Streetwise Professor

If Economics of Contempt and Yves Smith see something the same way I did, there’s probably something to it, as we seldom see eye-to-eye on much.  That something is the Volcker plan, and Paul Volcker’s defense of it in today’s New York Times.  The essence of the critique is that the plan’s focus on deposit taking institutions is overly narrow, and Volcker’s assumption (as set out in his oped) that non-bank “capital market” institutions don’t pose a systemic risk is just wrong.  As I noted in “Don’t Bank on It” and the follow up post, investment banks and hedge funds and foreign banks not subject to the plan’s constraints will take advantage of the profit opportunities foreclosed to banks by the plan.  These institutions will grow large and leveraged, and even though they are not beneficiaries of deposit insurance, they will be so enmeshed in the financial system that in the post-Lehman environment it is unlikely that governments would forego a bailout were they to run into trouble.  Knowing that, lenders will be willing to finance them at rates that do not reflect their actual risks, and they will grow to large and risky.

Here’s the way Smith puts it:

The consequence of this system of “market based credit” is that those markets have significant scale economies (network effects, high minimum scale required to be competitive, etc.). The result is a comparatively small number of firms have made themselves crucial. The Bank of England in its April 2007 Financial Stability report noted the importance of certain firms it called “large complex financial institutions” and deemed them to be important not simply due to their size, but also their crucial position in certain markets. Its list then was:

ABN Amro, Bank of America, Barclays, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman, HSBC, JP Morgan Chase, Lehman, Merrill, Morgan Stanley, RBS, Societe Generale, and UBS

Of course, that list is somewhat shorter now, but a bigger issue remains: if you tried breaking the capital markets operations of these dominant firms up, those businesses would tend to evolve back into a concentrated format. And it is these origination and trading operations that make them too indispensable to fail.

In reading Volcker’s op-ed, he completely ignores the 800 pound gorilla in the room, that this crisis extended a safety net under these global trading operations. More important, the industry recognizes full well how it is now situated. These origination and market-making operations will not be allowed to seize up. Before, they merely played with other people’s money. Now they play with other people’s money and a guarantee. Having the officialdom say it ain’t so or pretend it is working towards a solution when it does not yet have one does not fool anyone who understands the real issues.

Put differently, governments’ inability to commit credibly not to intervene to save big, interconnected firms is a huge gravitational pull that encourages the coalescence of such massive entities.  Deposit insurance is not the key problem.  Indeed, deposit insurance can encourage the formation of a lot of small, risky institutions that may pose a systemic risk collectively (see the S&L crisis); it is the inability to precommit not to save the big but failing that encourages the evolution of too big institutions.  And saying that deposit taking banks cannot engage in a certain type of potentially risky activity will primarily foster the development of big firms that don’t take deposits, but engage in this risky activity.

I think that Volcker’s main problem is that he has an anachronistic, and perhaps nostalgic, view of the financial system.  Putting aside the point of whether it is desirable to restore the financial system of the days of Leave it to Beaver, it is clearly impossible to do so.

Maybe all this is moot.  If this FT piece is to be believed, the Volcker plan is DOA in the Senate:

A proposal by former Federal Reserve Chairman Paul Volcker to limit bank’s proprietary trading will be either be dropped or significantly modified in the Senate, lawmakers and staffers told dealReporter.

Senate Banking Committee ranking member Richard Shelby (R-AL) said he opposes the so-called Volcker rule and the Obama administration’s call to levy a USD 90bn tax on banks. His comments come as House Financial Services Committee Chairman Barney Frank (D-MA) predicted the proposals outlined by President Obama could be law within six months.

Speaking to this news service on Thursday, Shelby said if Democrats push forward with the proposals they risk unravelling much of the bipartisan support already reached regarding the passage of financial regulatory reform in the Senate. Shelby said that the Obama administration risks losing Republican support for the bill if they begin to “politicise” the issue.

However, Shelby said he expects to hold a meeting with Banking Committee Chairman Chris Dodd (D-CT) regarding the way forward on regulatory reform in two weeks time. A Democratic banking committee staffer confirmed that the meeting between Dodd and Shelby will be critical as Dodd needs to determine the level of bipartisan agreement and the timing of bringing the bill through committee and on the Senate floor.

With the election of Republican Scott Brown to the Senate, the Democrats no longer have the necessary 60 votes to force through a Regulatory Reform package, and any bill will need at least some Republican support to pass. A Dodd staffer said the senator is likely to quietly drop or modify many of the recommendations in the Volcker rule to ensure Republican support for regulatory reform.

“Chris is retiring so he wants to end his career with an important regulatory reform bill and he wants to make the bill bipartisan,” the staffer said. “He is not going to risk bipartisan support to make the White House happy.”

. . . .

Senator Mark Warner, a Democrat on the banking committee from Virginia, also said he has concerns regarding elements of the Volcker rule, many of which are already being dealt with by the committee. He said that one of the problems is in the definition of what constitutes proprietary trading and that regulators should be more proactive in determining what constitutes excessive risk taking by financial players.

Warner also said that the prospective Senate version of the Kanjorski amendment passed by the House also includes using capital adequacy standards to reign in excessive risk taking by financial institutions and that such an approach gives regulators greater flexibility. [Pet peeve alert: it’s rein in dammit, not “reign in.”  It’s pretty bad when the editors of one of the world’s largest newspapers, and a British one no less, doesn’t know the difference.]

