OPINION: Very Short Memories

Terry Flanagan

Discussions about the concentration of risk in clearing houses and how to protect the financial system against the collapse of these systemically important institutions have come to the fore as the volume of cleared products increase.

It is right that these conversations are taking place, but we seem to putting the cart before the horse and forgetting the situation before the financial crisis. Until 2008 the mantra was that risks were so widely spread across the financial system that the failure of any one firm would be easily absorbed – and we all know how that turned out.

Regulations that force markets to increase transparency are beneficial to the system as a whole although they many not beneficial to the individual participants – such as the banks who make huge profits from opacity.

It is understandable that the large banks, who are the largest clearing members, want to ensure they understand the risk profile of a CCP and the full extent of their obligations if a CCP fails.

However it is ironic to hear banks complain they cannot fully assess their risk exposures without more disclosure from CCPs, including around stress test results.

After all, how many investors or bank analysts can fully assess the risk within a bank from any bank’s reported numbers ? Or how easy is it to compare risks across the banking system by comparing reported risk numbers as each firm uses its own risk model ?

When Vikram Pandit was chief executive of Citi he suggested that regulators should create a public benchmark portfolio of assets. In addition to reporting on their actual portfolio, institutions could also produce risk numbers for this benchmark portfolio using their individual models. This would allow investors to easily compare results and make their own judgements on which firms are being more risk adverse and which are understating risk.

This sounds sensible for both clearing members and CCPs.

Even if everybody fully understands the risks within CCPs, it is likely that there will be another financial crisis could overwhelm one or more CCPs despite their safety measures such as their collateral requirements, their default funds and their own capital. However I will bet my bottom dollar that the safety measures of banks will have been found wanting long before this happens.

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