In 2010, then-Federal Reserve Chair Ben Bernanke said a financial firm was “too big to fail” when its “size, complexity, interconnectedness and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.” When a firm is “too big to fail,” the government must step in to rescue it for the greater good – or so says the conventional wisdom.
Dr. Craig Lewis is Madison S. Wigginton Professor of Finance at Vanderbilt University’s Owen Graduate School of Management and former Chief Economist and Director of the Division of Economic and Risk Analysis at the U.S. Securities and Exchange Commission.
Christopher Culp is a Senior Affiliate with Compass Lexecon and a Research Fellow at the Johns Hopkins Institute for Applied Economics.
Patrick Parkinson is a Managing Director of Promontory Financial Group and a former director of the Division of Banking Supervision and Regulation for the Federal Reserve Board. He also served as principal staff advisor to Federal Reserve Chairmen Alan Greenspan and Ben Bernanke.
Peter Wallison is the Arthur F. Burns Fellow for Financial Policy Studies at the American Enterprise Institute. He previously served as General Counsel for the U.S. Treasury Department, as White House Counsel to President Ronald Reagan and as Counsel to Vice-President Nelson Rockefeller.
The concept of “too big to fail” gained broad popular traction after the government allowed Lehman Brothers to fail and every bank in the world suddenly seemed to be tottering. Lehman’s failure is widely perceived to have added greatly to the severity of the 2007-2009 global financial crisis. But once President Bush signed the Troubled Asset Relief Program (TARP) into law in late 2008, and the Supervisory Capital Assistance Program of 2009 began examining the capital buffers of the United States’ largest financial institutions, the world’s financial system slowly began to right itself. Subsequently, in 2010 the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), promulgating sweeping government oversight and regulations intended to reduce the risk of a similar crisis ever again occurring. The question now is, are we safer today with Dodd-Frank than we were before, without it?
One key element of Dodd-Frank was Title VII, which mandated the clearing of certain derivatives contracts through central counterparties (CCPs), ostensibly to reduce counterparty risk in the derivatives market specifically and systemic risk more generally. But are those mandated CCPs themselves too big and too interconnected to fail? Have they reduced or increased systemic risk?
At the latest FTI Consulting/Compass Lexecon Experts Forum, held in cooperation with the U.S. Securities and Exchange Commission (SEC) Historical Society, we assembled four market specialists to dive deep on that very question.
Dr. Craig Lewis: Before we begin, I want to revisit the over-the-counter [OTC] derivatives market as it existed at the time of the 2007-09 financial crisis.
At that time, OTC derivatives were traded in a market in which participants interacted directly with one another. Counterparties set contractual terms and confirmed that contracts were legal. Counterparties had to manage both the economic risk associated with the position and each other’s credit risk.
This bilateral trading was opaque to both market participants and financial regulators. Therefore, it was impossible to monitor the buildup of aggregate counterparty credit risk.
One of the primary regulatory concerns was that the failure of a large swap dealer or swap market participant could result in sequential counterparty defaults that would have a systemic impact.
Title VII of Dodd-Frank mandates the central clearing of certain contracts that in the aggregate are deemed to have the potential to create system risk. Its function is to transfer counterparty risk previously born by each party to the central party clearing houses, CCPs. CCPs are designed to reduce the likelihood that the default of a large swap market participant will result in sequential counterparty defaults.
Chris, could you give us a brief overview of how a CCP functions?
How CCPs Work
Christopher Culp: Thanks for setting the stage. The CCP interposes itself between two counterparties exposed to each other. If you’re going to have a central counterparty that’s doing that for a big number of transactions, it must be trustworthy and creditworthy.
How do CCPs maintain their financial integrity, the trust of the market? First, the CCP makes sure it only has direct relationships and exposures to clearing members. If you execute an over-the-counter transaction that’s cleared, anything that goes into the clearinghouse must be guaranteed by a clearing member. If a firm is not a clearing member, it must establish a relationship with a firm that is a clearing member. If the non-clearing member fails to perform on a trade, or fails to make a required payment, the clearing member is on the hook. Of course, there are all sorts of requirements to be a clearing member: capital levels, compliance with operational standards, risk management requirements and protocols. It’s a way of saying, we’re not going to have a relationship with you unless we know that you know what you’re doing and you have a lot of money.
