Streetwise Professor

May 6, 2010

Clearing and Capital Structure

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 8:26 pm

One of the arguments in favor of mandated clearing is that (a) CCPs require initial margin to collateralize trades, and (b) many OTC deals do not.  Requiring collateralization, the argument goes, reduces the default risk associated with derivatives.

Even assuming this argument is correct, it does not imply that clearing reduces the risk of failure of a financial firm, or the risk that its failure will have destabilizing spillover effects.  This is because the argument fails to address the equilibrium responses of affected firms.

In essence, collateralization reduces the credit/leverage in a derivatives transaction.  But if firms are forced to reduce leverage in one set of transactions, they can increase it in others.  Indeed, you’d expect this to happen.  If a firm has a given debt capacity, or a given target leverage, it will almost certainly respond to a mandated reduction of leverage in one set of transactions by using the debt capacity/target leverage freed up in this way by increasing leverage elsewhere.  For instance, it could borrow the initial margin amount.  (This is done, to some degree already for cleared transactions.)  A reasonable approximation of the first order net effect of mandated collateralization of some deals is that the firm’s leverage will not change much.  Yes, all else equal more collateral means less leverage, but all else is not equal.

Of course, the firm can’t be made better off by the imposition of a constraint.  Revealed preference implies that the firm is at most indifferent to forced changes to its capital structure, but likely prefers the freely chosen allocation of debt/credit capacity between derivatives transactions and other deals.  For instance, it may be cheaper to obtain credit/leverage through derivatives than through an on balance sheet loan.  (That’s the essence of my argument as to why end users may object to being forced to clear.)  But it is almost certain that firms subject to the clearing mandate will adjust their capital structures in ways that mitigate the impact of the mandate on their overall leverage and counterparty risk.  This is likely especially true for large financial firms that have many substitute funding sources.

Nor is it obvious that the form of the leverage will change all that much.  Even if you believe that the leverage implicit in derivatives trades, when combined with bankruptcy rules, encourages counterparties to run, it is likely that reducing that kind of leverage will encourage substitution into a form of debt that is similarly vulnerable to runs.  Runs are damaging to firms.  That’s why they can be a disciplining device.  By choosing its capital structure, a firm chooses a probability of a run.  This choice must be considered maximizing in some respect.  If you force a reduction of the use of one kind of credit that is vulnerable to runs, firms are likely to substitute towards another form that results in a probability of a run that is close to the original, maximizing choice.

This means that increasing derivatives collateralization will not substantially reduce the likelihood a firm will become bankrupt, or vulnerable to a destructive run.  Its main effect will be to redistribute the losses consequent to such a bankruptcy.  Derivatives counterparties may suffer smaller losses (due to multilateral netting and its effect on priority, and to lower leverage in derivatives deals due to greater collateral), but other counterparties will suffer commensurately greater losses.  As I’ve argued before, a priori one cannot conclude that this reallocation of default losses is more efficient than the one that results from the voluntary contracting decisions of the agents.  (Also note that the derivatives counterparties would often be the counterparties to the offsetting leverage increasing transactions.)

Put differently, the first order effect of clearing, whether through netting or increased collateralization is to change priority, not the amount  of leverage (and hence the risk of bankruptcy/default/run).  Its primary effect is redistributive.  It is not evident, moreover, that this effect is socially beneficial.  If there are externalities due to credit (arising from systemic risk, for instance), why should a credit exposure implicit in a derivatives transaction create a more harmful externality than a credit exposure inherent in some other transaction?

The amount of leverage, rather than the contractual means by which firms add leverage, is arguably the fundamental underlying concern.  Attempting to control leverage at the capillaries by regulating some transactions is pointless: leverage needs to be regulated at the heart.

This means that the most important steps should be to eliminate subsidies to leverage, whether through the tax code or subsidies to debt implicit in TBTF/bailouts.  The next most important measure is capital requirements and liquidity requirements, although I am much more dubious of their efficacy as they are, in essence, price controls set by (relatively) ignorant third parties which can be gamed by the much more knowledgeable parties that are supposed to be constrained by them.  Set the prices wrong and the cure can be worse than the disease; given the information imbalances, the prices are almost certainly wrong.  (The financial crisis, and the contribution of the Basel rules to it, provide a cautionary tale.)

This is another example, as if another was needed, as to how superficial analyses of the effects of clearing mandates create a false sense of security, and thereby encourage complacency.  They don’t fix a problem: they just move it around.  The cat won’t sit on a hot stove again, but in its obsession to avoid the stove it risks stepping in the rat trap.

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