But apparently JP Morgan Chase isn’t taking any chances about the Volcker rule (as Surya first noted in the comments over the weekend):

J.P. Morgan Chase & Co. is reconsidering its interest in acquiring the North American operations of RBS Sempra Commodities but remains in talks to buy the firm’s European metals and energy trading operations, people familiar with the situation said Monday.

The change in sentiment is tied to J.P. Morgan’s concerns about new proposals by President Barack Obama that could put a kink into any acquisition, as well as the notion that the North American natural gas- and energy-trading business overlaps with some of the bank’s existing operations.

The new proposals from the Obama administration, issued last week, could force a large commercial bank like J.P. Morgan to exit any proprietary-trading businesses like those up for sale.

A good illustration of the effects of policy uncertainty.

Henry Paulson’s new book alleges that Russia attempted to convince China to join it in selling large quantities of Fannie Mae and Freddie Mac (government supported entity, or GSE) bonds in order to force the US government to prop up the GSEs:

Russian officials had made a top-level approach to the Chinese, suggesting that together they might sell big chunks of their GSE holdings to force the US to use its emergency authorities to prop up these companies,” he said.

. . . .

“The Chinese had declined to go along with the disruptive scheme, but the report was deeply troubling,” he said. A senior Russian official told the Financial Times that he could not comment on the allegation.

Bloomberg has more:

Paulson learned of the “disruptive scheme” while attending the Beijing Summer Olympics, according to his memoir, “On The Brink.”

The Russians made a “top-level approach” to the Chinese “that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies,” Paulson said, referring to the acronym for government sponsored entities. The Chinese declined, he said.

Russia’s five-day war with U.S. ally Georgia started on Aug. 8, the same day as the opening ceremonies of the Beijing Games. Prime Minister Vladimir Putin told U.S. President George W. Bush during those ceremonies that “war has started,” according to Dmitry Peskov, Putin’s spokesman.

“The report was deeply troubling — heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets,” Paulson wrote. “I waited till I was back home and in a secure environment to inform the president.”

Putin spokesman Peskov denies the allegation:

Russia never approached China about dumping U.S. bonds, Peskov said today. “This is not the case,” he said by phone.

Note that Peskov is quoted in Bloomberg as a source of information about Putin telling Bush that war had begun; he is not necessarily a definitive source about this other allegation.  Note further that the FT could not get official comment one way or the other.

This occurred about a month before the Feds seized the GSEs, and 5-6 weeks before it all hit the fan in mid-September.  Although there were clouds on the horizon in the late-summer of 2008, there was little to suggest the severity of the impending tempest.  Thus, the Russians should be congratulated for their perspicacity.  I wonder what information led them to this conclusion, and how they obtained it.  (Although, their foresight was not perfect.  Even though the Russian market had already begun to show serious cracks post-Mechel and with the onset of the Russo-Georgian War, the official attitude was that Russia was becoming an economic juggernaut that was immune from adverse economic shocks from abroad.  Not exactly, as events proved.)

Of course, there is a single source for this allegation–Paulson–and he doesn’t provide any real detail as to how he came to know of this gambit, or what information led him to this conclusion.

That said, it is eminently believable.  Combine mercenary motives with the Putinists’ raging complexes and resentments of the US, and their desire to knock America down a few pegs, and to that add the “I wish my neighbor’s cow would die” element of the Russian character, and you can easily see this happening.

If it did happen, it says a lot about the Russian M.O. Clearly, Russia had 65.6 billion reasons to be concerned about Fannie and Freddie.  Moreover, they were rightly anxious about the financial condition of the GSEs, and the potential for a substantial loss in the value of their investment.  But, if Paulson is right, rather than behaving in a constructive and forthright way, Russia instead acted the manipulative gangster, and attempted to play Machiavellian Great Games and score geopolitical points.

Such attitudes should be kept in mind when dreaming about resets, and negotiating arms control agreements, Afghanistan logistics arrangements, and actions against Iran.

I’m not a big fan of Zero Hedge; it’s very high variance.  (Which kinda makes sense, if they’re not hedged:)  But every once in awhile “Tyler Durden” hits the nail.  Apropos AIG, he asks the question I asked, and Hank Greenberg asked: why didn’t the Fed/Treasury simply guarantee AIG’s contracts?:

Why did the Fed not guarantee AIG’s assets ahead of the firm’s implosion. Surely, the realization, which as everyone trumpets these days, that AIG’s failure would have destroyed the world should have been known to at least one person in authority? And as all know, the collateral call toxic spiral commenced only once AIG was formally downgraded by the rating agencies. Well, had the AIG had the formal guarantee of the Federal Reserve, which is implicitly a guarantee by the U.S., then AIG would not have been downgraded in the first place, and no collateral calls would be forthcoming. Of course, Goldman would end up owning CDOs that as Janet Tavakoli points out, and contrary to what the Fed claims, are now worth at best pennies on the dollar. Furthermore, Goldman’s AIG CDS would immediately have become worthless, with Goldman unable to sell them in the open market for a profit of billions of dollars, yet the firm would continue extracting collateral as per its prior arrangement with AIG, in essence not impairing Goldman at all. And had AIG not started down the downgrade spiral, then numerous other adverse consequences of the nationalization of the insurance company would not have transpired. While it would not have saved America’s financial system, it would have made the descent more manageable. Yet with Goldman having benefited massively from the elimination of a vast swath of competitors, one wonders if the guarantee track may have been considered and subsequently denied, under the wise tutelage of 85 Broad advisors. We suggest Senator [sic] Issa and Neil Barofsky focus very closely on any email released as part of the disclosure process that highlight the Fed’s reasoning as to why AIG should not receive a guarantee, and what the nature of such reasoning may have been. [Emphasis added.]

