What Risk Professionals Want

As memories of the 2007-09 financial crisis fade, we worry that complacency is setting in. Recent news is not good. In the name of reducing the regulatory burden on small and some medium-sized firms, the Congress and the President enacted legislation that eased the requirements on some of the largest firms. Under the current Administration, several Treasury reports travel the same road, proposing ways to ease regulatory scrutiny of large entities without changing the law (see here, here and here). And, recently, the Federal Reserve Board altered its stress test in ways that make it more likely that poorly managed firms will pass. It also voted not to raise capital requirements on systemically risky banks over the next 12 months.

A few weeks ago, one of us (Steve) had the privilege to speak at the 20th Risk Convention of the Global Association of Risk Professionals (GARP). Founded in 1996, GARP engages in the education and certification of risk professionals and has several hundred thousand members worldwide. (Disclosure: Brandeis International Business School and NYU Stern are GARP Academic Partners.) The organizers allowed us to solicit the views of the 100-plus attendees on two issues that are central to financial resilience: Are bank capital requirements high enough? And, do central counterparties (CCPs) have sufficient loss-absorbing buffers? They answered both questions with a resounding “NO” ….

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Resolution Regimes for Central Clearing Parties

Clean water and electric power are essential for modern life. In the same way, the financial infrastructure is the foundation for our economic system. Most of us take all three of these, water, electricity and finance, for granted, assuming they will operate through thick and thin.

As engineers know well, a system’s resilience depends critically on the design of its infrastructure. Recently, we discussed the chaos created by the October 1987 stock market crash, noting the problems associated with the mechanisms for trading and clearing of derivatives. Here, we take off where that discussion left off and elaborate on the challenge of designing a safe derivatives trading system―safe, that is, in the sense that it does not contribute to systemic risk.

Today’s infrastructure is significantly different from that of 1987. In the aftermath of the 2007-09 financial crisis, authorities in the advanced economies committed to overhaul over-the-counter (OTC) derivatives markets. The goal is to replace bilateral OTC trading with a central clearing party (CCP) that is the buyer to every seller and the seller to every buyer....

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Trade repositories: Still far from the "risk map" we need

Among the many reforms in the aftermath of the financial crisis is the agreement among international regulators that all over-the-counter (OTC) derivatives contracts should be reported to trade repositories. The goal is to help market participants and regulators gain a better understanding of the extent and distribution of risk taking in financial markets. G-20 leaders committed to this and other improvements to financial market infrastructure (we described the move to central clearing parties (CCPs) in earlier posts). But, unlike the shift to CCPs, trade repositories seem very unlikely to meet officials’ lofty aspirations in the next few years...
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Central Clearing Parties: What they are and why we need them - Part 3

The CCP Advantage: Incentive and Means to Control Counterparty Risks

The case of the insurance giant, AIG, highlights the information and incentives problems that CCPs can address. In the run-up to the financial crisis, AIG’s London-based Financial Products Group managed to sell enormous amounts of credit risk insurance without the liquid resources necessary to cover potential cash calls. By end-June 2008, AIG had taken on $446 billion in notional credit risk exposure as a seller of credit risk protection via credit default swaps (CDS).

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Central Clearing Parties: What they are and why we need them - Part 1

G-20 Leaders Vote for CCPs: What are they?

In September 2009, as the financial crisis was starting to slowly recede, the leaders of the twenty largest economies of the world (the G-20) met in Pittsburgh. At the end of their summit, they issued a communiqué of nearly 9000 words. Somewhere in the middle of the statement, the following sentence appeared:

All standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. 

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