More on central clearing and the leverage ratio

I talked some days ago about client clearing and some research that I have done on whether some new regulations (mainly the leverage ratio—LR) might increase its costs and reduce the willingness of banks to provide such services. I have since found out that the Bank for International Settlements has published a couple of relevant documents:

A consultative document to get feedback about whether to change the LR treatment of client cleared derivatives. The three options are—apologies for translating them in my own words:

  • Do nothing.
  • Allow initial margin to offset the potential future exposure (PFE).
  • Forget that this is a leverage ratio requirement and use the risk-based framework instead.

I would pick either the first or the second option. Well. No. The first option. I do think that, at the moment, the second option might be slightly better (not crazily better—I think our results do suggest that the cost is small although more work needs to be done and we are doing it) but the trend is clearly towards being more lenient, so I would favour resisting as much as possible unless the case is crystal clear.

The second is a more general report on the incentives to centrally clear. It has been developed by a bunch of international organisations in what is definitely a mouthful: FSB, BCBS, IOSCO, and CPMI (I did not know this last one). This report cites our previously mentioned research. You can tell the care and work put in the crafting of this report by reading my surname spelled “Rodriquez” instead of “Rodriguez” (fourth most common surname in Spain). Joking aside, I hope to comment on it in the near future once I am able to read it properly.

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Orwell’s Notes on Nationalism

I have recently found myself reading some of the greatest British thinkers and writers of the 20th century. Bertrand Russell’s History of Western Philosophy looks at me every time I sit on my desk—I am still in the pre-Socratics. Christopher Hitchens’s books—Hitch 22, Mortality, Letters to a Young Contrarian, The Missionary Position, and more—await in my tablet. And George Orwell, of course, George Orwell. Although my first contact with Orwell came probably due to his Homage to Catalonia—what is more Catalan than celebrating others talking about our defeats?—I also read 1984 several years ago. I have re-read it recently; one should do that with such modern classics: there is so much that I missed in my first read. A vivid memory of that time, now that I think about it, is realising that the government in Barcelona had installed a camera in the George Orwell Square.

The very first non-fictional text that I read by Orwell is Notes on Nationalism. Orwell defines nationalism in a very broad sense, most closely in meaning to tribalism—ethnic, religious, national, regional, or even ideological. As he puts it, it is “the habit of identifying oneself with a single nation or other unit, placing it beyond good and evil and recognising no other duty than that of advancing its interest.” He highlights a key characteristic, the inability of accepting facts that contradict its own position: “All nationalists have the power of not seeing resemblances between similar sets of facts”. A nationalist abandons rationality for a broad set of different emotions: “The point is that as soon as fear, hatred, jealousy and power worship are involved, the sense of reality becomes unhinged”.

The neural processes that govern these instances are fascinating. Sam Harris, together with other co-authors, tested in a paper which parts of the brain react when one is presented with facts that contradict their strongly-held beliefs. In this instances, as the authors say, there was “increased activity in the default mode network—a set of interconnected structures associated with self-representation and disengagement from the external world.” It would seem that the brain, to spare us from the terrible effort of changing our beliefs, decides to treat this information almost as fiction, almost as #fakenews.

Coming back to Orwell he admits there is no way out of nationalism (now that we are getting an understanding of the neural processes involved, there is no reason to think that a pill that forces the brain to treat all information as non-fiction will not be invented). What one can do, however, is to try to understand where some positions come from. “It is possible to struggle against them, and that this is essentially a moral effort”. Why do you get so angry when talking about the European Union? What do you despise the Tories—any Tory? Understand the nationalism, the tribalism, in you, and think what is the goal of any conversation. The goal has to be understanding the other’s position, where this position comes from, and help them—if that is the case—to identify the logical mistakes or the wrong assumptions they are making. Sometimes we will have our minds changed. But it all starts by recognising the nationalism in us.

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Client clearing

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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Emerging scholars conference

The programme for the Emerging Scholars in Banking and Finance conference is complete! This conference, organised by the Centre for Banking Research at Cass—of which I am a member—brings together emerging scholars in banking and finance to present their papers. This year is the 6th edition. The submissions were very good, and hence the line-up looks excellent.

I will act as discussant for Ishita Sen‘s job market paper Limits to optimal hedging for financial institutions. I have known Ishita for a while now: we started the same day at the Bank of England, back in summer 2015. So I look forward to discussing her paper.