I agree completely that this is the most important question.  The stuff about the disclosures is perhaps easier for the politicians and public to understand, but that’s a side issue, at best.

Timmy! Geithner basically blew off this issue.  Bernanke definitely blew it off.  Issa asked him about it, and in his response letter, Bernanke didn’t answer; he said only that that question had been answered by FRBNY General Counsel Thomas Baxter.  What, is Helicopter Ben averse to spending a few pixels to explain, in his own words, why this option wasn’t chosen?  Lawyering up always looks suspicious.

The refusal to answer this question is very telling.  That’s where the story really is.  Guarantee: no cash out the door, but no AIG implosion either, allowing time to manage the crisis.  There had to have been a compelling reason to eschew this option.  I haven’t heard it yet.  Like Z-H says, let’s see the paper trail.

In his article on the Volcker Plan in today’s FT, John Gapper meanders around in an attempt to defend it, and then stumbles on this realization that undermines most of his previous justifications:

There is, however, one substantial objection to the Volcker rule as it has been structured by the administration. [And believe me–it’s substantial.  Like so substantial as to demolish the case altogether.]  It focuses on deposit-taking banks rather than, as Mr Volcker’s G30 report last year phrased it, “systemically important financial institutions”.

This means that it would apply to, for example, JPMorgan and Bank of America, but probably not to Goldman Sachs and Morgan Stanley. These investment banks have the option of giving up their bank holding company status, shedding deposit-taking, and being able to continue combining proprietary and customer businesses.

Leaving aside the strange consequence that an attempt to curb banks could end up helping Goldman by reducing the competition, this is wrong in principle. Even if Goldman and Morgan Stanley surrendered access to the discount window and their bank status, do we really believe this deals with the problem?

Of course not, for we cannot (much as everyone would like to) erase the memory of the last time trouble struck. The Treasury was forced to bail out Goldman and intervene to prop up American International Group, the full details of which are now embarrassing Mr Geithner. [Emphasis added.]

Well, exactly.  But immediately after having the lightbulb go on, and figuring out that rules limited to deposit taking banks with access to the discount window will do nothing to prevent a recurrence of a financial crisis, and may actually make one more likely, he lamely sticks up for Volcker:

The Volcker rule is not perfect but is the best attempt yet to confront head on the legacy of that time. If it were extended to Wall Street as a whole, it would be better still.

Just what does “extend[ing] [the rule] to Wall Street as a whole” mean, exactly?  No prop trading by anybody?  That’s asinine.  If he means addressing To Big To Fail more comprehensively, well I agree with that, but it’s hard to figure how a non-asinine extension of the Volcker rule could do it.

Which means that you have to do something different altogether.  The Volcker plan is clearly insufficient to address TBTF in a serious way.  It seems the creation of a man–sorry to say it–who is past his prime and somewhat nostalgic for a Glass-Steagall world of his prime even though the repeal of Glass-Steagall really had zip to do with fomenting the financial crisis.  Volcker clearly has good intentions to tackle TBTF, but good intentions aren’t enough.

Some more imaginative thinking is in order.  TBTF is the result of the interaction between two, distinct, entities: financial institutions and the government.  All of the noodling has been directed at the former, very little at the latter.  TBTF wouldn’t exist if it were possible to make credible government commitments not to bail out.  To focus on banks alone is to assert that government is beyond hope.  That it has as much ability to make commitments not to indulge in bad habits as your typical methhead.

Maybe that’s true.

Is that what advocates of regulation actually believe?  Let them be explicit about it then.  Pretty scary thought: we have to trust the government with all sorts of powers over financial institutions because the government is constitutionally (small-c) unable to avoid taking destructive actions involving financial institutions.

Wouldn’t it be worth a little more effort to think of ways to improve the government’s ability to pre-commit, than to basically concede the point and focus all attention on how to keep banks from putting the government in a position where its willpower is tested?

Do we need to call in Dr. Strangelove?

I think it’s always worthwhile to work through the likely equilibrium effects of policy changes, to recognize that such changes will affect not only what is directly targeted, but will also induce other responses that can dampen, and even reverse, the intended effects of the policy change.

Let’s consider the unintended, equilibrium effects of Volker-Obama.  The V-O plan should affect big deposit taking institutions–universal banks–most acutely.  JP Morgan-Chase, Citi, BofA in particular.  The plan essentially forces firms to make a choice between being depository institutions or prop shops.  (Backdoor Glass-Stegall, if you will.)  The cost of becoming a prop shop would be very high for Morgan, etc.  So they are likely to jettison these operations, and become relatively old style banks again.  And that’s exactly what Obama and Volcker want.

