When Lehman went bankrupt, it had over 900,000 derivative transactions with other counterparties. While many of these transactions were closed down in the following weeks, a significant number of bilateral over-the-counter derivatives were the object of dispute for months, even years in some cases. The uncertainty that this introduced in the banking system was substantial: banks did not know with other banks were affected, thus worsening the liquidity problems that the market was already facing.
This was one of the reasons for the G20 to pursue the objective of having more derivatives cleared through a central counterparty (CCP), the so-called clearing obligation. When done through a CCP, all OTC derivatives share one counterparty—the CCP—and hence the bilateral exposures disappear. Why is this important? If a bank fails—if they have access to the CCP, we call them “clearing members” (CM)—the other CMs do not have a direct exposure to it. The CCP does have an exposure, but since it requires a lot of collateral (margin) and on top of that it has a default fund for these cases, the framework should withstand the shock.
Hence now if JP Morgan wants to enter into an interest rate swap with Barclays, they need to put the CCP in the middle. But things are a bit more complicated. First, not all derivatives are subject to this: exchange-rate derivatives, a huge market, do not need to be centrally cleared. Second, and more relevant for this post, not everyone has direct access to a CCP. In fact, because the infrastructure is expensive, only the biggest banks have access. In other words, only the biggest banks are clearing members (CMs).
But the clearing obligation also applies to non-CMs. Big insurance companies or other banks need to enter into derivative transactions. A Building Society, for instance, wants to hedge against interest rate risk, especially now that rates are very likely to keep increasing. What can they do? They need to access the CCP… through a CM. Only a subset of CM provides client clearing services. And they might be losing interest in doing so.
Providing client clearing services is not a very profitable business. Nevertheless, since it is very safe, this did not use to be a problem. Safe meant low capital requirements for banks, and thus low funding costs. But this has recently changed with the introduction of the leverage ratio requirement. This is an additional capital requirement that does not distinguish among risks: it demands the same amount of capital to back a German bund than to back a personal loan.
Client clearing is one of these activities that resemble a German bund more than a personal loan. And in a recent paper—which is very much still work in progress—my co-authors and I find some evidence that banks are indeed reducing the provision of these services due to the leverage ratio. Although we are not able—yet—to capture the effect as cleanly as we would like, the economic magnitude of the decrease in the provision of these services is around 3-5%. It is important, but these are early days, and the sector is adjusting to many changes. It could well be that this effect is temporary.
These results, I would claim, do not deserve any revision of the regulation. Especially when the memory of the financial crisis starts to fade; when the pressure from the industry—and some policy-makers—to walk back on some of the new regulation will only grow. But they do point towards the need for regulators and academics alike to continue thinking about the potential unintended consequences of the new financial regulation.
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