PrefBlog

The Bank of Canada has released the Bank of Canada Review – Spring 2012 with articles:

• On the Adjustment of the Global Economy
• On the Adjustment of the Global Economy
• Understanding Systemic Risk in the Banking Sector: A MacroFinancial Risk Assessment Framework
• Conference Summary: New Developments in Payments and Settlement

They have also released the June 2012 Financial System Review with articles:

• The Resolution of Systemically Important Financial Institutions
• Reducing Systemic Risk: Canada’s New Central Counterparty for the Fixed-Income Market
• An Improved Framework for Assessing the Risks Arising from Elevated Household Debt

The article by Pothik Chatterjee, Lana Embree and Peter Youngman on central clearing chants the familiar slogan:

The introduction of an appropriately risk-controlled CCP for the fixed-income market improves this market’s resilience by mitigating counterparty credit risk, thus reducing the potential for disruptions to be transmitted through the financial system.

… but does admit …

Given the centrality of the underlying market, the Bank considers that CDCS could pose systemic risk if appropriate risk controls are not in place (i.e., it is systemically important).

It has long been a puzzle to me just exactly why all these art-school dweebs who control politics and regulation are in favour of a system subject to single-point failure as opposed to a network. Can networks freeze? Sure:

During the financial crisis, the Canadian fixed-income repo market, like those in other countries, experienced periods of illiquidity as a result of lenders of cash taking measures to reduce their credit exposures to borrowers. When many lenders undertook these measures simultaneously, the amount of financing available was abruptly reduced, creating severe funding pressures in the repo market.

I always thought that reducing exposure to dubious credits was what bankers are paid to do, but I’m just old fashioned that way. I agree that sometimes this can go too far and lead to an unjustified and harmful credit lock-up, but this does not prove that single-point systems are better; if for no other reason than that is the point at which the central bank is supposed to step in and provide liquidity at above market rates – an alternative which is not discussed.

The authors also point out:

The decrease in repo activity was relatively more pronounced in Canada than in other jurisdictions, since repo business accounted for a greater share of the balance sheets of domestic banks than it did for their global competitors.

Sadly, they do not provide a business purpose for this statistic, nor do they discuss the regulatory implications of this preference.

However, they do disclose that a major source of the industry’s enthusiasm for such a move is regulatory arbitrage via elimination of the gross position:

To minimize the potential contraction of the repo market resulting from balance-sheet pressures during future stressful periods, members of the Investment Industry Association of Canada (the industry) sought ways to increase netting efficiencies in order to offset repo and reverse repo transactions on the asset and liability sides of the balance sheet.[footnote] The industry concluded that an appropriately designed CCP would allow them to reduce their balance-sheet exposures to the repo business by netting offsetting positions without changing their underlying repo activity. Using a CCP would therefore create a more resilient and efficient balance sheet that could absorb financial shocks with greater ease.

[Footnote] Without a CCP, if a bank transacts in both a repo and a reverse repo for the same security and term, but with different counterparties, both a liability and an asset are created on the bank’s balance sheet. If both trades are novated by a CCP, however, the bank would have offsetting trades with the same counterparty, allowing the counterparties to net the trades and not create separate assets and liabilities on their balance sheets.

Sure – just like netting out all deposits and loans would help shrink the balance sheet, too.

Credit risk is addressed as follows:

As depicted in Figure 3, in the event that CDCC faced a credit loss in closing out a member’s positions, the defaulter’s variation and initial margin and clearingfund contributions would be used first to absorb these losses. If this were insufficient, CDCC would use its capital to absorb the next $5 million of losses. If these funds were still not enough, residual losses would be borne by the surviving members’ contributions to the clearing fund. Members would be obliged to make an
additional “top-up” contribution to the clearing fund of up to 100 per cent of the value of their original contribution.

So clearly, another incentive to support the scheme is the ability to collectivize credit risk. You want to do a $20-billion deal with the Bank of Porky’s Corners? No problem! Other guys are worrying about credit quality and in the event of default your competitors will bear most of the cost!

But don’t worry about default. Everybody knows that a 22-year-old regulator with a degree in Medieval Horticulture and a certificate in boxtickingology can make much more judicious credit decisions than any dumb old banker.

You don’t actually have the $20-billion you’re lending to the Bank of Porky’s Corners and you have to fund it yourself with a reverse-repo? Again, no problem! You’ll be able to net out your repo positions and the offsetting transactions won’t attract any capital charge! Jack it up to the skies, man! If you can make a margin of a millionth of a beep, it’s all profitable! It’s all free money!

But that’s not the best part. The best part is:

Completion of the second phase will allow interdealer brokers to offer anonymous trading for repos cleared by the CCP, which are known as “blind” repos.

No moral hazard there, no sir!

Should all of CDCC’s private sources of liquidity be insufficient to manage a default, the Bank of Canada has the discretion to act as liquidity provider of last resort on a secured basis.

There’s no mention of this being done at a stiff premium to market (which didn’t happen during the crisis anyway).

Update, 2012-7-14: Note that the provisions for covering losses are equivalent to Unfunded Contingent Capital – whereas the BCBS speaks approvingly of pre-funded Contingent Capital and so does OSFI boss Dickson. The fact that the CCP’s notional capital is unfunded is a serious flaw in the scheme.

Mind you, though, I have no intrinsic objection to the idea of a CCP … but if it lends like a bank and borrows like a bank, it should be capitalized like a bank and regulated like a bank.

This entry was posted on Thursday, June 14th, 2012 at 2:50 pm and is filed under Interesting External Papers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.