Streetwise Professor

September 8, 2010

The Collateral Security Blanket

Filed under: Clearing,Commodities,Derivatives,Economics,Financial crisis,Politics — The Professor @ 8:35 pm

The FT ran a rather bizarre editorial on end user exemptions from clearing mandates.  As seems to be the wont of clearing advocates of late, it is strident, but hardly persuasive.

Here’s the core of the argument:

But the fact that reform might impose higher costs on non-financials is precisely the reason for sticking to it. Costly margin requirements indicate that the derivatives companies purchase not only insure them against adverse market movements but can require them to make substantial payments should market conditions move against them. If OTC derivatives are cheaper than taking out insurance, this suggests that the systemic risks of the OTC market and the banks that dominate it are being borne by taxpayers. Ending this subsidy would force corporations to bear the fair economic cost of their actions.

This is apparently the S&M theory of public policy: unless a policy inflicts pain, it is ineffective.  The more costly a policy is, the better it must be!

Here’s my most charitable characterization of the argument:  Due to Too Big to Fail, banks subsidize their customers.  In particular, they subsidize them by taking on default risk and not charging for it.  Therefore, it is necessary to impose costs on these customers in the form of collateral requirements in order to eliminate the subsidy.

Here is one testable implication of this theory: in the absence of TBTF subsidies, all deals will be fully collateralized.

This implication is refuted by experience.  For instance, prior to the formation of the Chicago Board of Trade Clearing Corporation (under government pressure), margining was discretionary.  Exchange rules permitted parties to demand margin: it did not require it.  Routinely brokerages extended credit to their customers and to other brokerages that they traded, and did not require the posting of initial margins, and only required posting of variation margins when a pre-established  credit limit was breached.  These brokers were not the beneficiaries of any TBTF subsidy.  So, credit exposure via incomplete collateralization existed even in the absence of a TBTF subsidy.

Moreover, this theory doesn’t explain why the credit terms extended by OTC dealers vary by customer and deal.  Such variation in credit terms means that dealers are evaluating credit and charging for it based on the nature of the customer and the trade.  Of course, it is possible that these terms are too generous overall (due to TBTF) but the behavior of dealers belies the simplistic story that the FT spins, to the effect that dealers don’t care about credit risk in doing derivatives deals, and hence it is necessary to deny them the discretion to choose their own credit terms.

Furthermore, the FT editorial, like much of the pro-clearing discussion, implicitly assumes that everything else will remain the same after the imposition of a clearing mandate; collateralization will reduce counterparty risk in derivatives trades, and other credit risks will remain unchanged, so overall banks will face fewer default risks.  This is certainly incorrect, and market participants will respond to a mandate by taking actions that undo much of its effect.

For instance, the mandate that all deals be collateralized effectively tells dealers: Thou shall not extend credit through derivatives transactions.  But there are multiple ways that dealers can extend their customers credit.  In particular, if precluded from extending unsecured credit through a derivatives trade, they can substitute other forms of unsecured credit for that they would have offered their customers via derivatives.  Now, revealed preference implies that this is not the preferred arrangement, as otherwise end users and dealers would have chosen it in the first place.  But the use of other forms of credit to finance, effectively, margin/collateral will almost certainly be a second best response to the mandate.  Thus, collateral requirements will do far less to reduce the amount of credit and leverage in the system than their advocates believe.

Moreover, and perhaps more importantly, if TBTF subsidies are the Original Sin, merely foreclosing one way to exploit these subsidies will have little effect on the riskiness of banks.  So if dealers are foreclosed from exploiting TBTF subsidies in their derivatives business, they have every incentive to find other ways to do so.  And they are sure to be creative.

That is, TBTF subsidies are like water.  They will find some outlet.  Dam up one outlet, and the water will find its level through some other channel.  So maybe OTC derivatives won’t be the source of the next crisis (just as they weren’t the source of the last crisis), but if TBTF continues to exist, risk taking will be continued to be subsidized, some excessive risks will be undertaken somewhere, and inevitably, this will cause problems down the road.

But whatever the next crisis, we may be able take comfort that derivatives will not have caused it.  Very cold comfort.

There will be other unintended consequences.  Even though dealers and other intermediaries are likely to try to design financing methods and provide services that reduce the operational and financial burden of end user collateral requirements, again by revealed preference, these alternatives are more burdensome to end users than the incumbent system.  As a result, some end users will decide not to hedge; others will hedge less.  Others will adopt different capital structures that are less efficient.  As a result, more end users will suffer financial distress, and others will incur costs in the form of less efficient investment policies, etc.  These are real costs.  And they can result in defaults–just not on derivatives trades.  Are we really better off when a firm that eschews hedging because of the higher burden inherent in collateralization defaults on its debt to a bank when the risk it would have hedged comes to pass?

If TBTF is the real problem, it is counterproductive to try to address it through micromanaging the ways that financial institutions  attempt to exploit the TBTF subsidy.  Deal with the real problem–the subsidy–rather than attempt to anticipate and foreclose every possible way that clever bankers can attempt to milk this subsidy.  Deal with TBTF upstream, not downstream.

Like a child’s security blanket, clearing and collateral mandates give some a sense of warmth and security.  And a false sense of security, as it turns out, because they do not eliminate or even reduce substantially the true source of danger in financial markets.

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