Streetwise Professor

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.

One of the most ambiguous, and often damning, phrases in a school or performance review is “works to his potential.”  Left unsaid is just what that potential is, and the comparison of performance to personal potential, rather than to the performance of peers, is often a polite way of communicating that that potential is rather low.  The quintessential way to damn with faint praise.

This came to mind when reading about a spat between Medvedev and a high ranking official at the Russian central bank.  Medvedev is pushing for 5 percent growth:

“The government’s main aim is to reach steady economic growth of at least 5% [a year], and achieve stable growth of Russian citizens’ wellbeing,” Mr. Medvedev said

But Central Bank first deputy chairman Alexei Ulyukayev rained on that parade, and delivered the devastating “works to potential” performance review:

We at the central bank of the Russian Federation assume that in Russia… economic growth roughly matches its potential.

That growth, mind you, is in the 3.5 percent range.  4 pct would be a major achievement.

This is rather pathetic for a country at Russia’s stage of development, and is a far cry from the pre-crisis growth rate.  In part, this reflects moribund world economic performance.  Europe is continuing to stall. China is on another sugar high, but the pressing need to transition from an investment-and-export-driven model will result in a decline in growth rates there as well.  The US is bumping along, and the impending Health Care Cliff and continued fiscal policy uncertainty will serve as drags on growth.

But it also reflects Russia-specific factors, and is in fact a damning verdict on Putinism.  Two other speakers at the conference where Medvedev and Ulyukayev spoke, Alexi Kudrin and my friend Sergei Guriev, pointedly said that Russia’s institutional deficit were the major drivers of its mediocre potential:

But Sergei Guriev, an influential economist and government adviser, warned in an op-ed Wednesday in the Vedomosti daily newspaper that the Kremlin is in danger of falling short of its targets for improving the investment environment because of slow progress on privatization and other moves to liberalize the economy.

Former Finance Minister Alexei Kudrin, who was also at the conference, warned that lack of reforms means “there are no grounds to achieve economic growth of more than 4% for the next five to seven years.”

Mr. Kudrin, who lost his job September 2011 over a disagreement with Mr. Medvedev over a sharp rise in social and military spending, blamed the lack of reforms on the government, which prefers “to throw in money to resolve problems and rely on oil prices,” he said.

Putin’s purgatory, indeed.  The mania for stability, the fear of change, the vested interest of the elites in the existing system, and the stasis that inevitably occurs with an aging leadership will conspire to throttle any “moves to liberalize the economy” and to encourage throwing oil money at problems.

Meaning that Russia’s potential for growth is nowhere near 5 percent.

One of the predictable though unintended consequences of Frankendodd (and its European cousins) will be to increase concentration in the banking sector.  Not just predictable: predicted, including by me (notably at the JP Morgan Commodity Conference in October 2011, and here on SWP).

The logic is fairly straightforward.  Frankendodd creates a huge regulatory overhead that in turn leads to scale economies.  Smaller-to-medium-sized entities will not be able to afford these overhead costs, and will exit the business, and the bigger firms will get bigger.  The overall level of activity is likely to go down as a result of the exit and expansion, but the biggest firms are likely to get bigger even if the market overall gets smaller.  Moreover, the capital and collateral requirements in Frankendodd, including in the derivatives title, have disparate impacts on different market participants  Since the smaller entities typically have higher capital costs than the bigger ones, this increase in capital needs to support trading businesses in particular will lead the smaller market participants to contract more than the bigger ones; this increase in their capital costs may also induce them to exit altogether, especially when taken in conjunction with the increase in regulatory overhead associated with trading businesses in particular

Given that Frankendodd was allegedly intended to address the too big to fail problem, it is perverse that one of its predictable consequences is to increase concentration, and likely increase the size of the biggest firms in the market.

We may be seeing the first major move in this direction, just as Frankendodd’s big boot is starting to kick in.  Morgan Stanley announced deep job cuts, and rumors are flying that it will exit the fixed income trading business:

Now the storied company — whose take-no-prisoners trading desks have at times been rivaled only by firms like Goldman Sachs — is cutting even deeper, raising questions among some on Wall Street about whether it should spin off or ditch much of its trading business as its Swiss rival UBS has, a suggestion the firm eschews.

. . . .

Morgan Stanley’s board, said people briefed on the matter, has discussed closing its fixed-income department. Instead, the firm is shrinking the unit, arguing that it is important to offer its customers those trading services. By cutting jobs and costs and exiting lines like structured products and other complex financial investments and focusing on less risky, less capital-intensive businesses like the trading of interest rates, executives contended that the division can generate a healthy return.

So they’ve discussed it, but decided to keep it in a shrunken state.  But it may have to revisit the more drastic measure:

In recent years, the fixed-income department has not been able to make enough money to cover the cost to Morgan Stanley of this capital, according to people briefed on the matter but not authorized to speak on the record

If it hasn’t covered its cost of capital pre-Frankendodd, lotsa luck with covering it afterwards.

