EU to Require Only 10 Million Euros of Capital for CCPs?

Bloomberg reports that a European Parliament committee voted that clearinghouses should have to hold capital of at least 10 million euros ($14.1 million) to absorb possible losses. Assuming the 10 million euro figure is not a typo, is that figure dangerously low?

Protection against CCP member default comes from four sources:

o Collateral provided by the member

o An insurance fund, consisting of contributions by members

o The capital of the CCP

o Limited commitments by members to contribute additional amounts if required

Absent regulatory requirements to the contrary, a CCP may theoretically maintain the same degree of safety with more or less capital, provided other elements of risk protection are adjusted accordingly. Therefore, there is no absolute minimum amount of capital that is theoretically correct; a CCP could operate as safely with zero capital as it could with $1 billion of capital, provided other requirements are adjusted.

Furthermore, a CCP with little capital may be safer than a CCP with a large amount of capital if the CCP clears only limited amounts of swaps, or swaps that involve little credit risk.

The benefit of a lower level of minimum required capital is that it facilitates entry by new competitors. This potentially helps encourage innovation and makes for better pricing. However, given the significance of netting benefits, the large investment in IT and sophisticated staff necessary for strong risk management and the networking benefits of concentration of clearing in a single CCP, CCPs tend to be natural monopolies, at least within a product class. So it is questionable whether encouraging competition is a desirable regulatory objective.

Nevertheless, politically the idea of facilitating entry in the clearing market appears to have great appeal. Requiring a high level of capital would tend to perpetuate incumbents and allow entry only by large players, such as CCPs formed by the major global banks.

Chicago Fed's Evans on Supervision of CRE Lending

Charles Evans, President of the Federal Reserve Bank of Chicago, has a front-line view of what went wrong in supervision of bank lending in the commercial real estate sector. An excerpt from his April 15 speech:

"In June of 2007, only 1.8 percent of these loans held by depository institutions were noncurrent. By the end of 2010 this fraction had increased sixfold. For the riskier construction and land development sector, things were even worse, with 16 percent of loans noncurrent at the end of 2010 compared to only 1.4 percent in June 2007.

"What could forward-looking prudential regulation have done to mitigate this deterioration in the commercial real estate market? When I asked my supervisory staff this question, their answers were a bit discouraging. The consensus was that we needed to act very early, probably in 2004 or 2005. But this was two or three years before the problems in this sector became clear. Realistically, it would have been very difficult to argue in 2005 that it was necessary to rein in this lending. The banks would give very good arguments why their business was well controlled. They would stress that the CRE loans on their books would be securitized and sold off in short order. Furthermore, real estate prices were rising, delinquencies were almost nonexistent, and various hedges were implemented. I wish it weren’t so, but given such arguments, it takes extraordinary confidence to make a contrarian call and rein in a profitable line of business that at the time faces negligible difficulties. In summary, prudential supervision is critical but can be difficult to implement perfectly."

Mervyn King's Grand Bargain for Global Rebalancing

Bank of England Governor Mervyn King argues we need a "grand bargain" to rebalance unsustainable national surpluses and deficits; if we don't we face 1930s-style protectionism:

"Such a 'grand bargain' should be the central objective of the G20's Framework for Strong, Sustainable and Balanced Growth. It would require a shared analysis, seemingly absent at present, of the relative importance of the 'good' and 'bad' aspects of the imbalances. And it should comprise (i) an agreed path for the reduction or increase of net exports relative to domestic demand; (ii) an agreed framework for allowing real exchange rates to support the path for unwinding the imbalances; (iii) a set of rules governing the circumstances in which countries would be able to limit short-term capital flows; (iv) macro-prudential policies to limit the build-up of imbalances and add to the instruments available to pursue financial stability; and (v) structural policies, including fiscal measures, to raise national savings in deficit countries and to lower savings in surplus countries."

The Wall Street Journal comments on the slow progress G-20 is making toward such a bargain. "At a meeting in Paris last month, which King attended, it took three days of negotiations before G-20 finance ministers agreed on a set of indicators for policies that contribute to global imbalances. . . . Advanced economies appear to want to move more quickly than developing nations, chiefly China, which is fighting a rearguard action to defend its managed exchange rate."

Jeremy Warner of The Telegraph challenges King's thesis, observing, "There is something fatuous and even faintly ridiculous about blaming the Chinese – GDP per head less than a fifth that of the US – for Western ills. One of the prime reasons why imbalances are fast reasserting themselves after the hiatus of the financial crisis is that rather than letting the economic adjustment run its course – which would have largely solved the problem – Western policy makers have instead been desperately trying to support domestic demand with loose monetary and fiscal policy."

Bagehot: Hazlitt and Macaulay Were Models of Style

"His models of style were probably Hazlitt and Macaulay. Burke also he must have read with close attention, but then Burke, far more than Hazlitt, wrote in the grand style, and one suspects that Bagehot secretly felt the grand style, especially in prose, to be a breach of true English reserve. Writing so lofty, so poetic, so extravagantly passionate, could scarcely awaken emulation in a literary young business man."

-- from Walter Bagehot, by William Irvine (1939)

Richmond Fed President Lacker Discusses Stress Testing

Jeffrey M. Lacker, President of the Federal Reserve Bank of Richmond, talked about stress testing at the 2011 U.S. Monetary Policy Forum:

"I would like to close with some general comments on the use of stress tests. As I have said, they have proven their usefulness in the crisis. Quantifying the risks at large financial institutions is a complex and costly process that is vulnerable to manipulation. A disciplined and well-organized supervisory process for validating those assessments strikes me as well worth the costs. Stress tests are not a panacea, however. In a sense they are only as good as the imagination of the scenario designers, who need to resist the temptation to dismiss extreme scenarios as too far-fetched or focus too much attention on preparing for the last war.

"One critical question about stress tests is whether or not to disclose the results, and if so, at what level of detail. A good case can be made for transparency; stress tests provide quantitative assessments that are forward-looking, independently certified and methodologically comparable across institutions. On the other hand, there can be good reasons to restrict the release of bank-specific supervisory information. As is often the case in financial regulation, the answer is not as obvious as it might seem." (footnote omitted)

Bagehot: Dignified Love Letters

"A quiet body of readers are aware that in his time Walter Bagehot decently occupied a prominent position in the financial world, that he made money unobtrusively, that he gravely edited a grave journal and wielded a powerful influence in the 'City,' that he published a few sedate tomes in later years and a few dashing essays in youth, and that in middle life he wrote dignified love letters to his future wife."

-- from Walter Bagehot, by William Irvine (1939)

Overreliance on Credit Ratings - ECB Comments

The European Central Bank published a comment in response to the European Commission's public consultation on credit rating agencies, addressing a wide range of topics. For example, concerning the use of external ratings in the mandates and investment policies of investment mangers, ECB said,

"Regarding the use of external ratings in investment mandates and policies, the Eurosystem suggests that for those markets and funds where it is assessed that decisions triggered by these mandates have significant economic value for the firm and a potentially significant impact on markets, introducing a flexibility clause in the investment mandates might reduce the simultaneous and forced selling of distressed securities. The advantages of introducing a flexibility clause in investment mandates are associated with a) the relative ease and speed to implement this measure and b) the contribution to mitigating cliff effects of ratings downgrades."

Other topics addressed include the use of ratings for internal risk management purposes; application of standardised approaches under the Basel II framework; enhancing transparency and monitoring of sovereign debt ratings; enhancing competition in the credit rating agency industry; civil liability of credit rating agencies; and potential conflicts of interest due to the "issuer pays" model.