By David Murphy
Something Must Be Done
The financial crisis of 2008+ revealed many vulnerabilities in the financial system. Too many mortgages had been given to questionable buyers against over-priced property, and some financial institutions were too leveraged, or too illiquid, or both. When the property prices started to fall, the potential for contagion inherent in the structure of the financial system allowed problems to spread from mortgage-related products to a much wider range of instruments, and hence to banks themselves. Many investors doubted the solvency of even the largest institutions, and central banks were forced to make massive interventions to support the system.
After these events, it was obvious that something had to be done, not just to address issues at individual institutions, but also to reduce system-wide vulnerabilities. There were two strands to this. Measures were taken to make individual banks safer, such as requiring them to have more capital and bigger ‘buffers’ of high quality assets which could keep the bank liquid in times of stress. At the same time, there was an effort to improve the properties of the system as a whole. ‘Interconnectedness’ became a buzzword: if we could reduce the degree of connection between banks, then stress at one was less likely to cause stress at its neighbour too. There are many types of direct connection between banks including one owning securities issued by another, lending from one to the other, secured financing (such as repo), and derivatives.
This is a multi-dimensional game of dominos. If you move the dominos further apart in one dimension, for instance by reducing the amounts banks lend each other, one can still topple another if you have not addressed the other dimensions too.
Another important element is uncertainty. In some sense we don’t just need the financial system to be safe: we need it to be seen to be safe. This is because investor doubts about an institution can become self-fulfilling. If everyone reduces their exposure to an institution at once, it can make it fail. Therefore (to push the metaphor) we need to shine a spotlight on the dominos so everyone can see how far apart they are.
It is striking how often one hears that derivatives were to blame for the financial crisis. The facts are rather different. The losses from most types of derivatives – including interest rate, equity, commodity, and FX derivatives – were small during the crisis. Credit derivatives were used to assemble some of the products that led to losses, such as some CDOs, but there is a sense in which blaming these is like blaming the hop farmer when you spill your beer. Sure, without his efforts you wouldn’t have had that particular beer to spill, but other issues are in play too.
Derivatives reform was necessary not because there was a problem with derivatives, but because they could, potentially, create damaging connections between financial institutions. Moreover, because disclosure of derivatives exposures was incomplete and difficult to understand, even if the actual exposures created by derivatives was small, no one was sure that this was true, and hence confidence could be lost.
A key issue, then, was to create repositories of derivatives transactions between financial institutions so that the size of exposures could be known. These trade repositories were a key part of the reform agenda, and it is vital that the data they contain can be effectively used.
Something had to be done about interconnectedness arising from derivatives, too, and several things were. First, the authorities decided that rather than face each other, banks must instead use central counterparties. These are special sorts of entity which sit in the middle of web of derivatives exposures, and guarantee each bank to the others. Of course, this will only work if these central counterparties are incredibly robust. Because they are connected to all the big banks, even the whiff of failure about a central counterparty could be incredibly destabilising. Therefore once the use of central counterparties became compulsory, it became extremely important to ensure their safety; an effort that is continuing in many jurisdictions today.
Not all transactions are suitable for central counterparties. Unusual or illiquid transactions are too difficult for a central counterparty to manage in a crisis. Therefore banks will still trade some derivatives with each other, and we need to ensure that this does not create vulnerabilities. The answer is to require that collateral is used. This keeps the exposures down and protects the system.
Nothing Is Simple
The last two paragraphs seem to suggest that the authorities have many of the answers. Sadly, the problem is more complicated than that. Central counterparties (at least for OTC derivatives) are relatively new, and it remains to be seen whether they will be safe. Collateral requirements do reduce direct exposure, but at the cost of introducing liquidity risk to system. Risks have been transformed and new risks have appeared as old ones have faded. The post reform financial system is certainly different from the old one, and it is unlikely to fail in the same way. But might it fail in a different way? That remains to be seen.
David Murphy is a leading expert in financial stability and regulatory capital. His latest book OTC Derivatives: Bilateral Trading and Central Clearing is the first to shed light on the new clearing and settlement process for OTC Derivatives, illustrating what it is, how it came about and how it could damage the derivatives trading markets.
This book is part of the new Global Financial Markets series from Palgrave Macmillan. Written across a range of disciplines, this series provides comprehensive but practical coverage of key topics in finance. This series will appeal to practitioners across the financial services industry, including areas such as institutional investment, financial derivatives, investment strategy, private banking, risk management, corporate finance, M&A, financial accounting, governance, and many more.
Books in this series include:
- Intelligent Investing: A Guide to the Practical and Behavioural Aspects of Investment Strategy
- Credit Portfolio Management: A Practitioner's Guide to the Active Management of Credit Risks
- The Complete Guide to Hedge Funds and Hedge Fund Strategies
- Investing in Asian Offshore Currency Markets: The Shift from Dollars to Renminbi
- Risk-Based Investment Management in Practice