‘Too big to fail’ issues just got bigger

Most everybody in the know is smiling about how “too-big-to-fail” (TBTF) banks have been successfully repositioned as “more-capital-no-worry” banks. It is likely because all the systemically important financial institutions (SIFIs) have recently passed their stress tests and have had their resolution and recovery plans (also known as “living wills”) accepted by government regulators.

Now, along comes the G-20 Financial Stability Board’s “Analysis of Central Clearing Interdependencies” that paints a dire picture of the fault lines apparent in regulators’ own construct for preventing future crises, most notably with respect to central counterparties (CCPs). The analysis describes the interconnectedness of TBTFs as clearing members and financiers of the newly-organized global network of CCPs, which now includes mandated clearing and guarantees of the $500 trillion notional over-the-counter (OTC) derivatives market.

{mosads}CCPs are organized as mutual, risk-sharing facilities with obligations by the largest financial institutions to support each other to meet their obligations in the event of failure. They require cash and liquid securities as collateral to be maintained against the obligations they have assumed on behalf of themselves and their clients.

CCPs vary the amount of required collateral on a daily basis based upon an assessment of the volatility of the markets. TBTF firms perform the creditworthiness checks on smaller, less-heavily capitalized institutions and individuals, as they introduce those clients’ trades for clearance.

In an attempt to prevent further government-led bailouts, the global framework set by the G-20 was to provision more liquid capital for the inevitable stress of another financial crisis. In this framework, there were two other measures: One was to set in place a mechanism for the TBTF banks to clearly define how they could recover from a near-financial collapse or resolve themselves by use of their living wills. The other was to require the use of CCPs to act as guarantors of settled trades between counterparties in the OTC derivatives market.

Central counterparty risk and related #basel #capital requirements are a key concern in 2017 #skininthegame

— The Gallatin Group (@TheGallatin) February 23, 2017

In the new regulator-imposed CCP regime, so as not to anticipate a government-led bailout as the last resort, the central counterparties contribute their own capital, then call on member capital and finally drawdowns of existing contingent commitments before a bankruptcy filing, depending on the regulatory regime the CCP is domiciled in.   

However, with more risk now concentrated in central counterparties, the inevitable question arises: Are those entities now too big to fail? The Financial Stability Board’s (FSB) conclusion is decidedly yes, as it is the TBTF banks that are primarily backstopping the CCPs risk of failure, the very same entities that questionably are too big to fail.

In the FSB analysis of 26 CCPs, more than 80 percent surveyed were exposed to at least 10 global SIFIs. The CCPs’ financial resources are also highly concentrated, with 88 percent sitting in just 10 CCPs. Of the 307 clearing members included in the analysis, the largest 20 accounted for 75 percent of financial resources provided to all CCPs. This concentration is made even more critically dependent on U.S. financial institutions when considered against U.S. TBTF institutions involvement in CCPs.

According to a study by the U.S. Treasury’s Office of Financial Research, four of the top 10 global systemically important financial institutions are U.S. TBTF banks; four of the 10 highest-scoring banks related to interconnectedness issues are U.S. TBTF banks, including the top two; and nearly 50 percent of the world’s financial assets are held by four U.S. TBTF financial institutions.

Importantly, the complexity scores of the highest-scoring TBTF institutions show five of the top 10 are U.S. banks, including the high­est-scoring bank. The complexity score includes trading activities and tradable assets and, most importantly, over-the-counter (OTC) derivatives, the latter category now cleared through the regulatory-mandated CCP regime.

Rama Cont paper: rather than eliminating counterparty risk, central clearing transforms it into liquidity risk https://t.co/7OyL3Wu02D

— John Kiff (@Kiffmeister) March 3, 2017

It should be noted that the five largest U.S. banks — each holding assets worth over $250 billion — that submitted resolution plans on July 1 (Bank of America, Citibank, Goldman Sachs, JP Morgan Chase and Morgan Stanley) are compelled to unwind or hedge their derivatives positions, including their bilateral (non-centrally cleared) positions, through listed derivatives exchanges and CCPs.

In resolution scenarios presented in the public portion of their filings, any of these TBTF banks, or any other of the 520 financial institutions required to submit such plans that have material derivatives positions, would similarly be compelled to offset positions through CCPs.

The FSB’s report on CCPs’ vulnerabilities presents another scenario for the contagion of systemic risk to cascade across the global financial system, regardless of the amount of capital set aside. The backstop of additional capital, much of which can be marked down as asset prices fall in a stressed economic environment, should be assessed against a collapsed CCP scenario and further safeguards should be provisioned for. 

A forward-looking transparency regime overseen by regulators would add an early warning system to the tools regulators now have. 

Allan D. Grody is the president and founder of the Financial InterGroup of companies in the U.S., which houses strategists, consultants and researchers in financial services with particular focus on bank regulation.

The views expressed by contributors are their own and not the views of The Hill.