But consider the effects of the exit of some players from prop trading.  They were presumably in the prop trading business because it was profitable.  Their exit creates a profit opportunity for somebody else.  In the first instance, potentially a Goldman or MOST that can become pure prop shops exempt from the restrictions at lower cost than Morgan, Citi, and BofA.  Moreover, currently smaller players may expand their prop trading, or new entrants will come in to take advantage of the opportunities.

In other words, someway, somehow, the exit of the deposit taking banks from prop trading will induce expansion and entry by others.  These others, in turn are likely to be quite large and systemically important.  Especially because VO doesn’t address the underlying source of TBTF–the government’s inability to commit NOT to intervene to bailout the creditors of a failing, interconnected, failing institution.  (Thought experiment: V-O is likely a boon to Citadel and D.E. Shaw.  Thinking back to LTCM, do you think that if one of these firms got into serious trouble, that some sort of government intervention would occur?  Yeah, the investors in the hedge funds would be wiped out, but that’s not the point.  To the extent that their counterparties, and the banks that finance their operations are convinced that they would be protected in the event of a big hedge fund collapse, they are willing to trade with and extend credit to them, permitting them to expand excessively.)

This means that equilibrium responses will undermine the effects of VO.  It is likely that VO will reduce the amount of prop trading, especially if there are synergies between this activity and other forms of intermediation offered by universal banks.  But it may lead to a greater concentration of what prop trading remains in the hands of a smaller number of less diversified firms.  Remember that the main casualties of the crisis were, in the first instance, Bear Stearns, Lehman, Merrill, and almost Morgan Stanley and Goldman.  If anything, the V-O plan would increase the number, size, and importance of these kinds of firms.  That’s hardly reassuring. Yes, these types of firms would not benefit from the deposit insurance system, but that doesn’t mean that they aren’t effectively guaranteed anyways if they become big enough.

Yes, we definitely need to do something to deal with moral hazard.  I’m just not convinced that the V-O framework does that.  Given that prop trading is apparently profitable, V-O will lead primarily to a shifting around of who does prop trading.  Yes, deposit taking institutions will do less of it, but others will swoop in to take advantage of their exit.  We’ll still be left with implicitly guaranteed institutions with an incentive to grow too large.

I’m ambivalent, at best, about Obama’s just announced a proposal–and remember, now it is just that–to hive off prop trading and private equity from financial institutions that issue insured deposits or have access to the Fed discount window.  On the one hand, it is to be welcomed that efforts are being undertaken to grapple with the too big to fail (TBTF) problem.  Moreover, although some have vented on the unconscionability of mandating the forced separation of proprietary trading activities from other bank functions, the multi-tasking and influence cost literatures both show that information/measurement problems can make it efficient to preclude agents/entities from engaging in some types of activities.  This means that you can’t rule out a priori the efficiency of the types of restrictions contemplated in the Volcker-Obama plan.

That said, I am dubious about the prospects for this endeavor–in the unlikely event that it is implemented–because it does not strike at the root of the TBTF problem.  Obama is putting his finger in one hole of the dike, maybe, but the intense pressure generated by the underlying sources of TBTF makes it inevitable that new holes will appear in short order.

TBTF stems from two, quite different sources.  The first is the government’s very credible commitment to make whole insured depositors.  The second is the government’s inability to make credible commitments NOT to intervene to bail out the uninsured creditors of large, interconnected financial institutions.

Obama focused on the first source of TBTF in his remarks. He said that he wanted to insure that financial institutions don’t benefit from taxpayer-insured deposits while making speculative investments.”  He also decried “bank[s] backed by the American people” operating hedge funds.

In all honesty, I don’t think that deposit insurance is the main, current culprit in TBTF.  (I’d also note that deposit insurance needn’t lead to too big to fail institutions.  As the S&L crisis showed, deposit insurance can allow the proliferation of many small, high flying operations that individually are trivial in size, but which collectively can impose huge costs on the government.)

No, I think that the real source of TBTF that we face today is the second one: the widespread expectation that the government will intervene to protect uninsured creditors of huge financial institutions.  The government can’t tie itself to the mast, and say: we will not bail you out.  At least, no government has shown the ability to do so.  Knowing this, people are quite willing to lend money at low rates that do not reflect total risks to financial behemoths, because they are convinced that the taxpayers, not they, will bear the downside risk.  Note that during the crisis, a trivial fraction of bailout funds were devoted to protecting insured depositors.  Moreover, the institutions that received support directly or indirectly didn’t issue insured deposits, and weren’t eligible to borrow from the discount window.

I don’t think that the Volcker-Obama proposal does anything to address that big, looming problem.   TBTF exists because risk taking by large institutions is subsidized.  Yes, prop trading or running a hedge fund is one way to take on risk, but there are many other ways to do that too.  If there is a subsidy to take on risk if you are big enough, and one way to take on risk is foreclosed, there are myriad other ways to get your hands on the subsidy by taking on risky assets, using risky capital structures, etc.  Historically, banks have gotten into trouble the old fashioned way, by making highly risky loans.  It’s like trying to fight substance abuse by banning beer, but letting people buy scotch, or do meth.

