Monday, January 18, 2010

Slicing margins for clearing houses poses fresh peril

Posted in the Financial Times by Aline van Duyn:

Wall Street has a lot to learn from designer handbags. Once these become the latest must-have accessory, they are regarded even more desirable when their prices go up. Indeed, marking them down can be a sure way of losing customers – no one wants a bag that is so unloved that it has to be discounted. It is such a striking phenomenon that high-end items such as this actually have a name: “Veblen goods”.

The idea is hardly new. Indeed, the economist Thorstein Veblen spotted the phenomenon and wrote about it in his 1899 paper “The Theory of the Leisure Class”. Conspicuous consumption existed then, and it still continues to thrive.

The concept applies to other situations too. If you need a defence lawyer, you are unlikely to pick the cheapest one. The problem in the financial system is that many of the shock absorbers of risk, the tools used to manage it, or even the basic loans underlying the credit markets, are priced in the same way that most goods are. The lower the price, the more people want them. Indeed, the customers for these financial instruments and loans are constantly clamouring for lower prices, and in many cases these are offered. The providers of credit and instruments such as derivatives that are used to manage credit risks are often competing for market share – creating further pressure for prices to come down.

There are plenty of examples of how this dynamic contributed to the financial crisis, and hopefully there will be much more probing of this by the Financial Crisis Inquiry Commission over the coming months.

Indeed, competition among rating agencies, bond insurers and mortgage providers is likely to have encouraged them to misprice risks. In most cases, however, complex models were rolled out that justified their approaches.

Even when the price is not lowered, the ultimate cost of the risk can fall by offering more for the same price. It is similar to the “supersize” approach that has worked so well to generate market share and profits in the fast-food industry. It is not the right business model for managing risks, however. Giving customers double the French fries for the same price might not be damaging to society as a whole – although that in itself can be debated – but when the quantities of credit exposure, default insurance or stamps of approval are pumped up, the outcome can be dangerous.

Worryingly, these dynamics are already under way among the new systemic risk shock absorber de jour – the clearing house. Regulators are pushing a growing proportion of the $600,000bn of privately traded derivatives contracts on to clearing houses, which act as a buffer if a big dealer should default. There are serious efforts under way to ensure these clearing houses can indeed handle the risks of defaults among derivatives dealers. Yet much of this is a work in progress. I’ve been told users of the clearing houses have started to ask for lower margins, on the grounds that a rival may offer a better deal. It may not be that prevalent, but such a trend could be dangerous.

Finding a way to turn clearing into a Veblen good – where pricier clearers are prized for the safety they offer – is the key to a sounder financial system. It is not easy, and the task falls to regulators, by tracking such behaviour and nipping it in the bud.

In addition, there have to be penalties for not taking the safest route – perhaps in the form of higher capital charges. It is not just about margins, but also about what is done with that money. Clearing houses investing rainy day funds in high-risk assets as a way to boost profits but may not be much use in the event of a default.

Applying the same value to managing risks as some people do to buying designer handbags and other trappings of a luxury lifestyle is the key to a safer financial system. It may increase the costs of credit, or reduce profits for Wall Street, but these trade-offs have to be analysed head-on.

That is the tough task regulators and lawmakers and the financial industry face.

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