Streetwise Professor

The President of the KC Fed, Thomas Hoenig has joined a rather loud chorus clamoring for “Glass Steagall-type” measures to prevent another financial crisis (h/t R). (It should give Mr. Hoenig some pause that LaRouchies are very outspoken advocates of Glass-Steagall, btw.)

I find this nostalgia for Glass-Steagall to be bizarre and disconnected from the realities of Financial Crises I and II. The theory behind Glass-Steagall (and GS-lite measures like the Volcker Rule and the swaps pushout provision of Dodd-Frank) is that banks with insured deposits are subject to moral hazard, and will take on too much risk.  This problem can be reduced by restricting the activities in which banks with insured deposits can undertake.  That is, the problem is deemed to be giving banks too much discretion on the asset side of the balance sheet, when the liability side is insured.

But this bears no relationship to what happened in the 2008 crisis, or the one currently going on.

For starters, most of the major institutions that cratered in 2008 were not universal banks that funded capital market activities (such as underwriting) with insured deposits.  Indeed, the opposite was true.  They were investment banks/broker dealers (Bear, Lehman, Merrill); GSEs (Fannie, Freddie); insurance companies (AIG); commercial or universal banks heavily dependent on wholesale funding; and SIVs (many of which did have connections to commercial banks, admittedly).

Indeed, one could make the case that those who prescribe Son of Glass-Steagall to cure our financial ilss have the diagnosis exactly backwards.  Many of the institutions that cratered–notably the IBs and SIVs–did so precisely because they did not have sticky funding (like insured retail deposits): they relied on short-term, uninsured funding like repo and commercial paper.   Others, like RBS, had some retail deposits, but notably were very dependent on wholesale (uninsured) funding, and that dependence had grown over time.  All of these institutions suffered classic runs.

In this interpretation, it is the concentration of risk in institutions that do not fund primarily through insured deposits that is the problem.  David Murphy has a new paper that looks at Lehman and RBS, and arrives at a similar conclusion.  This would imply that Glass-Steagall is utterly off-point.

The history of banking in the US supports this view as well.  Banking panics occurred throughout the 19th and first-third of the 20th centuries due to funding fragility.  These panics destroyed banks that engaged in traditional banking activities like commercial and real estate lending.  Yes, there were runs on investment houses too (Jay Cooke & Co., Barings) but the point is that it’s the liability side of the balance sheet that matters more than the asset side.  There was tremendous diversity in the asset side of the balance sheets of firms that suffered runs prior to deposit insurance: there was very little diversity on the liability side.  All were funded with short term liabilities that could run at the drop of a hat.

Similarly, S&Ls raped and pillaged deposit insurance even though they were very “narrow banking” institutions with significant restrictions on the asset side of the balance sheet (though those restrictions were eased by Garn-St. Germain in 1984).

As a last point, Financial Crisis II is concentrated in European banks heavily dependent on wholesale funding, and the underlying source of the problem is assets that regulators deemed to be utterly safe for commercial banks–highly rated sovereign debt.  Relatedly, many of the assets that caused commercial and universal banks in the US problems in 2008 were again deemed by regulators to be super-safe, carrying very low (and in some cases zero) capital charges. The assets that are raising/raised questions about the solvency of financial institutions would have been perfectly copacetic even in a Glass-Steagall world.

Which all suggests that the Glass-Steagall focus on the asset side of the balance sheet is completely misguided.  The fragility in the financial system comes from the liability side, and regulators and legislators are terrible at identifying the assets that are “safe” for insured institutions to hold.  Given this, measures to stabilize funding–like deposit insurance, or the existence of a lender of last resort–are key to establishing stability.

Of course this raises moral hazard concerns, but the Friedman-Kraus analysis in Engineering the Financial Crisis convinces me that this was not an important part of Financial Crisis I.  Gorton also argues that the moral hazard effects of deposit insurance have been overstated.  The S&L Crisis was a large part a moral hazard problem, but it occurred in large part because of grossly negligent regulators who (under pressure from Congress) let insolvent thrifts continue to operate rather than shutting them down when their financial condition weakened in the late-70s and early-80s: regulators (and Congress) let readily containable moral hazard flourish.  That crisis also shows that banks have plenty of room to engage in morally hazardous behavior even when they are very narrow institutions with extensive restrictions on the asset side.

Identifying the fragility of liabilities as the true vulnerability of the system of course raises important questions: why do financial institutions routinely rely on run-prone funding, as they have done for centuries? Diamond-Rajan argue that fragile funding plays an important disciplinary role: the threat of a run limits the ability of banks to act opportunistically and expropriate those who lend to them.  This implies that trying to reduce reliability on fragile funding will have a cost: There will be more opportunism.  The hard thing is to design regulations that balance between micro incentives (to control opportunism) and macrostability (arising from the fact that the fragile funding that controls opportunism is vulnerable to jumps to bad coordination game equilibria).