Moreover, there are ways to restructure firms to escape the constraint that the V-O plan would impose.   Volcker is well-known to be nostalgic for Glass-Steagall, and this appears to be an attempt to implement a modified version of that.  Let’s say it works that way, and we’re in a back-to-the-future world with deposit-funded commercial banks that don’t do prop trading, and big investment banks that don’t issue insured deposits and don’t have access to the discount window, but can grow big funded by lenders confident that Uncle Sugar will save them in a pinch, and who do prop trading.   The fundamental problem would still exist.  As long as funders were convinced that the government would protect them if a big investment bank ran into trouble due to a prop trading blowup, the new IBs would have the incentive and ability to grow too big to take advantage of that subsidy.  Some firms would restructure to escape the limits, or new firms designed to avoid the constraint would form/grow.

Indeed, it’s quite possible that the restrictions could make things worse, by lulling Congress, regulators, and the public into the belief that the TBTF problem had been fixed.

In sum, the Volcker-Obama plan is fundamentally flawed, in my view, because it does not price the crucial risk at issue: the risks that TBTF institutions create would still be unpriced if the plan were implemented.  The plan, at best, just raises barriers to some ways of taking on risk, but there are so many close substitutes that that doesn’t help much at all.  The basic problem is the huge gravitational pull exerted by the government’s inability to commit credibly not to bail out the creditors of big, interconnected firms.  This means that the relevant risk is underpriced.

The Volcker-Obama plan is also odd, because it seems to pretend that the world ends at the borders of the US.  The likely result is to be a shifting around of activity among regulatory jurisdictions, with little overall impact on the total amount of risk in the system, or the composition of that risk.  Given the interconnectedness of the global financial system, this means that the effects of the change will be small, even on the US.

I am also somewhat skeptical of the plan because it is less of a policy proposal that could be seriously expected to address a major problem, than a transparent populist pivot rolled out precipitously in a desperate attempt to stem Obama’s political implosion post-Massachusetts.  The last thing we need right now is more economic and political uncertainty, and this proposal cranks up the uncertainty quite a bit.  Markets around the world fell pretty hard on the news, and the standard gauges of risk, like the VIX volatility index, spiked.  Given that the dismal employment news is attributable in part–and likely, in large part–to policy and economic uncertainty, this is unwelcome news.  Ironically, this means that a measure intended in part to secure a short-term political benefit actually undermines Obama politically over the longer term, because populist boob bait won’t do squat for his fortunes if the employment picture remains bleak.

I sometimes disagree with Economics of Contempt, but he wrote a post yesterday that pretty much repeats my points that the fact that end users freely choose to trade on dealer markets despite the assiduous attempts of exchanges to woo them means that OTC trading must dominate exchange trading for a large group of firms:

More broadly, notice who the intended beneficiaries of all Mike’s preferred requirements are: not average taxpayers, mind you, but the end-users who trade OTC derivatives. These end-users are predominantly large institutions — bond managers, institutional investors, hedge funds, large corporates, etc. If pre-trade price transparency would be so beneficial to them, then why haven’t they already moved to exchanges? There’s absolutely nothing stopping them — the exchanges have been offering OTC lookalikes for years, with little success. The problem is that no one wants their products. And it’s not like there’s no competition in this space. To the contrary, the competition among the different trade execution venues (ECNs, dark pools, etc.) is incredibly fierce.

Even the price competition in the traditional OTC market is fierce, despite what journalists think. For example, according to Risk‘s 2009 survey of corporate end-users, 65.3% of end-users listed price as the most important factor in choosing a derivatives dealer. Fully 73.5% of end-users negotiated with 2-3 derivatives dealers before agreeing on a trade, and an additional 14.3% of end-users negotiated with 4-5 dealers.

I recommend reading the whole thing.

I don’t necessarily agree with EOC’s advocacy of requiring all trading in “standardized” derivatives go through clearinghouses.  Beyond all of the nettlesome issues relating to just what “standardized” is (and contractual standardization is clearly not a sufficient condition to make clearing practical), all of EOC’s arguments stated in this particular post can be achieved through mandatory reporting, which is different from clearing.  Clearing involves a mutualization of default risk; the informational advantages that EOC touts can be achieved without such (problematic) mutualization.

And one personal quibble.  (I know.  It’s always about me.)  EOC’s post responds to a Mike Konczal piece which is a direct response to something I wrote for FTAlphaville.  EOC:  Would it kill you to (a) acknowledge that, and (b) give some props for the fact that I made several of the arguments you advance in this post . . . before you did?  Just asking.

In the aftermath of the crisis, clearing has been advanced first and foremost as a means of reducing systemic risk.  In my opinion, for the most part, these assertions reflect a superficial understanding of clearing, when they don’t reflect abject ignorance.

Things are actually quite complicated.  I thought it would be worthwhile to present a list (which is long, but probably not exhaustive) of some of the ways in which the adoption of a central counterparty can actually create or worsen systemic risks.  These are presented in no particular order.

