Stress Testing Financial Networks: The Case of CCPs

Following the crisis of 2007-09, in which AIG’s bilateral derivatives trades played a notable role, the G20 leaders called for central clearing of standardized derivatives. The resulting shift has been dramatic: central counterparties (CCPs) now clear about three-fourths of interest rate contracts, up from less than one-fourth a decade earlier (see Faruqui, Huang and Takáts).

By substituting a CCP as the buyer to every seller and the seller to every buyer, central clearing mutualizes and can—with appropriate margining, trade compression, position liquidation procedures, and reporting—reduce counterparty risk (see Tuckman). CCPs also contribute to financial resilience by promoting uniform margin standards, reducing collateral and liquidity needs, and making risk concentrations (like that of AIG in the run-up to the crisis) more transparent.

At the same time, the shift to central clearing has concentrated risk in the CCPs themselves. Reflecting economies of scale and scope, as well as network externalities, a few CCPs serving global clearing needs have grown enormous. For example, as of the last report at end-September 2018, open interest at LCH Clearnet exceeded $250 trillion. Moreover, the clearing activity of some CCPs lacks any short-run substitute. As a result, to avoid disrupting large swathes of the global financial system, any recovery or resolution plan for these CCPs must ensure continuity of service (see CCP Resolution Working Group presentation to the OFR Financial Research Advisory Committee). Finally, CCPs are the most interconnected intermediaries on the planet, making them channels for transmission and amplification of financial distress within and across jurisdictions. As then-Governor Powell clearly states in the opening quote, the safety of CCPs is central to the resilience of the global financial system.

We and Richard Berner have been studying how regulators use stress tests (see our earlier posts here and here) to assess the resilience of financial networks, including banks and nonbanks. In our joint work, we focus on CCPs due to their centrality, their extreme interconnectedness and their lack of substitutability. This post is based on our research….

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” ….

Inflation risks and inflation expectations

U.S. inflation has been low and steady for three decades. This welcome stability is not merely a consequence of good fortune. Shocks that in the past might led to higher trend inflation—like the energy price increases—continue to buffet the economy much as they did in the 1970s and 1980s, when inflation rose to a peacetime record. Rather, it reflects the improved monetary policy of the Federal Reserve, which began acting as an inflation-targeting central bank in the mid-1980s, long before it announced a 2% target for inflation in 2012. As a consequence of the Fed’s sustained efforts, long-run inflation expectations have remained close to 2% for more than 20 years. One result is that temporary disturbances that drive inflation above or below target quickly fade.

This is the optimistic conclusion of the 2017 U.S. Monetary Policy Forum (USMPF) report. Since the adoption of the de facto inflation-targeting regime, one-off shocks have little impact on the inflation trend. Moreover, as many have observed, the relationship between unemployment and inflation—the Phillips curve (see our primer)—is now notably weaker. However, the authors of that earlier report warn that the Phillips curve “flattening” could be a direct consequence of the Fed’s success. Furthermore, since the sample period from 1984 to 2016 excludes any sustained period of a very tight economywide labor market, it would not be possible to detect an outsized impact, if any, of persistently low unemployment on inflation.

Enter the 2019 USMPF report, which focuses on the possibility that inflation may indeed respond differently when the unemployment rate is very low and projected to remain low for several years (see, for example the FOMC’s latest Summary of Economic Projections). The logic is straightforward: if labor is very scarce for an extended period, employers will bid up wages and (unless they are prepared to accept declining profits) pass on those cost increases in the form of higher prices….

Improving resilience: banks and non-bank intermediaries

Debt causes fragility. When banks lack equity funding, even a small adverse shock can put the financial system at risk. Fire sales can undermine the supply of credit to healthy firms, precipitating a decline in economic activity. The failure of key institutions can threaten the payments system. Authorities naturally respond by increasing required levels of equity finance, ensuring that intermediaries can weather severe conditions without damaging others.

Readers of this blog know that we are strong supporters of higher capital requirements: if forced to pick a number, we might choose a leverage ratio requirement in the range of 15% of total exposure (see here), roughly twice recent levels for the largest U.S. banks. But as socially desirable as high levels of equity finance might be, the fact is that they are privately costly. As a result, rather than limit threats to the financial system, higher capital requirements for banks have the potential to shift risky activities beyond the regulatory perimeter into non-bank intermediaries (see, for example here).

