Short-sighted regulators may create more risk than they prevent

Regulators’ fragmented approach to mitigating risk since the banking crisis can prevent them from seeing the adverse consequences a new rule may have on the financial system as a whole.

This regulatory myopia may explain the Financial Stability Board’s recommendation that central counterparties (CCPs) — the intermediaries between buyers and sellers in derivatives trading — expand their liquidity agreements with financial institutions, most of them banks.

{mosads}The problem is that larger commitments to CCPs may strain the ability of banks to service other parts of the market (e.g., make markets and lend) and perform other functions during a widespread disruption. 

The recommendation, made in July to G-20 leaders, highlights the strategic role regulators assigned to CCPs following the crisis. The role of the clearinghouses is to reduce risk by guaranteeing both sides of a transaction against losses arising from a default. They settle about 75 percent of all swaps, compared with 15 percent before 2007. 

By requiring buyers and sellers to use CCPs, regulators intended to create a buffer to minimize the risk that a default might trigger a domino-like reaction among financial institutions. But as the role of CCPs grew, so did the concern that the clearinghouses themselves had become so indispensable that the collapse of one could also endanger the system.

Although the FSB’s recommendation attempts to reduce that risk, it does not consider all the liquidity demand banks are required to meet. For example, banks are themselves the primary members of CCPs. Each member must help shoulder the losses of others by contributing to clearing house default funds.

The liquidity agreements that the FSB wants to expand are separate contracts for banks to supply additional liquidity in a timely manner if CCPs face significant shortages. But in a crisis, banks must also provide liquidity to the rest of the financial system.

For instance, some CCP customers, such as pension funds, borrow from banks to raise collateral, or “margin,” collected by the CCPs to reduce exposure to market turmoil.

The liquidity provided by banks is a key factor in determining the default risks of a CCP customer. A recent Milken Institute white paper argues that even with the higher capital and liquidity requirements imposed by Dodd-Frank, these competing obligations may place too much pressure on banks at the worst time. CCPs losses often occur during — and can be induced by — widespread illiquidity. 

The FSB’s apparent failure to consider the full range of banks’ obligations points to a shortcoming in the current regulatory framework. Macroprudential policy aims to mitigate risk across the entire financial system.

Most of the macroprudential assessments for CCPs are, in effect, microprudential tools that regulators apply to a single segment of the financial ecosystem. We need a broader evaluation of how a regulation designed for one part of the system affects the rest.

The FSB is right that CCPs need greater resilience, but before accepting the board’s recommendation, G-20 regulators should look carefully at the big picture. Pressured to act quickly to shore up the CCPs’ ability to withstand a shock, the FSB made a politically expedient yet risky decision. 

Addressing the legacy of our partial, rather than systemic, post-crisis approach to regulation is especially critical now. The Department of the Treasury is examining the expanded role of CCPs and the complex interdependencies that link them to other financial institutions.

In the short-term, the Treasury’s report, expected as early as this month, should provide clarity on CCPs liquidity needs. The more important, longer-term lesson policymakers should learn from the analysis is that effective financial regulation requires a broad, comprehensive view of markets and institutions.

Without it, the goal of making financial institutions safer and stronger, and the economy more resilient, will remain elusive.

Elham Saeidinezhad, Ph.D., is a research economist in international finance and macroeconomics at the Milken Institute in Santa Monica, Calif. The Milken Institute is a think tank that publishes research applies market-based principles and financial innovations to social issues in the U.S. and internationally.