On Wednesday, the Bank for International Settlement’s Committee on the Global Finance System (CGFS) published a report entitled “The Role of Margin Requirements and Haircuts in Procyclicality,” which reviews the impact of haircut-setting and margining practices in securities financing and over-the-counter derivatives transactions during the financial crisis.
In 2009, the CGFS published a report in which it identified haircut-setting in securities financing transactions and margining practices in over-the-counter derivatives as a source of procyclicality. In that report, the CGFS recommended exploring whether minimum haircuts or initial margins could help to reduce procyclicality. In light of this recommendation, the CGFS requested that a Study Group, chaired by David Longworth of the Bank of Canada, explore various options for reducing procyclical effects on financial markets.
The latest report recommends a series of policy options “to dampen the build-up of leverage in good times and soften the systemic impact of the subsequent deleveraging,” including:
- Discouraging the use of contractual terms that require market participants to be subject to frequent variation margin payments;
- Reassessing collateral requirements, preferably on a daily basis, when the mark-to-market losses on derivative trading exceeded threshold amounts;
- Disallowing the use of credit triggers as a factor for decreasing the estimated exposure at default;
- Requiring regulated market participants to have liquidity risk management systems;
- Encouraging supervisors to review the policies and risk management practices for possible procyclical impacts; and
- Improving the stability of the supply of secured financing by developing best practice guidelines for negotiating terms and requiring improved disclosure of the risks underlying reinvestment activities.
The report also makes two recommendations for further consideration:
- Setting capital requirements on securities financing for banks and broker-dealers on the basis of considerations that under normal circumstances are relatively stable through the cycle, including consideration of the prudential impacts and practical implications of imposing a countercyclical add-on which can be used by macroprudential authorities to make discretionary changes to capital requirements on secured lending.
- Promoting the use of properly risk-proofed central counterparties (CCPs) that mitigate counterparty risk concerns for clearing standardized derivative instruments and seriously consider the use of such counterparties – among other options – for securities financing transactions, including review by supervisors and other relevant authorities of the policies and risk management practices of central counterparties for possible procyclical impacts related to haircuts and margins and considering the prudential impacts and practical implications of imposing, through the CCPs, minimum constant through-the-cycle margins and haircuts, with a possible countercyclical add-on.