Derivatives Reform: Margin Requirements Rather than Divestiture
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Blanche Lincoln’s victory in the Arkansas primary pushed a new dichotomy into our political lexicon. In the race’s final days, she boldly reiterated her support for forcing banks to spin off their derivatives desks. In the political arena, nearly every complicated issue gets boiled down to a “pro” or “anti” slogan. Get ready for members being labeled “pro-derivative” for opposing Senator Lincoln’s hard-line approach. Sadly, this is not a joke – can’t you hear a prospective challenger in 2010 saying: “as voters in this district know, my opponent has a long record of being pro-derivative…”
As the hysteria around derivatives continues with the Senate-House conference on financial regulation reform underway, let’s analyze (again) the role of margin requirements and how improving the collateral process generally would be a better approach than straight divestiture.
Credit default swaps (CDS) did more to contribute to the expansion of credit for households, businesses, and governments over the past decade than any other financial innovation. Their notional value increased from almost zero in 2000 to $62 trillion in 2007. This proved to be both a blessing and a curse; the boost to economic output provided by greater access to credit was balanced by the creation of uncollateralized counterparty risk that threatened the stability of the financial system (see AIG).
House and Senate negotiators are now working to reconcile their differing provisions regulating over-the-counter (OTC) derivatives. While the reforms being contemplated would move many derivatives to centralized exchanges, the Senate bill includes a provision to require banks to divest their swaps dealer subsidiaries. (A modified version has also been discussed, but it has the almost all of the same drawbacks as straight divestiture.) This has led to predictable protests from banks, which depend on dealing swaps for a significant portion of their total profitability. Rather than forced divestiture (or a shift within the bank holding company structure), a simpler, cleaner, and more efficient approach to the problem would be to establish uniform margin and collateral requirements for all derivatives transactions.
According to the Comptroller of the Currency, bank trading revenue from OTC derivatives exceeded $22 billion in 2009 (page 3). The Senate bill would reduce this in two ways. First, by moving derivatives to exchanges, the bill would reduce revenues from market making. Dealers profit from bid-ask spreads and the less transparent the market, the wider these spreads tend to be. Second, by creating new rules to bar the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) from extending loans or providing deposit insurance protections to “swaps entities,” the Senate bill would essentially bar commercial banks from providing these services.
The argument presented by proponents of the Senate bill is that dealing swaps is an activity fundamentally distinct from the business of banking and should be carried out by separate entities. This is not necessarily true, as CDS (and interest rate swaps before them) facilitate credit creation precisely because of their impact on lending decisions. A CDS is a contract that allows buyers to pay a premium (usually quarterly) to sellers in exchange for a financial guarantee on a specific corporation or security. Although the payoffs on a CDS are zero sum – every dollar gain in the value of the contract for the buyer is a dollar decline in the value of the contract for the seller – their availability increases the total outstanding amount of credit market obligations by providing lenders with a low cost mechanism to hedge underlying exposures.
For example, a trucking corporation seeking a $10 million loan from a bank is more likely to secure that loan if the bank can immediately transfer some or all of the default risk to another entity through a CDS referencing the trucking company. The CDS also enhances efficiency by allowing the credit risk to be unbundled and transferred to a party that seeks precisely this type of exposure. In this case, another financial institution may believe oil prices are likely to fall moving forward, which could then reduce the risk of default in the trucking sector. The CDS, therefore, provides a way to attract this institution’s discretionary risk capital to bear the credit risk and complete markets. In this scenario, it seems reasonable to regard the swaps transaction as a logical extension of the lending process and rightly performed by the bank making the loan.
The problem posed by CDS in practice is that the discretionary risk capital (or the margin/collateral requirement) is often not supplied in sufficient quantities. The counterparty providing protection on the $10 million loan to the trucking company can do so with capital equal to a small fraction of its $10 million of notional exposure. At the end of 2009, commercial banks reported $212.8 trillion of notional OTC derivatives, a figure more than three times greater than the total net worth of U.S. households and four times greater than the entire value of outstanding U.S. credit market obligations. Banks generally regard notional values as meaningless, as they post collateral according to a contract called a credit support annex. This contract allows swap participants to “net” their exposures to each counterparty and then post the requisite amount of collateral.
For example, two banks could have entered 1,000 swaps with one another with a total notional value of $100 billion. But, the “fair value” of the exposure after netting might only be $100 million (or 0.1% of notional value). Depending on the bank’s credit rating and other factors, the bank with the $100 million net exposure might have to post only $25 million to $50 million in collateral. In this way, $100 billion of notional exposure can be financed with only $25 million of capital (0.025% or 2.5 basis points). In some cases, dealers of swaps do not require other dealers to post any collateral for certain contracts.
The International Monetary Fund (IMF) estimates that aggregate under-collateralization in the OTC derivatives market is likely to be between $2 trillion and $2.5 trillion. The IMF estimates that the five largest U.S. bank holding companies have roughly $500 billion in under-collateralized derivatives exposure, while the five largest European banks owe $600 billion more to counterparties than they’ve posted in collateral. This is an enormous capital hole at the very heart of the financial system and an obvious source of systemic risk.
The IMF’s estimate of under-collateralized derivatives exposure helps to explain why dealing derivatives is so profitable and so highly concentrated among a few players. If the counterparty in the trucking example receives $300,000 per year for writing the $10 million CDS protection on the trucking company, its return on equity is 15% if it holds $2 million in liquid reserves, or 30% if it holds only $1 million in reserve. In short, the less onerous the capital and collateralization requirements, the more profitable it is for the counterparty to write protection. And if derivatives dealers provide one another with a privileged status so as not to mandate adequate collateral for dealer-to-dealer positions, then it becomes impossible for non-dealers, or dealers outside of the designated network, to compete. This explains why $206.2 trillion (96.9%) of the $212.8 trillion of OTC derivatives in the U.S. banking system were held by only five commercial banks.
The problem here is not that OTC derivatives dealing is somehow alien to banking or that “swaps entities” should be walled off from banks, it’s that the current regime has become cartelized by incumbents. The privileged status large banks have afforded one another has allowed them to assume risks (and collect trading revenues) with roughly $2 trillion less capital than would otherwise be necessary. While market-oriented thinkers are generally inclined to respect the sanctity of contracts, it seems clear, post-AIG, that these dealers are willing to accept less collateral from one another than they demand from other counterparties because of a belief that they’re collectively “too interconnected” to be allowed to fail.
Rather than eliminate the efficiencies that come from allowing lenders and derivatives dealers to operate under one roof, Congress should simply eliminate the advantage swaps dealers have afforded one another by mandating uniform margin and collateral requirements on all contracts. Parties wishing to insure against credit events or adverse movements in currencies or interest rates should be required to post collateral that covers the entire fair value of the position plus some additional margin to account for further movements.
Christopher Papagianis is the Managing Director of e21 and was Special Assistant for Domestic Policy to President George W. Bush.