August 26, 2013
www.bis.org/press/p130826.htm
The Macroeconomic Assessment Group on Derivatives (MAGD) today published a report on the macroeconomic effects of OTC derivatives regulatory reforms.
In this report, the MAGD focuses on the effects of (i) mandatory central clearing of standardised OTC derivatives, (ii) margin requirements for non-centrally cleared OTC derivatives and (iii) bank capital requirements for derivatives-related exposures. In its preferred scenario, the Group found economic benefits worth 0.16% of GDP per year from avoiding financial crises.
It also found economic costs of 0.04% of GDP per year from institutions passing on the expense of holding more capital and collateral to the broader economy. This results in net benefits of 0.12% of GDP per year. These are estimates of the long-run consequences of the reforms, which are expected to apply once they have been fully implemented and had their full economic effects.
The MAGD was set up by the OTC Derivatives Coordination Group (ODCG), comprised of the Chairs of the Basel Committee on Banking Supervision (BCBS), the Committee on the Global Financial System (CGFS), the Committee on Payment and Settlement Systems (CPSS), the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO). It comprises financial and economic modelling experts from 29 central banks and other authorities, chaired by Stephen Cecchetti, Economic Adviser of the Bank for International Settlements (BIS).
Executive summary (excerpts)
In February 2013, the Over-the-counter Derivatives Coordination Group (ODCG) commissioned a quantitative assessment of the macroeconomic implications of over-the-counter (OTC) derivatives regulatory reforms to be undertaken by the Macroeconomic Assessment Group on Derivatives (MAGD), chaired by Stephen G Cecchetti of the Bank for International Settlements (BIS). The Group comprised 29 member institutions of the Financial Stability Board (FSB), working in close collaboration with the IMF. Guided by academics and other official sector working groups, and in consultation with private sector OTC derivatives users and infrastructure providers, the Group developed and employed models that provide an estimate of the benefits and costs of the proposed reforms. This report presents those findings.
Counterparty exposures related to derivatives traded bilaterally in OTC markets helped propagate and amplify the global financial crisis that erupted in 2008. Many of these exposures were not collateralised, so OTC derivatives users recorded losses as counterparty defaults became more likely or, as in the case of Lehman Brothers, were realised. Furthermore, since third parties had little information about the bilateral exposures among derivatives users, they became less willing to provide credit to institutions that might face such losses.
In response, policymakers have developed and are implementing reforms aimed at reducing counterparty risk in the OTC derivatives market. These include requirements for standardised OTC derivatives to be cleared through central counterparties (CCPs), requirements for collateral to be posted against both current and potential future counterparty exposures, whether centrally cleared or non-centrally cleared, and requirements that banks hold additional capital against their uncollateralised derivative exposures.
While these reforms have clear benefits, they do entail costs. Requiring OTC derivatives users to hold more high-quality, low-yielding assets as collateral lowers their income. Similarly, holding more capital means switching from lower-cost debt to higher-cost equity financing. Although these balance sheet changes reduce risk to debt and equity investors, risk-adjusted returns may still fall. As a consequence, institutions may pass on higher costs to the broader economy in the form of increased prices.
This report assesses and compares the economic benefits and costs of the planned OTC derivatives regulatory reforms. The focus throughout is on the consequences for output in the long run, ie when the reforms have been fully implemented and their full economic effects realised. The main beneficial effect is a reduction in forgone output resulting from a lower frequency of financial crises propagated by OTC derivatives exposures, while the main cost is a reduction in economic activity resulting from higher prices of risk transfer and other financial services.
These long-run benefits and costs depend on how the reforms interact with derivatives portfolios and affect the structure of the derivatives market more broadly, as this can significantly alter the amount of netting obtainable from gross counterparty exposures. In response, the Group analysed three scenarios that differ mainly in terms of the assumed degree of netting. [...]
Briefly, the main benefit of the reforms arises from reducing counterparty exposures, both through netting as central clearing becomes more widespread and through more comprehensive collateralisation. The Group estimates that in the central scenario this lowers the annual probability of a financial crisis propagated by OTC derivatives by 0.26 percentage points. With the present value of a typical crisis estimated to cost 60% of one year’s GDP, this means that the reforms help avoid losses equal to (0.26 x 60% =) 0.16% of GDP per year. The benefit is balanced against the costs to derivatives users of holding more capital and collateral. Assuming this is passed on to the broader economy, the Group estimates that the cost is equivalent to a 0.08 percentage point increase in the cost of outstanding credit. Using a suite of macroeconomic models, the Group estimates that this will lower annual GDP by 0.04%. Taken together, this leads to the Group’s primary result: the net benefit of reforms is roughly 0.12% of GDP per year.
As one would expect, for the scenarios with higher and lower netting these net benefits are respectively slightly higher and slightly lower. Importantly, the Group concludes that the economic benefits are essentially constant across scenarios because the reforms demand collateralisation of the vast majority of net counterparty exposures, whatever their size. But shifting between netting and collateralisation does affect the estimated costs and hence the net benefits.
Uncertainties arising from a combination of modelling limitations and data scarcity were handled in a variety of ways. First, examining a variety of macroeconomic models helped the Group to improve the precision of estimates of the impact of the reforms’ direct costs on the real economy. Second, by varying the structure of the network of bilateral OTC derivatives exposures within feasible limits as well as the strength of the relationship between losses on these exposures and the creditworthiness of the institution incurring them, the Group managed two other potentially large uncertainties. And finally, while some assumptions bias the results towards higher net benefits, many deliberately bias them in the other direction. For example, the funding costs of increased collateral and capital holdings were based on historical prices, rather than prices that reflect improvements in credit quality associated with these balance sheet changes.
In the course of completing the analysis reported here, the Group encountered a number of technical challenges. One related to a shortage of information about the structure of the OTC derivatives exposure network. In the absence of data on bilateral exposures, these were estimated using aggregate data and distributional assumptions. Conversations with derivatives users, infrastructure providers and regulators then helped to validate the estimated network. More generally, the Group found little prior analysis of how derivatives can affect the economy.
Despite statistical uncertainty and the need to make various modelling assumptions and to employ only the limited data available, the group concludes that the economic benefits of reforms are likely to exceed their costs, especially in the scenarios with more netting. Therefore, to maximise the net benefit of the reforms, regulators and market participants must work to make as many OTC derivatives as possible safely centrally clearable, with either a modest number of central counterparties or with central counterparties that interoperate. This should include efforts to harmonise the rules governing cross-border transactions, so that market participants have equal access to CCPs.
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