In addition, one of the most important aspects of central counterparties is the margining process. In the early days of the swap market, the use of a margin was a lot less common.
So, what is the margining system? First, it’s an initial requirement, a performance bond that says you, as a clearing member, must post a bond with the CCP that covers, say, 99.9% of the potential simulated estimated price movements in the underlying product that you’re clearing.
In addition to that, we have what’s called variation margin, sometimes called pay/collect, and that means that at least once a day (and usually twice) all current positions in the clearinghouse are marked to their current market price. If you’ve lost money, then you must pay up immediately, thereby limiting credit exposure. Basically, the CCP is only exposed to the risk that any given clearing member can’t perform on its next variation margin payment.
What happens if they can’t pay up?
Default management may include identifying clearing member firms that are willing to accept the positions of customers of a failing or defaulting clearing member. If you’ve got a process in place in advance, you don’t have to wander around and ask the day after a huge financial firm has failed, “Does anybody want to take these customers?” That would be bad.
Then there’s the question of cost and financial resources. Let’s assume that you have a failure of a large bank clearing member of a CCP, and the money that they owe at the time of their failure exceeds the amount of initial margin. They get a variation margin call, and they can’t pay that. (Let’s assume it’s not a customer problem, and the losses are on the firm’s proprietary accounts.) In that case, the CCP takes all the other assets of the clearing member, liquidates those and applies that to cover the remaining hole. If the clearing member still owes money, then the CCP looks to other resources.
Now, what happens if the clearing member owes money and can’t pay it, and the CCP’s own resources have been exhausted? (By the way, the reason it’s important that the CCP collects this money is because whatever the clearing member owed to the CCP, the CCP owes to other clearing members, and there are other clearing members waiting for this money, and that’s the interconnectedness problem.) The last line of defense is the clearing default guarantee fund, essentially a mutualized insurance fund that clearing members are required to pre-pay that is available on a mutualized basis to cover remaining losses.
Finally, some CCPs can go back to their clearing members and say, believe it or not, after all the margin, and after our resources that we’re required to commit, and after the whole guarantee fund has been spent, we still have unpaid bills to other clearing members. So, everybody must step up and pay some more.
More Risk or Less?
Dr. Craig Lewis: Pat, could you tell us a little bit about how central clearing is designed to mitigate system risk?
Patrick Parkinson: I think the real question is, mitigates relative to what? If you’re asking are we safer than we were in 2008, I’d say yes. But whether we’re better off in a world where there are requirements that all bilateral relationships be so brutally managed, that’s a tougher issue.
The CCPs have add-ons to those general margins, and that’s not very transparent. They are transparent to the regulators, I assume, but they may or may not be transparent to the clearing members of the CCP. But if the CCPs structure those margin methodologies to discourage and prevent the buildup of large aggregate positions, I think that’s the best argument for why they reduce systemic risk.
However, suppose they fail to do that; suppose they allow a large position to build up. Now Chris described what happens when the margin is inadequate. The CCP is going to have to cover those losses. That means the CCP has a thin layer of skin in the game. But beyond that, it looks to its clearing members either to tap the prepaid resources in the clearing fund or even ask for more. What’s the problem with that? Well, who are those clearing members? Those clearing members, and the CCPs, are the exact same small group of major global banks, all of whom are systemically important.
I think that’s what worries people. I think a lot more work needs to be done on what are the actual effects of CCP clearing as opposed to the hypothetical facts. There are studies suggesting there’s a potentially serious fly in the ointment here.
Peter Wallison: I might as well jump in to note that I am very skeptical about the mandatory clearing requirement. I believe it increases the possibility of systemic risk.
Chris said that before the financial crisis, before mandatory clearing, clearinghouses had to be strong financially to attract people to clear transactions. But when Congress authorized the Financial Stability Oversight Council to give these CCPs access to the Fed’s discount window, it gave clearing parties a sense that they are safer in a CCP, protected by the government. Now, because the individual clearing parties no longer need to worry about the financial condition of the CCP, the CCP might decline to take as much initial margin as Chris was talking about, and it might not ask for the updating of margin requirements. Why would it reduce these safeguards? Because the CCPs are competitive, and one of the ways to attract more business is to reduce the costs of the members and clearing parties. Although clearing swaps has become mandatory, the choice of the CCP is still with the clearing parties.
