: don’t induce perfect correlation in errors.  Create a diverse ecosystem, not a monoculture.   Imposing uniformity because disagreement is unseemly and reveals the fundamental uncertainty with assessing risk is exactly-exactly-the wrong answer.  It makes errors systematic.  Systematic errors create systematic risk.

Diversified, diverse populations are far more robust than uniform, monocultural ones.  Disagreement is a feature, not a bug.  Enforced agreement is the worst bug of all.  Sort of like smallpox.

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

More indications that Frankendodd, Basel III, and other measures intended to reduce the risk in the banking system, and to address the too big to fail problem, are leading to greater consolidation of the banking sector:

Investment banks must take further actions to improve returns and more will follow firms like UBS AG (UBSN) and Royal Bank of Scotland Plc  that have exited businesses, McKinsey & Co. said.

Only five or six companies will remain “bulge bracket” firms that offer all investment banking and trading products worldwide, the consulting firm said today in a report titled “After the Reckoning.” Others will step back from some businesses to focus on areas where they have a competitive advantage, according to the report.

. . . .

The top three firms in each asset class account for about two-thirds of trading volume in that product, according to the report. Banks that lack such scale or face higher funding costs will probably focus on businesses such as foreign exchange or structured rates and credit, McKinsey said.

So: increased concentration and reduced competition as some banks exit certain businesses.  The sector overall will almost certainly shrink, but the remaining bulge bracket firms will account for a greater fraction of business, and may grow absolutely.  It is also likely that these remaining firms will be as interconnected, or more interconnected, than was previously the case.

One of the themes of my writing on clearing mandates and other aspects of post-Crisis derivatives regulation has been that although these initiatives have been sold as ways of reducing risk in the financial markets, in reality, they shift many risks, transform others, and create new ones.  It is by no means clear that these new laws and regulations have reduced the overall vulnerability of the financial system.

For instance, clearing and collateral mandates are intended to reduce the amount of credit embedded in derivative trades.  But market participants can respond to this by substituting other forms of leverage.  The effects on credit risk and leverage overall are far more equivocal than the advocates of the mandates claim.  As another example, making derivatives more expensive means that some will eschew using them to manage risk.  Risk that was passed to others able to bear it at lower cost will remain with those who bear it at a high cost.  As yet another example-and the one that worries me most-is that clearing and collateral mandates have transformed credit risk to liquidity risk.  Since true crises are usually liquidity crises, this is highly disturbing.

The CFO of Rolls Royce made similar arguments forcefully at a conference a few days back:

European regulatory measures designed to make the financial system safer don’t actually eliminate risk, they simply move it to nonfinancial companies, warns Mark Morris, the finance chief for Rolls-Royce, the British aero-engine maker. And there could be a negative impact on the economy, he says.

Speaking at a conference organized by The Economist Group (a minority owner of CFO), Morris criticized European regulators for seeking to deal with over-the-counter derivatives risk in the financial sector by requiring some contracts to be centrally cleared or to have collateral posted.

The European market infrastructure regulation, known as EMIR, took effect last August but requires the European Commission to enact a series of technical standards before the rules can be fully implemented. Most are expected to be finalized by mid-2013.

“In essence, you can’t destroy risk,” Morris said. “It morphs into something else. If you take market risk and go into a foreign exchange [hedging] transaction with a bank, you’re replacing it with counterparty risk. If you try to replace the counterparty risk by using central clearing or some form of posting of collateral, what you’re doing is you’re replacing counterparty risk with liquidity risk.”

Morris makes some other good points in the article, so I recommend you read the whole thing.

It seems that the Europeans are more sensitive to these concerns than was the case in the US.  The European Parliament may demand changes in EMIR. Apparently they are aware of the legislate/regulate in haste, repent at leisure problem.  Unfortunately, with Frankendodd dismissed such concerns.  Methinks that the repentance stage will come soon.

Further my last.  Europe may be out of sight for now, but that’s only because it’s not out of the woods.

