There are six lessons to be learned from the financial crisis that are relevant for central counterparties (CCPs), according to the OCC’s John Davidson.
Davidson made the comments at the World Federation of Exchanges IOMA Conference in Chicago in the run-up to the 10-year anniversary of the financial crisis which he also referred to as the ‘Lehman Weekend’ in September 2008.
In a recent blog, he reiterated the six lessons he’d drawn from the financial crisis that he claimed should be considered by all CCPs.
He said, for one, that “Fat tails can't be underestimated—the returns on the many over-the-counter products that caused issues during the financial crisis are characterised as having ‘fat tails’. That is to say, extreme negative outcomes occur with significantly greater frequency than would be the case in the widely assumed ‘normal distribution’.”
“Those unprepared for such outcomes [...] experienced significant and sometimes material losses during the crisis. This characteristic was manifested with respect to credit risk exposures, as well as liquidity risk exposures, particularly where liquidity step-in components had been built into certain complex products.”
Davidson also claimed that for CCPs, “aggregation is a must, in managing or supervising large complex financial institutions, aggregation is extremely demanding, but critical.”
He stated: “Liquidity reigns—ultimately, it was not market or credit risk that brought many large financial institutions to the brink, it was the failure to understand the importance of liquidity.”
“The market-funded broker/dealer investment bank model that was the predominant form of organisation on Wall Street for most of the second half of the 20th century failed completely with the financial crisis. At the end of the day, the only dependable source of liquidity comes from bank deposits.”
Another lesson Davidson said should be considered is that “legal entities matter”.
He said: “It's critical to understand the exact regulatory form of your CCPs. While the long-standing instinct of a trader is to ‘book it fast and worry about the details later’ that ends up producing exposures that are virtually unfathomable. What protected clients, customers and US CCPs, and what enabled the coordinated handling of the consequences of the holding company's insolvency in the Lehman case, was the fact that its clearing member component was a fully capitalised and regulated broker/dealer and futures commission merchant.”
He further stated that “the right of set-off will be invoked”. He commented: “A fundamental component of the banking ecosystem is a bank's nearly unilateral right of set-off, which exists under common law and in specific regulations that are in place in nearly every major jurisdiction in the world.”
He concluded: “Rules matter, and flexibility does, too. A great deal of progress has been made with respect to completely appropriate regulatory oversight of CCPs and other elements of the financial infrastructure. However, one area where we've moved in the opposite direction is in regulators' unwillingness to grant flexibility to the managers of CCPs to use their professional judgment when they need to handle unanticipated events.”
“While rules, policies, procedures and associated internal documentation and governance have been greatly enhanced since the crisis, it's absolutely the case that the next systemic financial crisis will be much different from the last one. When it comes, CCPs will need the flexibility to respond to unexpected developments as the crisis plays out.”
Davidson closed by stating that when the next crisis comes along, and when unique circumstances may present themselves, the industry’s new regulatory regime will “present substantial challenges to the system”.
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