Streetwise Professor

December 1, 2015

The Red Queen’s Race: Financial Regulation Edition

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — The Professor @ 8:44 pm

Well over four years ago, I raised concerns about clearing mandates leading to the rise of “collateral transformation” whereby those needing high-quality assets to pledge as collateral against derivatives trades would obtain them via repos collateralized by low-quality assets. I argued that these transactions were inherently fragile, and could go pear shaped during period of market stress.

If this were the only problem that post-crisis regulations created, how lucky we would be! Yesterday, the FT ran a nice (meaning scary) piece about other regulation-related driven spurts in securities lending that are collateral transformation on steroids.

One big driver is the Liquidity Coverage Ratio, which requires banks to hold one month’s stress period liquidity needs in liquid assets like government bonds. Rather than sell other less liquid assets to raise the cash to buy Treasuries, Gilts, Bunds, etc., banks are posting their less liquid assets (including equities) as collateral against borrowing of government securities.

Think of how this could work in a crisis. Yes, a bank can sell the borrowed guvvies to raise cash to meet deposit outflows or other cash needs in a crisis. But it borrowed these securities, so it has to buy them back, eventually. Perhaps its liquidity crisis will have passed before the loan matures, but perhaps not. What then, genius? Liquidity crisis deferred, not necessarily prevented.

There are other concerns. The lender of the government bond is likely to haircut the collateral more steeply during crisis periods, meaning that the stressed bank is going to have to come up with more collateral to support its loan precisely when it can least afford to do so. The cyclicality of the collateral mechanism is a concern, and it can create all sorts of vicious cycles that have spillovers throughout the financial system.

Furthermore, the article notes that asset managers like BlackRock are the major securities lenders. They lend out bonds purchased to back government bond ETFs, and take other securities as collateral. That is, the asset manager is engaged in a financial transformation in which there can be a mismatch between the assets underlying the ETF and its liabilities: swapping government bonds for equity (or other assets) creates such a mismatch. What happens if the ETF sponsor is it by a wave of redemptions–especially if the redemptions occur because investors become concerned because the value of the collateral the sponsor has collected has fallen, and may be substantially below the value of the assets lent out (which is what the fund is intended to track)? One possibility is fire sales of the collateral and “fire purchases” of the assets the fund has lent out. A more likely outcome is that this is the kind of event which will cause the fund to demand significantly more collateral from the security borrower, setting off the vicious cycles described above.

Oh joy.

The article states that another reason for the rise in securities lending is that banks get better capital treatment on the borrowed securities than the securities posted as collateral. If this is true, it is totally nuts. The borrowed security is not an asset to the bank: the assets posted as collateral for the loan are. The borrower has the asset in his hot little hands, but has an obligation to give it back: these things offset. At the end of the day, the bank still has the other assets posted as collateral. If capital regs treat the borrowed bond as an asset, and don’t treat the securities posted as collateral as an asset, and reduce risk weighted assets (and hence capital requirements) as a result, the regulations are even dumber than I had thought possible.

That is really saying something.

The third reason for the rise in securities lending is my old favorite, collateral transformation to obtain CCP-eligible collateral. This part of the article made me laugh:

There is a third plus, too, as another facet of post-crisis regulation gains momentum. With so much derivatives trading moving to central counterparty clearing, there is increasing demand for high quality assets to be used as collateral. And for that, government bonds — even borrowed ones — avoid punitive haircuts imposed on some equities.

I laugh because in a collateral transformation trade, there is a potentially punitive haircut on the equities (or whatever) posted in the collateral transformation trade.

Whenever I see things like this I keep coming back to the story about the Indian village that was infested by mice, so it brought in cats which then multiplied and became such pests that they brought in dogs to run off the cats, but then the dogs became such a problem that they brought in elephants to scare away the dogs, and when the elephants started wrecking the place they reintroduced the mice to scare away the elephants.

Things like the LCR and clearing mandates were introduced to solve one set of problems (or perceived problems) inherent in the financial transformations that banks provide. But these regulations have led to the proliferation of other kinds of transformations that are problematic in their own ways. These new transformations create new, potentially fragile, interconnections. They create new counterparty and liquidity risks even as they mitigate some old ones.

Or to invoke another metaphor, this is like the Red Queen, running at breakneck speed to stay in the same place:

“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else—if you run very fast for a long time, as we’ve been doing.”

“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

Yes. Very much like that indeed. Perhaps we haven’t quite stayed in one place, but the running over the past 5 plus years has not moved us nearly as far as the Frankendodd and EMIR and MiFID II pom-pom squad claim.  Risks have been shifted and transformed, rather than eliminated. In the attempt to banish the devil we knew, we’ve teamed up with some lesser-known demons. Sadly, we are likely to become much better acquainted, sooner or later.

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1 Comment »

  1. The FT article is complete nonsense and confusing:
    Shares you recieve/give as collateral do not enter your balance sheet (the are usually specified in the footnotes), since the economic loss potential stays where it is. all you get is an entry Repo recievable/repo payable…This cannot lower your capital ratio.
    Further you can only meet your LCR with UNENCUMBERED govvies. If you had to borrow money to bring them on, they would obviously be encumbered already.
    Here is what could be the case:
    Banks buy government bonds, as these can be used to meet LCR requirements.
    the funding for said purchases they apparently get by posting illiquid collateral (with haircuts) for, say, 6 months.
    The 6 month outflow from the funding doesn’t affect my LCR, as it focuses on the 1 month redemptions. the government bond has to be unencumbered to be counted against those.
    There is no capital advantage from this whatsoever.
    No question, there are odd things going on, unfortunately this article obscures more than it clarifies…

    Comment by Viennacapitalist — December 2, 2015 @ 8:04 am

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