Draghi be damned: Spain still in a debt death loop.  And that doesn’t even take into account the fact that 90 percent of the Spanish state pension fund is invested in Spanish government debt.  Or that Spain has long leaned on its banks to buy its debt, meaning that Spanish banks buy the bonds of the government that is supposed to bail them out if they get in trouble.  There’s a financial Escher etching for you.

So what does Spain do? It begs Germany to increase growth. As if it’s like turning on a faucet.

And if there is such a faucet, the handle has come off in Germany’s hand: the economy contracted more in 4Q12 than at any time since the depths of the financial crisis.

Meanwhile, France is getting deeper into Mali.  IMO, best outcome: something like the American Punitive Expedition to Mexico in 1915, which futiley chased Pancho Villa around the deserts of northern Mexico for a year. Worst case: British army in Afghanistan, 1842, or Islawanda.

US support-per the linked FT article-is lukewarm at best.  We (and the Brits) are supplying airlift.  A telling illustration of the lack of sustained expeditionary capability in NATO outside of the US.  Given the extreme logistical challenges of operating in the Texas-size wilds of northern Mail it is hard to imagine a force of a few thousand frenchies doing anything but getting swallowed up in the vast, desolate expanses.

And as I noted yesterday, France is approaching economic zombiedom.

So yeah. Everything is just hunky dory. Maybe as long as Draghi’s paper lasts.  Or more accurately: as long as the bond markets believe in the magic of paper.

Europe seems to be challenging Alfred E. Newman-“What, us worry?” Draghi and the EU have papered over-I am tempted to say “literally”-the immediate financial issues pressing on Spain and Italy.  Given the respite from panic, the Europhoria seems to have taken over.

But the fundamentals are still abysmal.  European unemployment hit all time highs-over 11 percent across the Eurozone, 20+ percent in some countries, and 50+ percent in some demographics-notably younger working age individuals-in countries like Spain and Greece.  Greeks are reenacting a Mediterranean version of post-WWI Vienna, venturing into the forests to collect firewood.  Spain has stuffed its banks and pension funds with government debt-they have no capacity to absorb any more. Given the parlous state of the banks (Bankia is apparently billions of euros underwater), and the dire straits of the Spanish economy, it’s hard to see all of Draghi’s paper keeping out the gales of reality for long.  Add to that the continuing move of Catalonia towards independence, or at least greater autonomy, it is evident that the downside risks are huge.

Meanwhile, France is sputtering-to put it generously-under Hollande’s socialist government.  Growth is moribund-French economists have opined the the government’s point 8 percent growth forecast is overly optimistic.  Capital is fleeing.  The tax-and-spend approach is almost certainly going to condemn the country to stagnation, at best.

Meanwhile, with all going so well at home, France is intervening aggressively in Mali, with mixed results at best.  I shall pass over in silence French hypocrisy regarding foreign intervention.  The initial French air attacks apparently halted the Islamist rebels’ momentum, but not for long.  Within 24 hours the rebels had regrouped and recommenced their advance.  On the opposite end of the continent, in Somalia, a French commando raid to free a hostage-an intelligence operative who had been half for several years-turned out badly, resulting in the death of the hostage and one French soldier, and the capture of another.  Today the Somali Islamists announced the death of the captive, but boasted they had obtained much information from him.  Draw your own conclusions.

In the UK, Cameron is walking a tightrope, threatening to renegotiate Britain’s relationship with the EU, but refusing to put Britain’s membership to a vote.  His position is infuriating the French (go figure) and threatens his position atop the government in the UK, as splitting the difference just serves to get both the Europhiles and the Europhobes furious at him.  And Obama has told Cameron to get his mind right, and get on with the EU program-or risk the special relationship with the US.

And Germany?  Germany is being strangely quiet.

In sum, I think Europe is living in a fool’s paradise.  The ECB has staved off the imminent crisis, but the fundamental economic weakness remains, especially in Greece and Spain.  Moreover, France is in a dicey situation-at best-and socialist nostrums can only make things worse. Military action-and in particular, a protracted military engagement in a place as wild and sprawling as Mali-can only stress the French polity.