Has the increase of capital requirements since the financial crisis pushed risk-taking beyond the regulated banking system? So far, the answer is no. However, in some jurisdictions, especially the United States, the framework for containing systemic risk arising from non-bank financial institutions remains inadequate….

Common Ownership: Back to Basics

Do diversified investment vehicles―especially index funds―diminish competitive pressures in concentrated industries? There is an active (and contentious) debate among researchers, policymakers and practitioners about the costs and benefits of such “common ownership.”

In addition to a rapidly growing number of industry-level studies—looking at airlines (here and here), banking (here and here) and ready-to-eat cereals (Backus, Conlon and Sinkinson, forthcoming), or at broad groups of industries—other researchers have sought to link common ownership to macroeconomic phenomena, like the weakness of post-crisis investment. And, in response to anti-competitive claims, legal scholars propose using antitrust law to limit the holdings of institutional investors in oligopolistic industries. Against this background, competition authorities in Europe and the United States are taking the debate seriously (see, for example, the FTC hearing held in December at the NYU School of Law).

Our own view is that the discussion remains at a very early stage, and that it is likely to take years to resolve whether CO, especially through index-tracking mutual and exchange-traded funds, meets the cost-benefit test (for a skeptical view of CO, see here). Importantly, even if CO does reduce competitive pressures, we currently know far too little to about the scale or scope to identify remedies that would be most effective and least disruptive. Furthermore, should the case for broad-based anti-competitive effects become compelling, any response will need to consider the welfare trade-off between the very large consumer benefits arising from broad index funds and the consumer costs associated with a loss of competition in selected oligopolistic industries.

Against this background, we welcome two new papers (here and here) by Backus, Conlon and Sinkinson (BCS) that review the literature, provide new data to characterize the evolving pattern of share ownership, and suggest a back-to-basics approach for testing the CO hypothesis in specific industries. We hope that their work will spur a wave of CO research that will help us weigh the increasingly animated claims and counter-claims. In the remainder of this post, we highlight a few of the lessons from this recent research….

FOMC Communication: What a Long, Strange Trip It's Been

Following their January 2019 meeting, the Federal Open Market Committee (FOMC) came in for intense criticism. Instead of a truculent President complaining about tightening, this time it was financial market participants grumbling about a sudden accommodative shift. In December 2018, Fed policymakers’ suggested that, if the economy and market conditions evolved as expected, they probably would raise interest rates further in 2019. Faced with changes in the outlook, six weeks later they altered the message, suggesting that going forward, monetary easing and tightening were almost equally likely.

We find the resulting outcry difficult to fathom. The FOMC’s perceptions of the outlook may have been incorrect in December, in January, or both. There are myriad ways for economic and market forecasts to go wrong. But, to secure their long-run objectives of stable prices and maximum sustainable employment, isn’t it sometimes necessary for policymakers to change direction, and when they do, to explain why?

The point is that the recent turmoil arises at least in part from the Fed’s high level of transparency. In this post, we summarize the evolution of Federal Reserve communication policy over the past 30 years, and discuss the importance and likely impact of these changes. While transparency is far from a panacea, we conclude that the evolution has been useful for making policy more effective and sustainable, and remains critical for accountability and democratic legitimacy….

China: Mao Strikes Back

China is now a top-rank, market-moving source of daily news. It is not only the world’s second largest economy, but over the past decade, it accounted for nearly thirty percent of global economic growth. No wonder stories about a slowdown in China and trade conflict with the United States send shudders through financial markets. As conditions are worsening, uncertainty has jumped to record levels in China and elsewhere.

In the near term, if China and U.S. trade negotiators can come to an agreement avoiding a further hike of U.S. tariffs, some of this heightened uncertainty may fade. But a more persistent source of risk arises from China’s medium- and long-term growth prospects. While the country has sustained 6%-plus growth since 1991, in recent years it has done so by increasing investment per unit of growth. The prominence of these diminishing returns from incremental capital outlays lead many informed observers to conclude that a further medium-term deceleration is inevitable. Worries about the sharp increase in nonfinancial corporate debt over the past decade, and the lack of transparency regarding the risks in China’s financial system, only serve to compound this pessimism.