Frankendodd will cause a contraction of the financial sector, which isn’t necessarily a bad thing.  But the contraction will be uneven, and the fundamental nature of Frankendodd favors a relative expansion, and perhaps an absolute expansion, in the biggest-the JP Morgans and Goldmans and Deutsche Banks.

Hardly what was intended.  But that’s different to say it wasn’t predictable.

Stephen Bainbridge, an eminent UCLA law prof of my (slight) acquaintance, has been rocking on the Ace Greenberg suit against the federal government.  He brutally eviscerates those in Congress and the media that exhibited their high dudgeon at the temerity of AIG’s board in even considering joining the Greenberg suit.  But more importantly, he reinforces and complements the point in my previous post on the subject.  Specifically, he argues that there are serious issues at stake here.  That the fact that the government provided “assistance” to AIG during crisis conditions does not give the government carte blanche to dictate the price of that assistance, if in so doing (a) it tramples on the legal rights of AIG shareholders, and (b) expropriates wealth from those shareholders by exploiting AIG’s financial distress to impose punitive conditions on that assistance.

During the crisis, the government asserted that the gravity of the emergency justified extraordinary measures that trampled well-established legal protections and procedures.  The terms of the Chrysler bailout are one clearcut example.  The AIG case is plausibly another.

This turns things on their head.  If particular measures-like protecting AIG’s derivatives counterparties-are so important that they create a substantial amount of wealth, paying fair compensation shouldn’t be a problem. Moreover, doing that reduces fears that the government will expropriate wealth in the future, and that limits the chilling effects on investment that expropriation threats engender.  In contrast, the attitude that property and legal rights are forfeit when the government in its wisdom deems that emergency conditions justify it, has an extremely corrosive effect.

Put differently, a government that creates a reputation for protecting property and legal rights even during extreme circumstances also creates an environment that is conducive to growth.  In contrast, one that creates a reputation for opportunistically exploiting crisis situations by transferring wealth to itself, or to favored constituencies (like Chrysler’s unions), creates an environment that is hostile to investment and growth.

Sort of like Russia, in other words.

The US Senate s sometimes called the World’s Greatest Deliberative Body.  At times-most times, in fact-it seems that it would be more apt to call it the Deliberative Body With the World’s Greatest Proportion of Room Temperature IQs.  Many notable dimwits come to mind-Barbara Boxer, for instance. But the dearly departed (from the Senate, anyways) Blanche Lincoln was oh-so-special in her dimness.

As a sort of parting gift prior to her electoral rout in 2010, Blanche succeeded in inserting the eponymous Lincoln Amendment into Frankendodd.  This was the “swaps push out” provision, which precluded any “swaps entity” from receiving assistance from the Federal Reserve.  This requires banks to “push out” dealing in derivatives to separately capitalized subsidiaries that have no access to the Fed discount window, or other sources of federal support.

Crucially, the Lincoln Amendment was limited: basically, only equity derivatives, some credit derivatives, and commodity derivatives (with the exception of gold) were pushed out.  Banks were allowed to maintain their bread-and-butter rates derivatives business, as well as some of their credit trading businesses.  I guess the theory was that commodities are scary risky, but banks can’t jeopardize themselves by playing in interest rates.  Or something.

Well, that’s true of US banks, anyways.  But due to the meticulous drafting that characterizes Frankendodd, branches of foreign banks cannot avail themselves of the same exemptions.  This includes behemoths like Barclays and Deutsche Bank.

So now the Fed is trying to clean up after Congress, endeavoring to find ways to blunt the effects the provisions of the Lincoln Amendment on foreign banks.  Easier said than done, because despite the fact that “Ms Lincoln called her amendment’s treatment of foreign banks’ uninsured US branches a ‘significant oversight’ that was “unfortunate and clearly unintended. . . . the language of the legislation is clear, regulators are unable to use [Lincoln’s] statements on the Senate floor to unilaterally change the implementation of the law. ”

Good times.  Good times. Just another of the land mines lurking in Frankendodd.  Think of how many more are to be found.  And how many are buried in Obamacare.

Like I said.  Good times.

AIG has attracted a lot of ridicule and anger with the announcement that it might join Ace Greenberg’s suit contesting the Constitutionality of the firm’s bailout in 2008.  The prevailing theme is that AIG is being extremely ungrateful.  If the Feds hadn’t bailed it out, it would have gone bankrupt, and its shareholders would have gotten nothing.

Well, Greenberg’s point is that its shareholders did get nothing, and gave up something valuable in return.  That the government exploited AIG in its hour of distress.

I realize that the suit has a snowball’s chance in hell, and that there is a rather tragicomic aspect to it.  But, contrarian that I am, I feel obliged to offer up a couple of counterpoints to the conventional wisdom.

Most notably, bankruptcy law incorporates several provisions intended to protect the claimants of financially distressed firms from the depredations of would-be saviors.  Preference and fraudulent conveyance provisions of the bankruptcy code permit other creditors to claw back money from a “savior” that buys assets from a distressed firm at bargain prices.

AIG didn’t declare bankruptcy, so this isn’t a legal issue.  Moreover, it would be a remedy available to creditors, not shareholders.  But the basic principle is pretty clear: you can’t take advantage of a firm’s financial distress to extract unduly favorable loan terms, or to buy the firm’s assets at unduly favorable prices.