But though I don’t have an answer to what the right balance is, I am pretty confident that it is appropriate to focus more on the liability-side issues as opposed to the asset-side issues.  Which further implies that pining for a return of Glass-Steagall is misguided, and positively dangerous, because it distracts attention from the real problems.

The Bank of England’s most recent Financial Stability Report includes an extended discussion of the various systemic risks posed by CCPs.  For SWP readers, the analysis will be familiar.  It focuses on the margin mechanism as a channel of contagion, procyclicality, and wrong way risk.  It emphasizes the risks arising from the pivotal role of sovereign debt in the clearing system.  Adverse shocks to sovereign debt prices can initiate the destabilizing margin cycle.  Moreover, given the correlation between the financial condition of CCP members and sov debt prices, sovereigns are a source of wrong way risk in teh system

Recognizing the very real possibility for a CCP failure, the BoE recommends the implementation of a resolution regime for CCPs to ensure that the market can continue to operate even if a CCP exhausts its financial resources.  I recommended this in  my ISDA white paper.

So I concur wholeheartedly with this BoE analysis.  But as was the case with Bernanke’s warnings about the systemic risks of CCPs, I ask: where the hell was the BoE  when everyone was drinking the clearing KoolAid?  Some of this realism would have been much more constructive before Frankendodd, the G-20 clearing commitments, and other moves to mandate clearing around the world.   Right now, the BoE, the Fed, and more than a few financial journalists remind me of someone who stood on the platform waving goodbye to a departing train, but are now running down the track screaming that its brakes are defective.

So regulators are no scrambling to figure out how to buttress the much expanded clearing system against its inherent vulnerabilities.  Would that as much thought and effort had been expended to identify, anticipate, and mitigate these vulnerabilities before regulation and legislation imposed such heavy reliance on CCPs.

Clearing was mandated in haste.  Unfortunately, given the current tumult in world financial markets, we may not have the luxury of mitigating the risks of these mandates at leisure.

A while back–summer of 2010, if memory serves–I predicted that any CFTC position limit rule would be the subject of legal challenge.  My prediction was that someone would argue that the CFTC did not have the statutory authority to promulgate position limits because it had not made a finding that there was indeed excessive speculation that made it necessary to impose limits.  Subsequently, a DC Appeals Court decision that overturned an SEC regulation due to a failure to carry out an adequate cost-benefit analysis, made it clear that  this would be a major vulnerability for a variety of CFTC rulemakings, position limits among them. The day after the post-Dodd-Frank position limit rule was passed, speaking at a JP Morgan commodity conference, I said a suit challenging the rule would be “coming soon to a courthouse near you.”

Well, soon means about 6 weeks.  Today ISDA and SIFMA filed suit in DC contesting the position limit rule.   These organizations allege that the CFTC:

— Erred in concluding that the Dodd-Frank Act required it to establish position limits without first determining whether they were even necessary;

— Failed to present a reasoned analysis or consider all evidence in setting position limits;

— Failed to conduct an adequate cost-benefit analysis as required by law;

— Conducted a flawed rulemaking process that prevented commenters from meaningfully participating.

I imagine that others–such as the CME and maybe ICE–will follow suit, as it were.  I also expect that other rules will also wind up in court.  The position limit rule is probably the most vulnerable because of the statutory language about excessive speculation, but all of the rules the CFTC has passed are on extremely shaky on cost-benefit analysis grounds.

Frankendodd is under some pressure in Congress, but given the Democratic control of the Senate and the White House, nothing is going to happen on that front.  Instead, pieces of it will be chipped away in court.  Position limits could well be the first chip off the block.  Which is as it should be.

Back in the summer I argued that sovereign CDS are acutely vulnerable to wrong way risk.  Indeed, the problem is so severe as to call into doubt the viability of these instruments.  From today’s Dow Jones News Wires:

But some market participants said that, if risk aversion from Europe spirals out of control and credit markets freeze, a large firm could fail to meet its obligations in a credit-default swap, setting off a chain reaction that threatens to destabilize the global banking system.

They are urging closer scrutiny of banks’ gross sovereign CDS positions and of the interconnectedness of the banking system.

“When there is a high degree of correlation between the underlying risk and that of the hedge counterparty [in this case, the sovereign and a bank selling CDS], can you rely on a payment from your protection seller?” asked Joyce Frost, partner at Riverside Risk Advisors LLC, a derivatives consultancy.