1. The adoption of a CCP affects the priority among creditors.  In essence, netting positions improves the priority of the claims of derivatives counterparties (more exactly, of clearinghouse members via the clearinghouse) of a defaulting member.  It also worsens the priority of the claims of the bankrupt/defaulter’s other creditors.  It is not clear a priori that this reallocation of priority improves welfare, or reduces the likelihood of a systemic shock resulting from the default of a large derivatives trading firm.  For instance, worsening the position of those supplying short term credit will exacerbate their losses in bankruptcy/default.  These creditors (e.g., repo counterparties, corporate paper buyers) may be systemically important.  (EG, worsening the losses of CP buyers may result in runs on money market funds that hold CP.)  Moreover, worsening the position of some creditors will tend to make them more likely to run.  This can tip a shaky but surviving firm into failure.  Changing priority will affect capital structure and transactions costs in complex and unknown ways that could have systemic implications, as market participants adjust contracting behavior in response to the change in priorities.  Of course, changing priority in favor of derivatives counterparties could reduce systemic risks by reducing their incentive to run, and reducing the losses they suffer.  But it is by no means clear a priori how this cuts.  This is related to the general point that the first order effects of clearing are to change the allocation of risk, not its total amount.  It is not trivial, to say the least, whether these reallocations reduce or increase systemic risks.
2. A system with customer clearing (as in futures markets, and as is being proposed/advocated/adopted in some OTC clearing organizations) tends to increase the default losses that CCP members suffer, even holding total trading positions constant.  (Customer positions are likely to increase, moreover, as I discuss below.)  Since the CCP members are likely to be systemically important financial institutions, this would tend to exacerbate systemic risks. In a bilateral market, exposures to the default of firm A is limited to A’s counterparties, in relation to their trades with A.  Some end users who trade with A, who would not be members of a CCP, suffer from A’s default, as do other dealers likely to be CCP members.  In contrast, in a CCP with customer clearing, the obligations of A, as a CCP member, to non-members are transferred to other member firms.  That is, adoption of clearing tends to redistribute the burden of default losses from end users who are not CCP members to financial intermediaries who are.  (Indeed, this is one of the advertised virtues of CCPs.  For years, the Board of Trade Clearing Corporation touted the fact that no CUSTOMER had lost money as a result of default: that’s exactly because clearing insured customers by transferring the risk to clearing members, i.e., large financial intermediaries.)  Thus, clearing tends to increase the default losses borne by systemically important financial institutions.  Another example of the effects of clearing on risk allocation that plausibly increase systemic risk.
3. CCPs create a single point of failure, and a concentration of risk.  This can have a variety of effects beyond the obvious one of the systemic shock that would result if a CCP in fact fails.  It means that there is less diversification of the risk of errors, e.g., model risk, or other risks in the evaluation of default risk.  If a CCP’s model/methodology/information for evaluating performance risk is flawed, these flaws are almost by definition systemic because the pricing of risk in all deals is wrong.  In contrast, when multiple parties are evaluating each others’ performance risks using different models or different information, errors will be less correlated.
4. CCPs generally do not price balance sheet risk (due to informational and governance considerations), which can encourage more trading by weaker firms, and can also encourage firms to take on more balance sheet risk (e.g., by taking more risk on non-cleared positions/investments).  This tends to increase risk in the system, and not just in the derivatives market: it can increase risks in other markets too.  It also provides another mechanism by which risks in other parts of the financial system affect the derivatives markets.
5. CCPs mutualize default risk.  Mutual arrangements tend to encourage moral hazard and risk taking.  These can be controlled, but only at a cost.  Moreover, monitoring and control of risk are delegated to an agent typically subject to low powered incentives, and monitoring of the agent by the principals (CCP members) is subject to free riding because the benefits of monitoring accrue to all members but the costs fall completely on the member that incurs them.  In a CCP, deficient monitoring tends to have systemic consequences for reasons discussed above.
6. Clearing can result in the capture of scale economies, but sacrifice scope economies, in the allocation of default risk.  It is not evident that this trade-off, and its effects on the allocation on default risk, is beneficial.
7. The adoption of clearing is likely to have a tendency to increase total positions and trading volume.  This tends to increase overall market risks, and default risks along with them.  Position sizes are likely to rise for several reasons.  First, netting tends to reduce the capital required to support a given size of net position.  Expanding netting through clearing therefore tends to reduce the costs of maintaining positions, leading market participants to hold bigger ones–thereby taking on more risks.  (Another equilibrium effect.)  This cost reducing-position increasing effect is mentioned by advocates of clearing (I can provide cites) as one of its advantages.  More efficient use of capital is generally desirable, but it is important to note that bigger markets pose greater risks–including greater risks of default.  (The effects of netting on position sizes was actually advanced as a reason for not adopting clearing at the CBT in the 1910s-1920s: lack of clearing was said to “encourage conservatism” by limiting the size of positions–and hence risks–that firms could hold with a given level of capital.)  Second, by redistributing default risks from CCP non-members to CCP members, the adoption of a CCP tends to increase the derived demand to trade by end users.  This also encourages growth in market size, and via the channel discussed above, tends to increase the risks faced by systemically important institutions.  Put differently: do advocates of clearing really want derivatives markets to be bigger?  That’s a very likely consequence of clearing.
8. In times of market stress, and large price moves, the rigidity of CCP collateral mechanisms can exacerbate liquidity problems.  Daily and intra-day variation margin payments are financed to a considerable degree through the extension of credit.  Large variation margin obligations resulting from large market price moves therefore translate into large increases in credit demand in stressed market conditions.  As was demonstrated during the Crash of ’87, under these conditions banks may decline to extend credit due to heightened uncertainty and lack of information about who is solvent and who is not.  Failure to obtain credit to make a margin call may force closure of a clearinghouse (again, as almost happened to the CBT and the CME in October, 1987).  Given the systemic, bottleneck nature of a large CCP, this would almost certainly spark a systemic crisis; it would certainly put pressure on central banks to provide liquidity, just as would occur from the failure of a large dealer in the OTC market.  Moreover, the traders who need to make variation margin payments are likely to sell assets.  This can create a positive feedback mechanism with very negative effects, by accelerating and exaggerating asset price declines, thereby necessitating additional margin payments, etc., etc.

