What Risk Professionals Want

As memories of the 2007-09 financial crisis fade, we worry that complacency is setting in. Recent news is not good. In the name of reducing the regulatory burden on small and some medium-sized firms, the Congress and the President enacted legislation that eased the requirements on some of the largest firms. Under the current Administration, several Treasury reports travel the same road, proposing ways to ease regulatory scrutiny of large entities without changing the law (see here, here and here). And, recently, the Federal Reserve Board altered its stress test in ways that make it more likely that poorly managed firms will pass. It also voted not to raise capital requirements on systemically risky banks over the next 12 months.

A few weeks ago, one of us (Steve) had the privilege to speak at the 20th Risk Convention of the Global Association of Risk Professionals (GARP). Founded in 1996, GARP engages in the education and certification of risk professionals and has several hundred thousand members worldwide. (Disclosure: Brandeis International Business School and NYU Stern are GARP Academic Partners.) The organizers allowed us to solicit the views of the 100-plus attendees on two issues that are central to financial resilience: Are bank capital requirements high enough? And, do central counterparties (CCPs) have sufficient loss-absorbing buffers? They answered both questions with a resounding “NO” ….

Resolution Regimes for Central Clearing Parties

Clean water and electric power are essential for modern life. In the same way, the financial infrastructure is the foundation for our economic system. Most of us take all three of these, water, electricity and finance, for granted, assuming they will operate through thick and thin.

As engineers know well, a system’s resilience depends critically on the design of its infrastructure. Recently, we discussed the chaos created by the October 1987 stock market crash, noting the problems associated with the mechanisms for trading and clearing of derivatives. Here, we take off where that discussion left off and elaborate on the challenge of designing a safe derivatives trading system―safe, that is, in the sense that it does not contribute to systemic risk.

Today’s infrastructure is significantly different from that of 1987. In the aftermath of the 2007-09 financial crisis, authorities in the advanced economies committed to overhaul over-the-counter (OTC) derivatives markets. The goal is to replace bilateral OTC trading with a central clearing party (CCP) that is the buyer to every seller and the seller to every buyer....

Making Markets Safe: The Role of Central Clearing

The financial crisis of 2007-09 prompted two distinct types of regulatory reforms. The first uses capital and liquidity requirements to make financial institutions resilient in the face of severe macroeconomic events. The second concerns market infrastructure and the ability to trade securities and derivatives or to use them as collateral. Here, the emphasis is on both information collection through trade reporting—who is buying or selling what to whom--and on shifting transactions from over-the-counter (OTC) markets to central clearing.

This post examines central clearing of OTC derivatives and highlights its importance for financial stability...

The Scandal is What's Legal

If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]

But we're not film critics, The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....

Can Margin Requirements Improve Financial Resilience?

Eight years after the financial crisis began, the regulatory reforms it spawned continue apace. Over the past year, regulators introduced total loss absorbing capacity (TLAC) and the liquidity coverage ratio (LCR) to make banks more resilient. And, with an eye toward strengthening market function, authorities continue to push for central clearing of derivatives (CCPs).

Overlapping with these goals—and extending to nonbanks—is the recent move to establish standards for margin requirements in securities transactions: that is, the maximum amount that someone can borrow when using a given security as collateral...

Commentary

Money, Banking, and Financial Markets