The correlation may be so strong, she said, that if Italy, for example, continues to deteriorate, the protection purchased from a highly correlated European bank may not be worth as much as originally thought. The value of that hedged position would be worth less than if the CDS were written by an uncorrelated counterparty–a U.S. or Canadian dealer, for example.

This is a phenomenon market experts call “wrong-way risk.”

Katy Burne goes on to argue that “[t]he lack of sovereign CDS clearing makes individual institutions more vulnerable to a messy default.”  This is fundamentally incorrect.  Clearing does not make wrong way risk go away because banks are CCP members, and would be on the hook in the event that a big loss on sovereign CDS caused a bank/clearing member to default.  In particular, the senior tranche of a CDO-like nature of CCP default funds makes them acutely vulnerable to wrong way risk.

Wrong way risk is intrinsic to sovereign CDS.  If big sovereigns are at risk of defaults that would cause payouts on CDS–heck, if even sovereigns that seem small in the scheme of things, like Greece, are in trouble–banks are likely to be in trouble.  The correlation is a fundamental feature of the instrument.  Whether banks are the ultimate counterparties in bilateral trades or via CCPs is immaterial: the problem is there.

Ironically, in financial markets positive feedback loops are typically a very negative thing.  Self-reinforcing spirals in tightly coupled systems like the financial markets are usually downward spirals.

Margining and collateral mechanisms are the most important positive feedback mechanism in financial markets.  AIG and MF Global are two examples of how these mechanisms turn high flying financial firms into smoking holes in the ground.  They suffer losses, counterparties demand more collateral, that puts further stress on the firm, they lose customers, counterparties demand even more capital, and before you know it–impact with the ground at high speed.

Procyclicality of margin can work at the level of the market too.  We are seeing the first signs of that with respect to Italy today.  LCH.Clearnet SA (the French arm, and not RepoClear) raised margins on Italian government debt today.  This will tend to induce some sales of leveraged Italian bond positions, which will reduce prices further.  Similarly, increasing haircuts will tend to reduce liquidity, which will also tend to put downward pressure on prices.  Lower prices and lower liquidity put further pressure to raise haircuts.

So–lookout below!  The spiral has begun.  Keep eyes on RepoClear.  I imagine it will be under tremendous pressure to avoid jacking up repo margins.  And who knows, since the 450 basis point  margin raising trigger* is based on the spread over an average of German, French, and some other countries’ debt, maybe RepoClear won’t have to raise margins on Italian bonds because French yields are rising too, due in large part to French banks’ holding of $400 billion in Italian bonds.  The looking glass world of Europe . . . .

Another comment, following on the previous post.  There will be tremendous pressure on CCPs to accept riskier collateral in the clearing mandate world.  Sovereign debt has been a primary asset for margining purposes, and the assumption has been that this collateral is low risk.  But we now know that is a fiction.

Pressure to expand collateral pools, combined with the risk that said collateral can decline in value, and precipitously, creates another positive feedback mechanism.  Markdowns in collateral held at CCPs (or indirectly, via collateral transformation services) will induce fire sale liquidations of margined positions, or of other assets in order to raise cash to offset the decline in the value of collateral.

Geithner, Gensler and others have touted collateral as the elixir for all derivatives market ills.  No.  In some circumstances the elixir is really a deadly poison.  Positive feedback mechanisms destabilize financial markets, and collateral mechanisms are among the most important sources of positive feedback in these markets.  We are moving to a regime in which more collateral is being required, collateral mechanisms are being made more rigid and less flexible (e.g., reducing hypothecation) but the supply of safe collateral is contracting–or at least not growing commensurately with the demand.  This will be a major source of fragility in the system, and one that has been built into the system all in the name of making it more robust.  Another gift from the sorcerer’s apprentices.

* The term “trigger” is hardly comforting in this context.

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

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

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

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

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

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

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

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

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

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

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

As usual, Deus Ex Macchiato is worth reading:

One difficult criticism for those of us who believe that strong financial regulation is necessary – even if we don’t believe that the current structure is heading in the right direction – is that of rent seeking. The issue is that the stronger regulatory power is, the more it can be exploited. For me, the clearing provisions in Dodd Frank are a great example of this. The clearinghouses have been handed juicy profits by regulatory fiat.

Read the rest.  That’s an order.

Gretchen Morgenson is getting good reviews for her book Reckless Endangerment, which unlike most of the financial crisis genre casts considerable blame on Fannie and Freddie.  So bravo for that.

But sometimes she can be so clueless.  I mean really: how can she not understand the difference between credit default swaps (“complex swap deals it had struck with its trading partners”) and repo?  She goes on and on comparing MF Global to AIG, claiming both were brought down by CDS.  Then she goes into a riff on CDS written on Greece, and credit linked notes, and ISDA, and blah blah blah.