In other words, we could find ourselves in a position down the road where many of the safeguards in CCPs today are, for many reasons, relaxed. This could occur because of incompetent regulators, Congressional pressure for clearing riskier swaps or the CCPs themselves trying to become more profitable.
So, say there’s a lot of risk in a CCP, and it suffers a loss so large that it is unable to meet its obligations. When the payments from the CCP don’t arrive, the institutions that were expecting payments cannot pay what they owe to others. If the failure is large enough that many payees are affected and can’t make their own payments to counterparties, that is the very definition of systemic risk.
I’m afraid we are putting ourselves in a position where, sometime in the future, we are going to face the possibility of systemic risk because we set up these mandatory central clearing parties.
The Problem with CCPs
Christopher Culp: I agree with a lot of what you said, Peter.
The fact that there’s a mandate doesn’t mean there’s a mandate to go to one CCP or another, and there’s a huge amount of competition. But I think that’s a very important disciplining mechanism.
The business of the CCP is to set margin low enough that it doesn’t drive business to a competing entity, but high enough that it doesn’t create a loss of confidence among market participants. I believe this is one of the main arguments against having a super CCP. The Bank for International Settlements did a report that warned that, although there are lots of benefits of central clearing, there’s all sorts of risks for clearing members, so let’s make sure we don’t have just one of them.
Patrick Parkinson: A couple of points, one factual. There is one instance in which regulation has mandated a monopoly clearing house: the Options Clearing Corporation clears for all U.S. options markets.
The second thing, I think the regulators’ answer to a potential race to the bottom in the margin process is that CCPs are subject to uniform comprehensive regulation and to a body that I worked with for many years, the Committee on Payments and Market Infrastructure (CPMI). It sets international standards for CCPs. Market participants have extensive guidance on how CCPs should diminish their risk, but the Committee has a lot of work yet to do on recovery and resolution.
Last, to say something about the Fed’s authority under Dodd-Frank to provide marginal liquidity assistance to a CCP, I think the key thing is that should be just liquidity assistance. A member of a CCP shouldn’t be counting on the Fed to absorb losses. Basically, the Fed only lends against liquid collateral provided by the CCP and, if [the CCP doesn’t] repay it, they’ll seize the collateral. For example, if you have Treasury securities, and it takes you a couple of days to turn those into cash, the Fed would give you a bridge loan until you can sell them and then repay them.
And you can’t rule out the risk that CCPs may think the government is going to give them more protection than they’re authorized to do. Then you’re relying solely on regulation to make sure that CCPs are managed prudently, and I think we’re always better off not trusting either regulation or market discipline. After all, both failed in the financial crisis. The key is to try to get both working in the same direction to help address concerns about systemic risk.
The Chances for Change
Peter Wallison: Chris mentioned that we have mandatory clearing, but we are at the beginning of a new Republican administration, and there are a lot of people in the Republican party who don’t believe in and did not vote for mandatory clearing when it came through Congress.
Christopher Culp: Good point.
Patrick Parkinson: I think a very unfortunate thing about Dodd-Frank is that we’re stuck between one group in Congress that says repeal it, while the other says it’s perfect, and the truth, obviously, lies somewhere in between. Even if I would agree that we’re better off with Dodd-Frank than we were in the wild west of 2008; that doesn’t mean that various, important modifications to Dodd-Frank might put us in better, safer positions. I could be accused of being wildly optimistic if I said that there was a hope that that kind of debate might occur in the next Congress, but we’ll see.
Christopher Culp: There is one other thing about this that’s also worth keeping in mind. Lehman was a success story in terms of its own relationship with central counterparties. It had a lot of voluntarily cleared swaps through the London Clearing House [LCH] that were resolved in a very orderly manner without any loss.
Patrick Parkinson: Margin more than covered it.
