Regulations to Reduce Systemic Risk to Be Sidestepped?

Collateral transformation: turning a pig’s ear into a pig’s ear not so cloaked in a silk purse?

More obviously troubling was a Bloomberg story on how major financial firms are going to undermine the effectiveness of clearinghouses by engaging in “collateral transformation”:

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead. [emphasis added]

[And:]

U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment

Translation: the regulators are aware of the banks’ plans to finesse the clearinghouse requirements, and they neither intend to put a kebosh on it (which could easily be done by taking the position that any collateral transformation to meet clearinghouse requirements was an integrated part of the clearinghouse posting and could not be done separately on bank balance sheets) nor understand the impact of their flatfootedness.

Finally:

It seems that Richard Bookstaber’s observation can’t be repeated enough: in tightly coupled systems, the only way to reduce risk is to reduce interconnectedness. Otherwise, measures to reduce risk actually wind up increasing it. And that looks to be precisely what the introduction of clearinghouses will achieve.

Read Yves Smith’s whole article: Quelle Surprise! Regulatory Measures to Reduce Systemic Risk Are Proving to Be Ineffective, Possibly Counterproductive « naked capitalism.

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