Clearing and the Fed: A Hobson’s Choice

The issue of the systemic risks posed by a clearing mandate that expands the scale and scope of central counterparties has come to the fore of late.  Too late, perhaps, but even at this late date it is an advance.

The focus of this concern is now on whether CCPs will be too big to fail, and whether they should have access to the Fed’s liquidity provision facilities.

Now that the financial defo . . . I mean “reform” bill is on the verge of passage, with (a) a clearing mandate, and (b) a provision granting CCPs access to the Fed, as one of the people who raised the profile of this issue I should restate my views.

First, yes, the clearing mandate will make CCPs a much more integral part of the broader financial system; CCPs can fail; a failure would be catastrophic; and hence CCPs are likely too big to fail.

TBTF is pernicious.  So how to deal with it?  In this instance, by not mandating clearing and thereby creating new TBTF institutions.

But it looks like a clearing mandate is inevitable, so the question becomes: given that CCPs are crucial financial institutions whose failure threatens the stability of the financial system, should they have access to the Fed?

Here, my answer is a qualified yes.  The Fed has legitimate lender of last resort functions that involve the supply of liquidity to solvent institutions during times of liquidity crises.  CCPs can be prodigious consumers of liquidity, especially during times of market stress that induce big price movements that trigger big flows of margin money.  A solvent CCP could face a severe liquidity crunch in such circumstances, and access to Fed liquidity, either directly, or indirectly (a la 1987) can prevent this liquidity crunch from causing the failure of a CCP–which would have serious systemic consequences.  These consequences include the closure of markets, large moves in asset prices, and asset fire sales.  Thus, if one could trust the Fed to be a classical Bagehotian LOLR, lending to solvent institutions against good collateral, permitting CCP access to the Fed’s liquidity programs could improve the stability of the financial system.  This would make a disastrous meltdown of CCPs due to liquidity problems less likely.

But that “if one could trust the Fed” clause is why my answer is a qualified one.  The truth is that the Bernanke Fed has stretched and bent the Fed’s legitimate LOLR functions beyond recognition in a way that must have Bagehot spinning in his grave.  Many of its actions (e.g., AIG) can legitimately be seen as bailouts that exacerbate moral hazard problems going forward.  As a result, there is reason for legitimate concern that giving the Fed a new set of institutions to bail out is a very bad thing indeed.

But the problem is that although cutting off CCPs from the Fed altogether would preclude it from bailing them out, it would also preclude legitimate liquidity support.  It is difficult to say, here and now and in the abstract, whether this package deal is superior to the alternative–a risk of bailouts, but the ability to prevent future liquidity crises from blowing up CCPs.   As it stands, that is the choice.  It is a stark one, and not an easy one to make.

This illustrates a fundamental problem with a lot of the financial regulation debate.  The issues that are being debated are the consequence of underlying problems that remain unaddressed.  In the present instance, the underlying issues are (a) the role, power, and discretion of the Fed, and (b) clearing mandates that expand clearing, and expand it into more problematic and difficult areas.  Clearing mandates have been a given from almost the beginning.  The Fed’s role has been debated, but it has emerged from the process as powerful, or more powerful than before.  The failure to address these underlying issues is why we are confronted with the Hobson’s choice between risking CCP bailouts and being unable to respond to CCP liquidity crises.

The increasing angst over the Hobson’s choice should have led to a serious rethink of clearing mandates.  To spark such a rethink was one reason why I have hammered on this issue for some time.  But that hasn’t happened; since the whole rationale for clearing was to reduce systemic risk, to proceed apace with mandates even as it became evident that CCPs created their own systemic risks and then argue over how to deal with that consequence was irresponsible in the extreme.  It should have also led to a more searching evaluation of how to constrain the Fed to its legitimate Bagehotian LOLR role.  That hasn’t happened either.

Well, Congress has made its choices, and we’ll all have to live with them.  It’s summertime, but the living ain’t easy.