Gretchen: secured lending–repo–brought down MFG.  You could have written something interesting about the repo market, how it works, how it is a fragile form of financing that can bring down firms.  That would have been informative and useful.  But to flog the CDS horse when CDS aren’t even involved.  Sheesh.

Gillian Tett of the Financial Times is shocked! shocked! to learn that Frankendodd: (a) has dramatically increased the complexity of financial markets; (b) creates myriad opportunities for regulatory arbitrage; and (c) gives advantages to big, sophisticated, politically juiced players that can decode, game, and influence the regulatory process most effectively.

Yeah.  I can sympathize.  It’s not like anybody could have seen that coming.  Nosiree.

Starting with my earliest post-crisis writings on clearing, I have pointed out repeatedly that the supposed virtues of clearing–netting and greater collateralization–look far different when you examine the nexus of financial contracts as a whole, rather than focusing on derivatives alone.  A primary effect of netting and greater collateralization  is to increase the seniority of derivatives in bankruptcy.  But if you increase the seniority of one claim, the seniority of other claims is reduced.  Sure, you can make derivatives more secure, but at a cost of making other claims less secure.

The systemic implications of this are ambiguous.  The implicit presumption seems to be that derivatives are somehow uniquely threatening to the stability of the financial system.  I say “implicit” because the clearing pom-pom squad has never discussed explicitly the distributive aspects of reshuffling priority via regulation, so I don’t even know if they are even aware of it.

But it is not hard to imagine scenarios in which giving derivatives even greater advantages in bankruptcy (due to safe-harbor provisions they already have a lot) can cause a systemic problem, but through another channel.  For instance, derivatives counterparties of a firm teetering on the brink of failure may rest easy given their priority status, especially if the CCP is considered safe.  But other claimants may not be so serene.  For instance, consider money market mutual funds  that invest in the paper of the dodgy firm.  Realizing that they will be totally hammered in bankruptcy, the investors in the money market fund may run.  That would not be pretty.

It’s even more complicated than that, because given the new seniority rules, there is likely to be widespread alterations in capital structures of derivatives market participants, and repricing of those claims.  Who knows how that is going to play out, and what new fragilities will be baked into the new structures?

This point is finally dawning on people.  One person who caught on long ago is Harvard’s Mark Roe.  Today, he published an oped that makes the point clearly and forcefully. It is definitely worth a read.

Money quotes:

Equally problematic is the fact that, while the clearinghouse and its participants can net wins and losses to reduce risk for those inside the clearinghouse, the clearinghouse does not assuredly eliminate the basic risk facing the entire financial system. Often, it merely transfers that risk to creditors outside the clearinghouse.

. . . .

Whether the clearinghouse reduces systemic risk depends on the relative systemic importance of those inside and those outside the clearinghouse – AIG versus Citibank in this basic example – not on the clearinghouse’s capacity to reduce risk among its members. In this example, if Citibank is precarious and is as systemically vital as AIG, the clearinghouse has obscured that it has saved AIG only by transferring risk from the clearinghouse to Citibank, which then fails.

Much recent regulatory activity has focused on enabling, enhancing, and requiring clearinghouses for these kinds of financing arrangements. Yes, clearinghouses offer many benefits, including greater transparency, better pricing, and better regulatory focus, and we should try to make them viable. But regulators world have overestimated their overall benefit. Too much of what is justified as reducing systemic risk is really just offloading risk onto others.

Exactly.

Reading Mark’s piece  brought to mind Bernanke’s quoting of Puddin’ Head Wilson in his discussion of CCPs.  Bernanke said if you are going to put all your eggs in one basket, keep a very close eye on that basket.

One of my problems with the whole CCP debate is that too often the tendency is to treat derivatives as the only eggs that matter.  But if you pay attention only to the basket with the derivatives eggs, you will not pay attention to other ones that are as valuable, or moreso.

To change metaphors, target fixation all too often leads one to miss the bogey that just jumped your six, with fatal results.  The obsessive focus on derivatives, and clearing, is a form of target fixation.  It risks diverting attention from other potentially mortal dangers. You need to have a system-wide perspective to truly understand systemic risk.

Mark is generally negative on giving derivatives any priority.  He has written things very critical of safe harbors.  He and I have discussed this, and have agreed to disagree: I can see reasons for differentiating the treatment of derivatives from other claims.  But the important point is to understand that this is an issue, and one that has to be examined from a system-wide perspective, because seniority rules shift risk around.

Mark gets that, and makes serious arguments about what the right rules should be.  Unfortunately, all too many of those who make the decisions and the rules don’t appear to get it.