Yields are down, and there is a sense that the crisis has passed.  But the ECB can only levitate things for so long, especially if France struggles-or worse.  Greece and Spain are in extremis. In my opinion, it is only a matter of time before the bond markets get a serious case of the yips again.   So enjoy the what-me-worry? moment while it lasts.  I don’t think it will last long.

I’m sure you would never peg me as a green type, but I have decided to join the recycling movement!

I am doing so in response to the call by Barney Frank (the Frank of Frankendodd) to merge the SEC and the CFTC.  This idea has itself been recycled many times, dating back to the 1980s and the birth of stock index futures.

One of the recycling efforts was by Hank Paulson, in the spring of 2008, in his proposal to reform the financial markets.  A centerpiece of this proposal was the org chart shuffling.  What I said then holds true today, so I’ll conserve scarce resources (mainly my time), and merely recycle:

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

What he, er I, said.

Expecting miracles from mashing together org charts is insane.  At best, it has no effect.  The more likely outcome is to make things worse.  (Want an example?  Look at the effects of the reorganization of the intelligence community post-911.)   The point about specialization is particularly apposite, IMO (naturally, since I brought it up!)  The five commissioners of the CFTC and the five commissioners of the SEC are already overwhelmed by their complex responsibilities, and can devote relatively little time to becoming expert in any one particular area.  Extending the scope of the commissioners’ responsibilities is supposed to make that problem better?

In the end, nothing is likely to happen.  This is a lame duck kerfuffle.  The people who will have skin in the game in the next Congress will want nothing to do with this, as has been the case for about the last 15 Congresses.

It is hard to overstate the importance of this report by Hal Scott and the Committee on Capital Markets Regulation, titled “Interconnectedness and Contagion.”  It evaluates the issue of systemic risk through the lens of the Lehman Brothers failure (and to a lesser degree, the AIG failure).

One way to summarize the report is “everything you knew about Lehman was wrong.”  Certainly, everything Gensler and Timmy! and Frank and Dodd and legislators and regulators around the world knew was wrong.

That conventional narrative is that Lehman’s failure brought the world financial system to its knees because it was so interconnected to the rest of the financial system.  That losses on exposures to Lehman-an most notably through derivatives exposures-threatened to propagate through an interconnected set of large financial institutions.   That the crisis was the result of a “daisy chain” or “domino” effect via what Scott refers to as “asset interconnectedness” (e.g., derivatives exposures) or “liability interconnectedness” (e.g., a big supplier of credit/liquidity fails, thereby forcing those dependent on it for credit or liquidity to fail).

Scott thoroughly debunks the interconnectedness narrative.  Instead, he shows persuasively that a contagion caused the crisis.  The Lehman shock dramatically shifted beliefs about whether large financial institutions would be bailed out, and also conveyed information about the severity of losses on real estate assets that were held not just by Lehman, but by a wide array of financial institutions.  This raised doubts about the solvency of all financial institutions, resulting in a run on their liabilities and a refusal to roll over these liabilities.  Given the dependence on short term credit, this run caused a major crisis.

In other words, it’s all about the funding mechanism.  It’s about liquidity.   It’s about runs.

Scott notes that the configuration of the financial network does affect its vulnerability to contagion, but that attempting to mitigate systemic risk through policies intended to affect the degree of interconnection is unlikely to reduce substantially the risk arising from contagion.

This is incredibly important because Frankendodd and EMIR and all of it is largely predicated on the belief that interconnection is the source of systemic risk.  But the diagnosis is wrong, meaning that the prescription is almost certainly wrong too.

Scott looks at CCP mandates in particular, and gives them 1.5 cheers.  I think that’s one or 1.5 too many, but it is gratifying to see that he does forthrightly downplay the potential benefits of CCPs as a means of preventing future crises.