Christopher Culp: This was before the mandate; they were voluntarily submitting swaps for clearing. Now take the contrast to AIG. Those were not just credit default swaps; they were credit default swaps on asset-backed credit default securities, or ABCDS. But Congress chose to focus just on credit default swaps.
We just did this literature survey on the credit default swap market. There’s hundreds of articles that have been written studying it, and virtually none of them argue that credit default swaps are an inherent source of instability or risk. Nevertheless, the products that are right now subject to the clearing mandate are primarily swaps and similar products.
The stuff that didn’t get us in trouble is what’s been forced into the clearing houses. Why aren’t ABCDS being cleared? Nobody much does them anymore, and I can’t imagine a CCP that would be comfortable assuming the risk. That’s a further perversity of this whole thing: it’s the stuff that didn’t really get us into trouble that’s subject to the clearing mandate.
The Persistent Problem of Interconnectedness
Peter Wallison: Regulators, frequently under political pressures, could require things to be cleared through the CCPs that the CCPs would not take on themselves. That’s a real danger because if we were in a completely voluntary system, the CCPs wouldn’t do it. But we’re now in a system controlled by the government.
Christopher Culp: I agree, there’s a lot of grey area, stuff we haven’t dealt with yet in Dodd-Frank. One of them is a provision that says regulators can dictate what must be cleared and what’s traded, too. Technically, CCPs have the right to say something’s too risky. But would they? What worries me a little bit more is there’s not a lot of definition about how the CCPs can argue that they shouldn’t clear something when it’s perceived as too risky.
Peter Wallison: The sponsors of Dodd-Frank focused a lot on the danger of interconnections, but by definition CCPs are the source of massive interconnections. If a major bank (I’m talking here about an insured deposit-taking institution, not a bank holding company) fails, we’re in big trouble; interconnected CCPs may be facing failures by a whole lot of financial institutions. That is the way systemic risk is propagated, and we have put ourselves in a position where we require these interconnections legally.
Patrick Parkinson: The presumption is that the CCPs are like islands, and they should be able to survive the collapse of the entire global banking system. I just don’t think that’s feasible.
Is Dodd-Frank a Source of Moral Hazard?
Peter Wallison: My question, unfortunately, goes back to what I said at the beginning: We may have created a worse problem than we had before. We know how the market functioned before Dodd-Frank: pretty well. Counterparties didn’t go to CCPs unless they were very confident in the financial stability of the CCPs. Many – if not most – swaps were cleared through banks. And when this bilateral clearing system had its biggest test – the failure of Lehman Brothers – it worked as expected.
Christopher Culp: I very much agree that there’s a risk that some of these mandated clearing regulations could move us the wrong way, especially if they create these “too big to fail” perceptions that translate into muted risk management incentives. That’s the essential moral hazard argument against “too big to fail” in the first place. Too many people are going to say, “You know what? I’m not going to worry about it because Uncle Sam will come to the rescue.” That was the Fannie and Freddie issue. We know we can induce historically bad risk management behavior with moral hazard arising from a government guarantee.
Peter Wallison: Exactly. Fannie and Freddie is the poster child for exactly what happens in those situations.
Christopher Culp: And the Savings & Loan crisis – I mean, it’s not like we don’t know that these moral hazard issues are real.
Patrick Parkinson: If we are going to go back and look at Title VII, I find it much easier to support the provisions relating to bilateral risk management in terms of capital margin requirements. I think it would be a mistake to just repeal Title VII, but I think a critical reexamination of its individual provisions is entirely appropriate.
Christopher Culp: I think that unless you’re deliberately trying to force everything into a CCP, the current non-cleared margin requirements are crazy high. The law isn’t the problem; it’s the implementation.
Patrick Parkinson: The concentration of clearing is a problem. The clearing membership is a relatively small number of banks. Some of the things that have been done on the regulation side, particularly the so-called supplemental leverage ratio, are causing some banks to think about whether they want to be in the clearing business, which could make it that much more concentrated and make the original problem worse.
Dr. Craig Lewis: Gentlemen, thank you so much for the very insightful discussion. On behalf of the SEC Historical Society, I’d like to thank FTI Consulting and Compass Lexecon for their generous sponsorship of The Experts Forum series.