That’s the gravamen of Greenberg’s claim.  That the Fed and Treasury obtained control of AIG at a fraction of its true value because the firm had no alternative but to accept these terms.  “The firm was  going to fail if it didn’t accept my terms” doesn’t fly in bankruptcy court.  Given the implicit principle in that, why shouldn’t the same argument apply to the US government?  I would actually suggest that the question should be: why shouldn’t that argument apply with special force to the US government, given its disproportionate power, especially during such extraordinary times?  Bankruptcy law is structured to protect the creditors of desperate firms from the the predations of those who exploit that desperation.   An efficiency-driven economic story can be told to justify that structure.  That story applies when the potential exploiter is the government.

Interestingly, at the time of the crisis, Bernanke testified before Congress that due to the liquidity crisis, market prices of assets were far below their fair values based on discounted expected cash flows.  He did so, in part, to justify Fed assistance to everyone from banks to money markets: “It’s a liquidity problem, not a solvency problem, so we’ll get paid back.  It’s not really a bailout.” Given the evaporation of liquidity and the implosion of asset markets at this time, it is pretty clear that conditions were extraordinary, and those with money to spare-like the Fed and the Treasury-wielded the whip hand.  The liquid were in a dominant position to extract wealth from the illiquid.

And that in a nutshell is what Greenberg is claiming that the Fed did: the Fed exploited AIG’s illiquidity (which reflected the general implosion of liquidity) in order to get assets for a song.  So Greenberg’s claims should not be dismissed out of hand.  Indeed, Bernanke’s Fire Sale Chat provides considerable validation for his claims.

That said, there are other considerations.  Moral hazard, for instance.  Bagehot’s dictum for the lender of last resort-lend against good collateral, at penalty rates-reflects a balance between liquidity and moral hazard considerations: the penalty rate provides a disincentive to court trouble.  Pour encourager les autres, it was appropriate to pay below fair value for AIG’s assets/equity, lest others take excessive risks in the comfort that a Fed put would protect them from the worst.

But how much below?  That’s a harder question.  But it’s by no means obvious that 100 percent below is the right answer.  Those responding to Greenberg and AIG in such high dudgeon believe it is the right answer.  Contrarian that I am, I wouldn’t be so sure.

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.

Go to a conference where derivatives or Frankendodd are discussed, and you can’t escape without hearing somebody’s tongue trip over the word “extraterritoriality” (say it 5 times fast!) -the imposition of Frankendodd rules (such as swap dealer registration) on foreign firms.  Gensler has been quite aggressive in his interpretation of where the CFTC’s writ extends: in his mind, it basically extends everywhere that directly or indirectly could have an impact on US markets.  In an interconnected financial world, that doesn’t limit things much.

Foreign financial institutions (and other firms, such as pension funds and money managers) are less than thrilled.  To say the least.  Some smaller institutions have announced their intention to have no dealings with US firms that could put them in the monster’s grip.

Foreign regulators have also criticized US assertions of authority, both in writing and now in GiGi’s face:

Financial regulators from around the world have rounded on the main US swaps regulator over its attempts to extend new rules on derivatives overseas, warning of destabilising effects on the global financial system.

Supervisors from Japan, Europe and Hong Kong have previously criticised the Commodity Futures Trading Commission in written correspondence. On Wednesday, the regulators set out their concerns during a public meeting at the CFTC in Washington.

GiGi nodded, and then defended the CFTC’s actions.

Regulatory arbitrage is a concern, but unilateral assertions of US authority, and foreign pushback on those assertions, raise various concerns of their own.  In particular, they threaten to balkanize derivatives markets (and financial markets generally) as non-US firms limit their dealings with US entities.  This will reduce liquidity; tend to lead to concentrations of risk; and will impede the efficient allocation of risk.

Per usual, Gensler is appealing to a simplistic version of the financial crisis to justify his position, and not acknowledging the adverse consequences-most notably due to fragmentation-that will result from over-aggressive American initiatives.  Regulatory consistency across jurisdictions (which would mitigate regulatory arbitrage) ironically is undermined by the unilateral efforts of the US regulator to impose its will around the world.

This is particularly amazing given the CFTC’s less than glorious record at regulating a subset of US derivatives markets.  Hubris, anyone?  And unfounded hubris at that?

Speaking of regulatory hubris, David at Deus ex Macchiato is justifiably outraged at the assertion by an Irish regulator that global regulations of OTC markets had “the explicit policy objective” of reducing the size of these markets.  Because of course regulators know exactly how big OTC derivative markets should be and know with metaphysical certainty that the markets will reconfigure themselves to the regulatory fiat in ways that enhance stability.  Yes, these are the most complicated, interconnected markets in the world, so of course guys in Dublin and DC should know exactly how big they should be and exactly how they should be configured.  Because that always turns out just swell.

This is exactly what Hayek meant by “the fatal conceit.”  And I fearlessly predict that this very conceit will be the source of the next crisis.