Pro-cyclicality: ISDA and the FSB use the same term but want very different things

The term pro-cyclicality seems to always get people on edge. If you are in the securities financing or derivatives business these days, you never want to be associated with that label. But why?

Wikipedia says, “…In business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be pro-cyclical. That is, any quantity that tends to increase when the overall economy is growing is classified as pro-cyclical…” and “…it refers to any aspect of economic policy that could magnify economic or financial fluctuations…”

We wrote a post on November 26, 2012 about procyclicality and the FSB. In the FSB’s paper “Strengthening Oversight and Regulation of Shadow Banking, A Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos” they promoted minimum haircuts on repo as a way to lean against pro-cyclicality. From a practical point of view, what the FSB wants is for repo haircuts not to go down too far when markets are seen as less risky. It is easy to understand why traders, credit and risk people would go along with lower haircuts when they think the underlying collateral is “money good” and/or the counterparty is an excellent credit. But these lower haircuts mean higher leverage that, in turn, promotes bubbles and potential crisis. The FSB noted that corporate bonds and securitization products had a “pro-cyclical feature”.  By this, we think they must mean the paper is more fragile…and we would agree.

From the FSB paper, “…Minimum regulatory haircuts for repos and securities financing transactions (whether bilateral, tri-party or CCP) may limit the build-up of excessive leverage and reduce pro-cyclicality in the financial system via the financing of risky assets, in particular by entities not subject to prudential regulation…”

Ironically, ISDA in their paper released on November 27, 2012, “Initial Margin For Non-Centrally Cleared Swaps, Understanding the Systemic Implications” (we wrote about it in a SFM post dated November 29, 2012) also cited pro-cyclicality when arguing against high (and variable) margin levels being proposed for non-cleared derivatives. ISDA wrote, “Pro-cyclicality can be cured by moving to a regime where margin amounts are fixed at the time of transaction and not changed as markets move to a stressed condition…”

So ISDA is arguing against high IM and VM — the repo equivalent of not changing haircuts nor making calls – in the name of preventing pro-cyclicality while the FSB wants repo haircuts not to be too low, also citing pro-cyclicality as the reason. Wait a second….

In a weird way, both are right. The FSB wants to curtail leverage – and the systemic risk that comes when everyone is doing the same thing — by leaning against haircuts that are too low. ISDA knows that when IM (and probably more important variation margin) goes up suddenly, requiring large amounts of additional collateral to be posted for a given trade, some counterparties simply can’t handle it and go bust. Given the inter-connectedness of the markets, that too creates systemic risk. (The same could be said for haircuts or variation margin on repo going up suddenly.) As an aside, we would note that advocating not raising margin when markets get riskier seems a difficult argument to make stick.

Setting a maximum or capped margin in derivatives risks simply turning the market off when risk managers determine the appropriate market level is higher than the permitted level. No new trades. It reminds us of what happened in tri-party repo during the crisis: business was normal with no one changing haircuts until one day the music stopped. It was an on/off “cliff” market and that characteristic made everything much worse.

However there is a lot of cross-product leakage that can defeat regulatory limitations. To their great credit, the FSB noted that repo and total return swaps can both achieve the same end: financing a security and should be looked at together. But there are many ways to achieve the same end and inevitably one won’t be subject to the same regulatory constraints. Wall Street is really good at that. You want to go long a security and need financing, but don’t like the haircut on a repo? How about structuring a long +  financing as a forward purchase or a single stock option? If derivatives morph into futures contracts with lower margin requirements, as some exchanges are advocating, then the market risk remains, albeit with a new coat of paint. Some non-cleared derivatives are in that bucket because they are too complex to be handled by CCPs and not likely to be reincarnated as futures contracts, but never say never to Wall Street innovation. It becomes a game of risk whack-a-mole. 

A link to the ISDA paper is here.

A link to the SFM post on the ISDA paper is here.

A link to the FSB report is here.

A link to the SFM post on the FSB paper is here.

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