The reason that I think he is not negative enough on this point is that he only looks at the first order impacts of CCPs, through their effect on derivatives netting, for instance.  He does devote some attention to the effects of CCP mandates on funding and liquidity, but more focused attention on the indirect effects of clearing and collateral mandates would, in my view, raise more serious concerns, especially in light of the primacy of funding/liquidity contagion channel in creating systemic risk.

Scott, citing Duffie’s work, claims that CCPs may reduce the incentive to run on big financial institutions.   I can see that in some scenarios, but I can also envision others in which a rigorous, highly-time sensitive, no-credit system like that will result from CCP and collateral mandates can lead to runs, either on the CCP, or on firms connected to the CCP.  That’s my take on what happened on Black Monday, 1987.

Clearing and collateral mandates will lead to a whole series of changes to the demand for liquidity, and the mechanisms for supplying it.  A cleared system is more tightly coupled; increases the likelihood in big shocks to liquidity demand; potentially ties up liquidity (especially under rigorous segregation regimes); and on and on.  Given the nature of cleared systems (and the imposition of rigorous daily variation margin based on mark-to-market for non-cleared derivatives), market users will make arrangements to secure contingent liquidity.  As a result, the entire financial network topology will change.  How it will change, and how these changes will affect systemic risk, are impossible to divine at present.  But it is certain that these changes will be profound and it is not difficult to imagine scenarios in which the new topology is as fragile in the face of large shocks as the old one.  Indeed, it’s not hard to imagine scenarios in which the new topology is more fragile than the old.

Clearing and collateral mandates should also be viewed as regulations of capital structures.  (“No credit extended through derivatives transactions” and “derivatives are at the top of the priority queue.”)  Capital structures will respond to this regulation, again in unpredictable ways, and in ways that affect the vulnerability of the system to contagion.

I am giving a talk on Monday at a joint Bundesbank-University of Frankfort conference about central banking.  My talk is about systemic risk and CCPs, and I will explore all of these themes.  The overarching theme is that you cannot view an intervention into the structure of financial markets, like a CCP mandate, in isolation.  You have to consider the endogenous responses throughout the system. The entire structure of financial contracts will change as the result of such a big intervention, and this structure will have its own special vulnerabilities.

When evaluating these vulnerabilities, one should pay special attention to liquidity issues, and liquidity contagion.  This was a theme of my JACF article “Clearing and Collateral Mandates? The New Liquidity Trap?”  Scott’s report adds special force to this contention that liquidity and contagion, rather than interconnection, should be the focus of any regulatory and legislative efforts.

It also suggests that much, and arguably virtually all, of the regulatory response to the 2008 Crisis was misdirected, and hence will either not reduce systemic risk, and may increase it.   Given the costs that these regulations impose, this is a sobering conclusion.

It finally suggests that it all comes down to central banks, as lenders of last resort.  If it is a liquidity problem (and in this Scott is closely aligned with Gary Gorton), the institutional means for supplying liquidity in times of crisis-which now means central banks-is of paramount importance.

One of the things that turned Japan’s initial early-90s crash into Double Dip Lost Decades was the refusal to let failing firms die and the failure to force other firms to restructure or reorganize.  Zombie banks were allowed to live on, rather than being wound up or recapitalized.  Zombie banks continued to lend to inefficient loss making firms in desperate need of reorganization, restructuring, or seppuku, letting them stumble on unreformed, half-alive, half-dead.   The overwhelming urge was to retain the status quo to the greatest extent possible, and to resist the forces of creative destruction by all means available.

We can see the results, with a Japanese economy lurching along, also half-alive, half-dead.

A Reuters article suggests that the social and political pressures to maintain the status quo, to prop up existing firms (that just happen to have political connections), are leading China down the Japanese path:

The problems at China’s Yingli Green Energy Holding Co Ltd (YGE.N), the world’s No.3 solar-panel maker, are going from bad to worse as the company struggles with mounting losses, collapsing product prices and a stock in free-fall.

And yet, despite a government directive to rein in loans, Chinese banks keep extending credit to the New York-listed firm, and at below-market rates. Outstanding short-term borrowing has almost tripled to 8.2 billion yuan ($1.3 billion) since 2009, according to Yingli’s 2011 annual report.

