Thursday, August 22, 2013

European Parliament Skeptical of FSB Approach to Minimum Haircuts

In an effort to combat the pro-cyclicality caused by changes in repo and securities lending haircuts during a crisis, the Financial Stability Board has proposed to introduce minimum standards for the calculation of haircuts.  In the belief that higher haircuts would curb the procyclical effect of risky assets and curtail the build-up of excessive leverage, they are also considering putting a floor under haircut calculations.   Responding to these recommendations, the European Parliament's Directorate General for Internal Policies has issued a paper entitled, "Shadow Banking - Minimum Haircuts on Collateral." The white paper assesses and responds to the recommendations of a Financial Stability Board working group on the effectiveness of minimum haircut levels as a tool to enhance stability in the financial market.

Overall, the European Parliament paper welcomes the the FSB's proposals to implement more rigorous methodologies for calculating haircuts and collateral revaluation and margining procedures.  The EU white paper finds:

  • The minimum standards for calculating haircuts recommended by the FSB do reflect best market practice. However, market practice in Europe varies very widely. 
  • Moreover, the use of haircuts in the European repo market is selective. The minimum standards should recommend that firms calculating haircuts consider some additional factors such as the delivery period for margins, the existence of legal documentation, thresholds for margin calls, margin disputes and delivery failures.

However, they also point out that in order to to be fully effective more refined market data will be required to support these haircut calculations.  They note that better data should become available through initiatives to improve market transparency, but those initiatives have not reached full effect yet.

Regarding whether minimum haircuts should be mandated, the European Parliament is skeptical on a number of fronts.  The white paper finds:

  • It is not clear how much impact the FSB proposal for mandatory minimum haircuts will have in the European market given the preponderance of high-quality collateral, assuming that the proposal is limited to risky assets. 
  • The proposal will add to the expense of funding and drag on the efficiency and liquidity of the market, as well as conflicting with the regulatory objective of greater collateralisation. It may also shift borrowing back towards the unsecured market. 
  • A serious objection to mandatory minimum haircuts is that changes in haircuts did fuel pro-cyclicality in the 2007-09 crisis and so the proposal would prove ineffective in a future crisis while imposing immediate costs on the market. 
  • The use of asset types and remaining term to maturity as criteria for identifying risky assets is crude and often inaccurate. Risk should be measured in terms of the long-term volatility of prices against a low-risk benchmark. 
  • The High-Level approach to minimum mandatory haircuts is likely to encourage the market to gravitate to these floors as ‘de facto’ standards. The Back-Stop Level approach is therefore the least-worst option but may not achieve the objective of reducing pro-cyclicality and excessive leverage unless regulators enforced standards in the calculation of haircuts. The Back-Stop Level floors could be used as a monitoring tool here, rather than as a limit. Alternatively, the High-Level and BackStop Level approaches could be combined, with the latter available to firms meeting certain standards in the way they calculate haircuts and the former for all others. This compromise would be similar to that available in the calculation of haircuts for the adjustment of loss-given-default under Basel. 
  • The proposal to exempt securities lending transactions which do not contribute to pro-cyclicality or leverage from minimum mandatory haircuts would be difficult to implement.
  • While transactions between regulated financial intermediaries should be exempt from mandatory minimum haircuts, other regulated entities should be exempted as well. The most efficient and simplest application would be at the interface between the regulated and ‘shadow banking’ sectors.

The white paper also recognizes that mandatory minimum haircuts are controversial and also raises some doubts about their effectiveness and the potential for evasion.

. . . perhaps most problematically, there is strong evidence questioning the role of changing haircuts in feeding pro-cyclicality and a serious likelihood that mandatory minimum haircuts would be circumvented by the tightening or relaxation of other credit conditions in response to increasing counterparty credit risk and vice versa. 

 The paper also points out that instituting mandatory haircuts would require more data and necessitate more precision in determining what qualifies as a "risky asset."

. . . there is not sufficient data to calibrate mandatory minimum haircuts at a level which strikes an optimal balance between dampening pro-cyclicality and the build-up of excessive leverage on the one hand and maintaining the efficiency and liquidity of the market on the other.

. . . if minimum mandatory haircuts were to be adopted, it would be important to have an objective criterion for defining risky assets. Classification of securities by type and term to maturity is crude and inexact. A better measure would be the long-term volatility of price against a low-risk benchmark. Such an empirical risk-based metric would also avoid
the need to try to carve out non-procyclical, non-leveraging securities lending transactions, given that securities lending typically relies on low-risk collateral and would automatically qualify.

At least with regard to mandatory minimum haircuts, on the whole, the European Parliament appears unconvinced that the FSB proposals would be effective in curbing  the pro-cyclicality caused by changes in repo and securities lending haircuts during a financial crisis.  Though not exactly asking the FSB to scrap its proposals, the Europeans clearly indicate that they believe the proposals are only a first draft in need of substantial revision.