Like I said at the outset, this list isn’t exhaustive.  And I certainly don’t know how, on net, all the various effects of clearing would play out from a systemic risk perspective.

But the point is that the advocates of clearing don’t either.  I haven’t seen evidence that they’ve even inventoried the possible effects, let alone made reasoned judgments about the net effect, or if that is even possible given the complexity of the system, the likely complicated equilibrium effects (i.e., how people adjust their behavior in response to the new regime), and the inevitable lack of information necessary to estimate the effects.

In brief, the mandated adoption of clearing will have big effects on the allocation of risk, the total amount of risk in the system, and the incentives of firms and individuals to take on, manage, and monitor risk.  Many of these effects plausibly increase systemic risk.  There are plausibly offsetting effects, but suffice it to say that anyone (and that means you, Timmy!, Gary, et al) who sells mandated clearing as a surefire means to reduce systemic risk are guilty of false advertising, not to say outright fraud.

Since the financial crisis began, and people began casting about for “solutions,” I’ve argued that central clearing is not a panacea; not the silver bullet; not the cure.  Over here, that’s the decided minority view, and the Treasury and the Fed and Congress and the SEC and the CFTC are all gung ho for clearing, and forcing its widespread use.

In Europe, however, they are having some second thoughts on the subject, as this article by Aline Vanduyn and Jeremy Grant in the FT makes plain:

In the months that followed the near-implosion of financial markets, regulators scrambled to figure out how to rein in the vast over-the-counter (OTC) derivatives markets that were seen as central to the crisis.

But, as numerous high-level meetings this week by central bankers and regulators show, the hunt for solutions has thrown up a fresh dilemma: new risks posed by clearing houses.

Clearing houses have been touted as the perfect shock absorbers for risks [sadly true, especially in the US] associated with the $600,000bn, privately-traded or OTC derivatives markets, since they guarantee that trades are completed even when a party to a trade – such as a derivatives dealer – defaults.

. . . .

‘Clear more, and faster’ is what we are being told to do,” says an executive at a derivatives dealer. Indeed, dealers who met regulators in New York yesterday are expected to sign up to just that. However, it is rapidly dawning [I wouldn’t call it rapid; “finally dawning” is more like it] on regulators that, while forcing more OTC derivatives into clearing houses removes systemic risks from one area of the financial system, it may at the same time be concentrating new risks in clearing houses themselves. [Eureka! They’ve finally figured out that clearing just reallocates risks, rather than making them disappear.]

Minds are being focused in recognition that many of the OTC products that look set to be cleared have never been handled by clearing houses before. [And I wonder why that is?  Better late to asking that question than never.]

. . . .

That concern is mirrored in Europe. Alexander Justham, director of markets at the UK’s Financial Service Authority, says: “We should be under no illusions that clearing houses are highly systemic, therefore what goes into them and the risk standards that apply must be extremely high.”

. . . .

They call for clearers to forge links with each other to facilitate cross-border clearing and give traders a choice over where to send their deals for clearing, rather than being tied to one monopoly clearer.

Yet regulators are now concerned that the creation of these links – a process called “interoperability” – could be the source of another systemic crisis. The worry is that the weakest in the chain could bring others down if it were involved in a default and was insufficiently capitalised to meet margin calls. [In other words, clearing doesn’t eliminate linkages, it just reconfigures the system of linkages.]

. . . .

Yet there are many other questions that need answering even before new rules are set. The complexities are so great that a new regulatory group has been created to tackle them. [Complexity?  Who knew?]

. . . .

Damian Carolan, a partner at Allen & Overy, warns: “There is a real risk that the focus on ensuring that CCPs are sufficiently robust to withstand these historically unseen risks is lagging behind the work to push derivatives through those clearing houses. The two have got to go hand in hand.” [Listen to the man.  First do no harm.  Too much clearing can be as systemically risky–or more so–than not enough.]

All true.  And there’s so much more.  I’m compiling a list of ways central clearing can actually increase systemic risk–the concentration and interlinkage issues mentioned in the article being only two.   Hopefully this will be the subject of a blog post in the coming week, travel and teaching schedule permitting.

But it is at least a relief that somebody, the Europeans in this instance, have disabused themselves of the notion that CCPs are “perfect shock absorbers.”  It is also a relief that some people finally recognize that the concentration of risk in a single entity that uses a single method to evaluate and price risk means that mistakes in this methodology are inherently systemic in nature.  (Think “rating agencies.”)

Fools rush in where angels fear to tread.  Grand constructivist schemes to re-engineer a vast, complex system like the OTC derivatives markets create a huge systemic risk–the risk that the scheme is ill-advised, or implemented badly.  If it doesn’t work, the resulting crisis in response to a shock could be devastating.