We have a couple of PhD students at Cass presenting their papers: Robin Tietz and Elisa Pazaj. I have found, in the past, that having a discussant can be extremely useful: our paper Securities trading by banks and credit supply: Micro-evidence from the crisis benefited enormously from Jeremy Stein‘s discussion (a bit off-topic here, but the keynote speech that Stein gave in this year’s EFA annual meeting was great). Therefore, I hope both Robin and Elisa find this experience beneficial.

We also have speakers from the Fed, IMF, St. Andrews, Bank of England, Bonn, BI Norwegian, etc. And a great line-up for discussants too. More information, including how to register, can be found here.

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Seven myths about education, by Daisy Christodoulou

Since my daughter was born, almost a year and a half ago (already!), I have been concerned about how to educate her. My own experience suggested that even the education from some of the best primary schools might still fall short of extracting as much potential as possible. For this reason, I watched the interview of Katharine Birbalsingh in The Rubin Report with great interest. She mentioned a book, called Seven Myths about Education, by Daisy Christodoulou. After reading the great reviews, I bought it immediately.

Christodoulou does something that should be common practice but it almost never is: she “steelmans” her opponents. A common practice when arguing against a position is to strawman this position: to create usually an extreme version of your opponent’s view, one that they are unlikely to hold, and then attack that view rather than your opponent’s.  Christodoulou, however, does the opposite: she goes to the actual sources to show that the myths she is referring to are present in the educational system in Britain; she takes the most benign view on the intentions of their proponents; and then she refutes them using a vast amount of evidence—including evidence from the scientific community.

The myths can be found at the end of this post. But I will mention the main two takeaways that I got from the book. One is the false dichotomy between knowledge and skills, and the failure to recognise that skill is extremely dependent on knowledge, in particular knowledge stored in our long-term memory. As we make progress in understanding how the human brain works, we are better able to tailor the way we teach to achieve the maximum impact.

The second point is more general and applies to many different situations: it seems that some (many?) teachers in Britain base their teaching on one or several theories rather than relying on the empirical evidence on what works best. Christodoulou mentions some examples of teachers that did not have any exposure to such evidence. Why would one want to be blind to this? Is not it the key objective to improve the education of our kids? I am sure it is, but sometimes it seems like it is more important to shield and protect certain theories—irrespective of how wrong they are—from the truth.

The book is great, with a superb work collecting evidence. Highly recommended.

The seven myths are:

  1. Facts prevent understanding.
  2. Teacher-led instruction is passive.
  3. The twenty-first century fundamentally changes everything.
  4. You can always just look it up.
  5. We should teach transferable skills.
  6. Projects and activities are the best way to learn.
  7. Teaching knowledge is indoctrination.
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Finalising Basel III

After several years, Basel III has (almost) been finalised. Basel III is the third iteration of the Basel Accords, minimum international standards for prudential regulation of banks. It started after the financial crisis, when it was clear that Basel II was insufficient to ensure the solvency of the sector. Some bits of Basel III have already been implemented (buffers, liquidity regulation) but some others were still subject to discussion. This came to an end last December, one year later than promised. Now, apart from some details, the reforms have been agreed and there is a calendar for implementation. The document summarising these reforms can be found here. In the following weeks, I will go over some of them.

When I was at the Bank of England, I was involved in supporting the seniors in finalising Basel III, so this is also a small victory of mine. I am joking, it is not, and it certainly does not feel like it. The other policy work I was involved in was the regulatory treatment of sovereign exposures. The BCBS has also published a Discussion Paper on this (can be found here). They mention, however, that they are not consulting on it yet: there is no consensus regarding whether the existing treatment needs to be changed. This is disappointing in so many levels: after the European sovereign debt crisis, it should have been obvious that sovereign exposures are not risk-free. And I bet that, if the ECB had not stepped in (“whatever it takes”), we would already have changes in this. But it turns out that this ex-post interventions might also increase the moral hazard of policy-makers.

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Mankiw and Weinzierl 2011

While working on a project in its very early stages, I stumbled upon this paper by Mankiw and Weinzierl from 2011 in the Brookings Papers of Economic Activity. It is a very simple macro model with monetary and fiscal policy where the economy can hit the zero lower bound. I found this paper very interesting for two main reasons:

  1. it discusses a lot of issues (monetary policy through short-term rate vs long-term money supply, zero lower bound, role of fiscal policy) in a very simple framework; and
  2. this framework can be adapted to study the interaction of monetary policy with other policies—for instance, financial regulation—especially in the zero lower bound.

It is also quite thought-provoking to read the discussants and the general discussion: particularly useful to get ideas for future research.

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