Tag, You're It! Too Big to Fail Risk Transferred, Not Eliminated

Whenever we think of giant firms that a government feels it must bailout, big banks generally come to mind. Sure, an insurance company sneaked in there too, but AIG might have been more of an exception, since it so grossly underestimated the risks it was taking on its financial products and lived in a grey regulatory area. Although last summer's giant financial regulation bill sought to eliminate the systemic risk that led to a crisis a few years ago, it may have merely transferred some of it, creating a new breed of too big to fail firms.

Those who understand the crisis know that derivatives were involved, particularly through AIG. It needed to be bailed out, because it did not have enough capital on hand to back up the credit default swaps agreements it had written. A large number of those were tied to the housing market, which caused the crisis.

In order to avoid this problem derivatives pose in the future, new financial regulation demands that all derivatives are cleared, when possible. For those who aren't familiar with clearing, the general idea is that each derivative is matched with an equal, opposite derivative through a central bookkeeper -- a clearing house -- to net out the risk they pose (more explanation with a lengthy analogy here).

This sounds better in theory than it works in practice. For one thing, many derivatives are customized, so finding a counterbalancing derivative is next to impossible. Another problem, however, is that one counterparty (the firm that has to pay up if money comes due from a derivative) is often riskier than another. That latter problem can be a serious one.

For example, imagine if AIG had cleared all of its credit default swaps. In theory, that means a clearing house would have ensured that the insurer had ample cash (or other collateral) on hand to satisfy their payouts. In reality, however, the clearing house would have likely failed to do so. It would probably not have anticipated the severity of the losses these derivatives would incur and it might not have realized just how weak AIG's capital position was in regard to the losses it would face. So you would get a situation where the clearing house would be forced to pay investors on the other side of that transaction, but it wouldn't have funds from AIG to do so.

Craig Pirrong, a Professor at the University of Houston, has penned a new paper for the International Swaps and Derivatives Association (ISDA) that explains that this essentially transfers derivative risk from financial institutions to clearing houses. Consequently, he asserts that these clearing houses must be regulated just like other too big to fail firms (CCP ~ clearing house):

It may be the case that a CCP, while solvent, cannot meet immediate demands for the return of clearing member collateral (or other cash calls made on it). Central banks should be aware of this risk and make provision to mitigate it. This could, for instance, include either direct CCP access to central bank funding, or central bank lending to clearing members. To avoid the moral hazard problems that such lending mechanisms can create, it is essential that CCPs be subject to close prudential oversight of the same standard as that which applies to other large systemically important financial institutions. (emphasis by the author)

It's interesting to see ISDA put its name on a paper that makes this argument. This would sort of be like if the American Bankers Association had written a paper in 2005 that argued the largest five investment banks needed tighter regulation and access to Federal Reserve funding, because they were too big to fail. That probably would have raised some eyebrows, and this should too.

On one hand, you have to applaud ISDA's transparency and insight. It knows that the new regulatory framework has essentially ensured that clearing houses are too big to fail. In the past, this was a smaller problem, because fewer derivatives were cleared and only large banks really used them, which at the time nobody thought would fail. Now, far more derivatives will be cleared and many counterparties will have much weaker capital cushions. That provides clearing houses much more risk to absorb.

On the other hand, the paper argues that additional regulatory oversight will justify the moral hazard created by bailing out clearing houses in a pinch. But at the same time, it says that the new regulatory standards established by the Dodd-Frank bill would actually exacerbate financial crisis, as they would demand firms pay up to cover potential derivative losses at a time when they can least afford to do so.

The best solution here might be to find a way to facilitate clearing house failure, when necessary. For example, something like the new non-bank resolution authority needs to be developed for clearing houses. The paper addresses this as well. There legal barriers currently in place that would make resolution difficult. For example, the right agreements between counterparties might not exist to make transfer legally feasible. And then, of course, there's the practical barrier that there aren't many clearing houses and if their risks are correlated, then all the planning and swiftness in the world won't prevent a financial crisis.

So in a sense, we're back where we started. When the financial sector begins to deteriorate, some of the risk that used to be contained in firms like Lehman Brothers or AIG will now be found in clearing houses. That doesn't make the market any safer. In fact, it could create even greater instability.