In the US especially, the attitude is a Red Queen-esque “Sentence first, verdict afterwards.” Or, “ready, fire, aim.”  It would be far better (as Vernon Smith might say) to understand the ecology of the OTC derivatives markets before attempting to reshape them; to view them from a biological perspective, rather than engineering one.  To understand how this complex order has emerged, before attempting to engineer a new one.

I’m reading a book titled The New Institutional Economics: A Guidebook, by my friends Eric Brousseau and Jean-Michel Glachant.  One thing that comes clear in the book, and in reading the NIE literature generally, is that it is very hard to reform complex systems and institutions.  Embeddedness, interconnections, path dependence, beliefs, and informational demands, to name just a few, affect institutional performance, and are very difficult to understand, let alone take into account when making wholesale changes.  The potential for adverse unintended consequences is huge.  I think that if you are an NIE scholar, you are predisposed towards humility and skepticism about the potential for root-and-branch restructuring of complex economic and social systems.  Hopefully the FT article and the views it reports are harbingers of a growing humility about the advisability of a grandiose restructuring of the OTC markets.

I’m sure that kudzu sounded like a good idea to somebody at one time.  (H/T SW Mom.)  The idea of bringing in the cats, then dogs, and then elephants all sounded good to the apocryphal Indian villagers infested by mice.  The problem in each case was that “solutions” to one problem were based on reductionist analyses that focused on that problem in isolation, didn’t take into account the ecological complexities, and ended up creating worse problems than the one they were intended to fix.

We are on the verge of making that error in financial market regulation.  But only on the verge.  The FT article gives some hope that we aren’t about to bring in the elephants just yet.

I was talking to some folks at a research/policy institute at another university about regulation of carbon derivatives trading who are attempting to educate Congress (or, more precisely, Congressional staff) on the matter.  They told me that there was a widespread belief on Capitol Hill that customized, OTC derivatives offer little or no social benefit, and that as a result, their use should be highly restricted, if not eliminated altogether. The view is that these instruments create systemic risks, but confer no corresponding benefit that cannot be offered by exchange traded products.

I disagree, for reasons I set out in a Brookings paper released last fall.  But I don’t want to focus on the details of that argument here.  Instead, I just want to flash back to a historical example that demonstrates that limiting the contracting choices of commodity market participants can have extremely perverse effects, and can in fact create systemic risks.

The legislation that restructured the California electricity markets, AB1890, precluded the state’s major utilities from entering into long term contracts for power.  Instead, in order to ensure the “success” of the spot market for power, the utilities were required to buy electricity from generators through an exchange–the Power Exchange (“PX”).  The bill also capped the price that utilities could charge their customers for power.

This legislation created a huge short position for the utilities.  They were exposed to increases in prices on the PX, and could not pass on these costs to customers.  Most importantly, the bill prevented the utilities from managing their price risk by engaging in long term forward contracting.

We all know what happened.  Power prices spiked, and two utilities still subject to the constraints (SoCal Edison and PG&E) suffered huge losses.  PG&E went bankrupt.

The problem would likely have been less severe had the utilities been given the ability to hedge.  Indeed, the absence of forward contracts may have exacerbated the price spikes, because these contracts would have precommitted the generators to supply power, whereas they arguably had an incentive to restrict output on the PX when conditions became tight.

Moral of the story: limiting the ability of firms to manage risks can impose substantial dangers of financial distress on those companies.  Indeed, if they limitations are systemic (as they were in California), they create the risk of a systemic problem.

Now, the analogy should not be stretched too far.  In its infinite, tofu-fueled wisdom, California chose to favor one type of exchange trading (spot auctions on the PX) for different reasons than Congress in its infinite God-knows-what-fueled-wisdom is contemplating favoring exchange trading of carbon (and other) derivatives.  Moreover, the restrictions in California were particularly draconian, especially when combined with the retail price caps.

Nonetheless, the tale should be a cautionary one.  Firms use derivatives contracts to pass risks to others who bear them at a lower cost.  If you constrain their ability to do so, they will wear more risk than they would otherwise.  This raises the likelihood that they will suffer crippling financial losses.  The more draconian the restrictions, and the wider the scope of their application, the greater the likelihood, severity, and extent of these losses.

That is, by avoiding one risk, you create others.  Rational policy requires a prudent trade-off between these various risks.  But fixated as they are on the risk (largely chimerical, IMHO) of OTC markets, most policy makers in DC are blind to the risks they are effectively choosing.  Their ability to weigh these tradeoffs is, moreover, extremely limited due to a fundamental lack of information.  Carbon trading regulation in particular will have systemic effects: it will impact every producer and consumer of energy.  How could Congress possibly have the knowledge to evaluate the risks that they are forcing on such a vast and diverse group of companies when they restrict their ability to choose the instruments that they can use to manage that risk?  Short answer: they can’t.

I would hope that the California experience would at least make policy makers aware of the possibility that restrictions on the contracting choices available to market participants creates risks.  So far, however, the debate appears to have taken no recognition of this very real possibility.  Keeping their eyes fixed on the skies to reduce the risk of being hit by a falling object, they face the very real risk of stepping into an open manhole.