Given these circumstances, Nicholas Lardy’s excellent new book, The State Strikes Back, could hardly arrive at a better moment. Using careful analysis to challenge common hypotheses, Dr. Lardy takes a close look at the principal factors affecting China’s longer-run growth prospects. Ultimately, he is hopeful, but realistic: China could sustain its recent pace of growth for an extended period—or grow even faster—but only if the government is willing to return to its earlier commitment to serious reforms that favor market, rather than state, allocation of resources. So far, despite the prominent market advocacy in its 2013 “policy blueprint”—the first under President Xi Jinping’s leadership (see the opening citation)—the Xi government has shifted in precisely the opposite direction.

In the remainder of this post, we explore Lardy’s conclusion that China’s growth potential remains high. On the key issues of substance, his logic is compelling. A combination of the opportunities generated by convergence to advanced-economy productivity levels, continued improvements in competition and trade, and a renewed shift toward the private allocation of resources—especially through changes in the structure of both state-owned enterprises and the financial system—points to the possibility of a return to higher growth. Nevertheless, we find ourselves somewhat less hopeful. Even if China’s government were to make fundamental economic reform its top priority, in our view the odds favor a further slowdown over the next decade….

Antitrust and the Financial Sector

Antitrust has again become a hot topic in U.S. policy discourse. There are lots of contributing reasons: Online firms have grown large and ever more important in many individuals’ lives. Media references to “Big Oil”, “Big Pharma”, “Big Tech”, etc., have become more common. The Obama Council of Economic Advisers issued a 2016 report that highlighted rising seller concentration—and related concerns about rising market power—in many sectors of the U.S. economy. These concerns have been echoed by The Economist and by a number of academic and “think tank” studies. There have been efforts to link this increasing size and concentration to wage stagnation and worsening income distribution.

The term “monopoly” is heard far more frequently today than was true even a decade ago.

Antitrust is one of the major policy tools in the United States—along with direct regulation—designed to address monopoly and more generally the exercise of market power. For the financial sector, regulation of various kinds generally overshadows antitrust. But even for the financial sector, antitrust plays an important role: indeed, in June 2018, the U.S. Supreme Court decided an important antitrust case that involved American Express’s relationship with the merchants that accept its payment card.

So, let’s first review some basics about antitrust. We’ll next describe the recent trends in company sizes and seller concentration. And we will then move on to the relevance of antitrust for the financial sector….

Bad Precedent

Recent reports that President Trump wanted to fire Board Chairman Powell in response to Federal Reserve interest rate hikes are unprecedented. Denials from senior officials―Treasury Secretary Mnuchin and Council of Economic Advisers Chairman Hassett―have even less credibility than would a statement (or tweet) from the President himself. We find this entire discussion extremely disheartening and surely damaging to economic policy and the credibility of the Federal Reserve. As former Chair Yellen has stated, the risk is that people lose “confidence in the Fed, in the basis for its actions and its responsiveness to its mandate” (see here, time mark: 18:51).

To be sure, there is some debate over whether the President can fire the Fed Chair, other than “for cause.” We are not lawyers, but thoughtful people such as Peter Conti-Brown suggest that the answer is yes. Against this background, we view President Trump’s actions (and reported wishes) as the most serious threat to Fed independence since the Treasury-Fed accord of March 1951….

Navigating in Cloudy Skies

Stargazers hate clouds. Even modest levels of humidity and wind make it hard to “see” the wonders of the night sky. Very few places on our planet have consistently clear, dark skies.

Central bankers face a similar, albeit earthly, challenge. Even the simplest economic models require estimation of unobservable factors; something that generates considerable uncertainty. As Vice Chairman Clarida recently explained, the Fed depends on new data not only to assess the current state of the U.S. economy, but also to pin down the factors that drive a wide range of models that guide policymakers’ decisions.

In this post, we highlight how the Federal Open Market Committee’s (FOMC’s) views of two of those “starry” guides—the natural rates of interest (r*) and unemployment (u*)—have evolved in recent years. Like sailors under a cloudy sky, central bankers may need to shift course when the clouds part, revealing that they incorrectly estimated these economic stars. The uncertainty resulting from unavoidable imprecision not only affects policy setting, but also complicates policymakers’ communication, which is one of the keys to making policy effective….

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Money, Banking, and Financial Markets