. . . .

Yingli is one of many companies in China receiving life support from the country’s banks. That support – at a time when China’s economy and financial system are also under pressure – is raising fears that a spike in bad loans will push Chinese lenders into default.

“Banks like lending to us,” said Yingli’s Chief Financial Officer Bryan Li in an interview. “They feel that we are a potential winner if there is any consolidation in the industry.”

That feeling may come back to haunt the banks.

A Reuters News analysis on 40 of China’s most indebted companies – most of them from sectors already reeling with overcapacity such as wind-turbine maker Xinjiang Goldwind Science & Technology Co Ltd (002202.SZ) and COSCO Shipping Co Ltd (600428.SS) – showed debt levels rising as profits decline across industries that Beijing has said it wants to promote.

On average, operating profit at these companies dropped 15 percent in 2011 as their debt piles grew by the same percentage, according to company and Thomson Reuters data.

. . . .

Goldman Sachs & Co (GS.N) estimates in a research note that the NPL ratio is more than six times the official rate. [Gotta love that official Chinese data!] That’s already less pessimistic than most investors, who expect NPL levels of at least 10 percent, according to the bank.

Much of the pressure to lend to unprofitable firms comes from the government’s desire to prevent a total collapse in industries struggling in an economy that has slowed for the seventh consecutive quarter.

“If you run a bank’s operations in a certain province and the governor tells you to roll over a loan, you are going to do it even if it doesn’t make commercial sense,” said Arthur Kwong, head of Asia Pacific equities at BNP Paribas Investment Partners.

Japan misallocated capital for years, and is paying the price now.  China, through its stimulus programs, showcase projects, and now these efforts to prop up politically connected losers, is also wasting capital on a colossal scale.  When originally “invested”, this money shows up as GDP, and props up the growth rate.  But if that capital is used unproductively, that GDP gold turns to dross.

The Chinese hatred for everything Japanese-a hatred that is waxing particularly hot right now-will likely prevent them from learning something from the Japanese experience.  But by failing to heed the Japanese experience, China is running the very serious risk of repeating it.

It is far better to submit to the gales of creative destruction than to attempt to preserve an unviable structure and unviable firms.  Japan tried otherwise and failed.  China seems intent on making the same mistake.

After the US economy began to recover rather robustly in the mid-1930s, a series of ill-considered government policies, notably a tax on undistributed profits, a big increase in marginal rates on high incomes, the Wagner Act, and a Fed contraction of the money supply led to a substantial contraction in 1937.  The depression within the Depression.

One notable feature of the 1937 episode was the so-called “Capital Strike”, a sharp decline in corporate investment.

The imminency of Obamacare and Frankendodd, and the continued failure to address seriously the country’s fiscal situation, with the associated uncertainty about taxes and spending, may be creating a modern-day version of the capital strike.  The WSJ reports that growth in investment expenditure has slowed to a standstill, and that many large companies are slashing investment plans.  The article places the blame on the “Fiscal Cliff”, but in reality, this is overdetermined, as they say.  There are multiple factors at work, and all in the same bearish direction: the regulatory friction (epitomized by Obamacare, Frankendodd and the EPA) is a major drag on growth, and a major source of investment-killing uncertainty.  Indeed, I would put the least weight on the Fiscal Cliff as it is conventionally portrayed: that conventional portrayal is almost purely comic book Keynesian in nature, focusing on “aggregate demand”.  IMO, the handling of the expiration of various tax reductions and the potential for sequestration is relevant not because of AD-a slippery and largely chimerical concept-but because of what it portends about the future course of government spending, and in particular the appetite to deal with entitlements and transfer payments.

If what the WSJ reports is indeed a harbinger of a modern day capital strike, that would be consistent with my broad forecast in my post-election post.  A protracted period of stagnation/slow growth.  Which will only exacerbate the fiscal situation and increase the risk of a rollover/funding crisis.

As if we really should need another Ghost of Christmas Future to warn us, take a look at Japan right now.  Just saying.