Preparing for the next financial crisis

There is a natural tendency for financial regulators and supervisors to fight the last battle, looking for systemic weaknesses revealed by the most recent crisis. It happened after the 1987 stock market crash, during the Asian crisis, and again following the LTCM collapse. And it seems almost certain to happen again this time. So, while it is surely important to examine the specific problems involving banking system off-balance-sheet activities, the quality of collateral used to back commercial paper, and the manner in which ratings are used, I believe that we need to look further.

While market forces seem likely to cleanup much of the current mess, punishing the people who had inadequate oversight and risk controls in place, government officials who create the regulatory environment in which these problems occurred still have work to do. My proposal is that existing international committees like the Financial Stability Forum examine the design and trading of securities, especially derivate instruments, working to increase standardised and encouraging the movement of trading to organised exchanges.

In looking at the financial landscape, we can see that securities fall into three broad categories: (1) exchange traded; (2) standardised, but over-the-counter traded; and (3) customised. In the first case, the securities are standardised, transparent, and traded through a clearinghouse system. The first two properties mean make it more likely that you will know what you own and that you will know the best way to try to sell it.  The existence of the clearinghouse helps to improve the stability of the entire financial system.  Let me explain why.

A critical part of any financial arrangement is the assurance that the two parties to it meet their obligations.  In organised exchanges, there is something called a “clearinghouse” that insures that both sides of the contract will perform as promised.  Instead of making a bilateral arrangement, both the buyers and sellers of a security make a contract with the clearinghouse.  

Beyond reducing counterparty risk, the clearinghouse has other critical functions.  The most important are maintenance of margin requirements and the “marking to market” of the gains and losses.  In order to reduce the risk that it faces, the clearinghouse requires parties to contracts to maintain deposits whose size depends on the details of the contracts. And at the end of every day, the clearinghouse posts gains and losses on each contract to the parties that are involved – positions are marked to market.

Since margin accounts act as buffers against potential losses, they serve the same role as capital does in a bank.   And marking to market creates a mechanism for the continuously monitoring the level of each participants capital.

It is important to realise that because they reduce risk in the system as a whole, clearinghouses are good for everyone. They are what economists refer to as “public goods”. But the fact that everyone obtains the benefits regardless of whether they pay the costs, means that they are difficult to set up.  Private markets will not supply public goods, so governments have to get involved.

Looking at securities markets, where and how should we encourage the formation of clearinghouse-based trading?  There are two ways to we could go about this.  The first is to think about the natural maturation cycle of a security, and the second is to consider restrictions on what sorts of securities different financial institutions should be allowed to hold.

On the first, it is useful to think about securities the same way we think about drugs.  Drugs are in four basic categories: (1) those anyone can walk into a store a buy, like aspirin; (2) those that require prescriptions for doctors, including antibiotics and steroids; (3) experimental drugs that are only available in drug trials; and (4) heroin and other drugs that are universally illegal.[1]

It doesn’t take much imagination to see how the three types of financial instruments are analogous to the first three categories of drugs.  (There are financial transactions that are illegal. But since the problems we face are with what’s legal, I am going to ignore those.) As with drugs, safety should be the rationale for categorizing financial instruments.  When a security is new, with prices that come from models based on historical data that may or may not be representative, safety is difficult to assess.  With experience, we improve our understanding of both the pricing and the usefulness of securities and they can migrate from being experimental to available by prescription.  Finally, once generally safety and standardization is established, a security move to being sold to being traded on an organised exchange.

Looking at the topography of the financial system, we see several immediate candidates for migration to exchange trading.  I will mention two:  (1) bonds and commercial paper, and other fixed income securities; and (2) interest-rate swaps and other derivatives that are traded in large volume. Bonds as we know them have been around since at least 16th century.  And the quantities outstanding are substantial – in the United States there something like 4000 distinct corporate bond issues with a market value of roughly $10 trillion.  I can see no reason that these “fixed-income” instruments are not traded on an exchange.

Among the myriad of derivative instruments that are out there, interest-rate swaps are the most important ones that are not traded on an exchange.  The Bank for International Settlements reports that at the end of 2006 interest-rate swaps with a notional value of $230 trillion and an estimated gross market value of over $4 trillion outstanding.[2]  While this market has been growing at a rate of more than 20 percent per year, it has been around for nearly a quarter century.[3]

Not only is the interest-rate swap market mature, but a small number of commercial banks dominate the trading.  In the U.S., for example, the U.S. Treasury’s Office of the Comptroller of the Currency reports that of the $81.3 trillion of notional value outstanding at the end of 2006, the top five banks were responsible for $79.9 trillion – that is, all of it!  Internationally, one suspects that the top 10 to 15 banks account for virtually the entire market.  This sort of concentration suggests that the banks making this market have already standardised the instruments, so moving the trading to an exchange should not be all that difficult.[4]

How can we encourage the movement of mature securities onto exchanges?  The answer is through a combination of information and regulation.  On the information side, it is important that less-sophisticated investors realise the importance of sticking with exchange-traded products.  The treasurer who manages the short-term cash balances for a small-town government should not be willing to purchase commercial paper, or any security, that is not exchange traded. 

As for regulation, over the years we reached broad agreement on which financial institutions are critical to the operation our economic system and proceeded to impose substantial restrictions on the assets that they can hold.  These come as a combination of outright prohibitions and differential treatment in capital regulation.  For example, commercial banks in the United States are not allowed to hold equity, and they are discouraged from holding corporate bonds.  It is not difficult to imagine changes in regulation and supervision that would encourage migration of a variety of bonds, commercial paper, and derivatives onto organised exchanges.

In conclusion, as we think about the right response to the current and future crisis, there are two things to keep in mind.  First, we do not want to stifle innovation.  In the same way that we all want newer and better drugs, we all want newer and better securities. Second, the innovators will always find and exploit the weakest point in the system.  So, just as drugs are tested outside the general population, we need to test financial innovations in places where they are least likely to do damage to the parts of financial system we deem critical.   But then, once we know that something is safe, it should be standardised and pushed onto an organised exchange where it will be traded through a clearinghouse.

This essay first appeared on www.eurointelligence.com.

[1] As an aside, it is interesting to note that the development of a new drug, from synthesis to final approval, takes an average of 12 years and costs $1 billion.

[2] Interest rate swaps are agreements between two parties to exchange a fixed for a variable interest rate payment over a future period. In a typical American example, the fixed-rate payer in a swap would pay the U.S. Treasury bond rate plus a risk premium, while the flexible-rate payer would pay the London Interbank Borrowing Rate (LIBOR).  Interest rate swaps are useful when a government, firm, or investment company can borrow more cheaply at one maturity, but would prefer to borrow at a different maturity.

[3] The first swap was invented by an investment banker in 1981 in response to the fact that the World Bank had issued bonds in dollars, while IBM had issued bonds in German Deutsche Marks and Swiss Francs, and each preferred to make interest payments in the currency of the other.

[4] Concentration has almost surely created a problem for regulators, as these banks have made themselves much too big to fail.  If you have an enormous derivatives business, no government can afford to let you disappear.