While most of our discussion on financial regulation is centered on banks and bank holding companies (BHCs) it is the interconnectedness of the current financial system that is the main mechanism through which financial shocks can spread and imperil the entire financial system.
A new paper published by NBER discusses how central counterparties (CCPs) play a role in regulatory stress tests of financial institutions:
Stress tests applied to individual institutions are an important tool for evaluating financial resilience. However, financial systems are typically complex, heterogeneous and rapidly changing, raising questions about the adequacy of conventional tests. In this paper, we interpret the current stress test practice from a network perspective, highlighting central counterparties (CCPs) as an example of a critical network hub. Networks that include CCPs involve deep and broad interconnections, making stress testing a challenging task. We analyze supplementing both private and supervisory CCP stress tests with a high-frequency indicator constructed from a market-based estimate of the conditional capital shortfall (SRISK) of the CCP’s clearing members. Applying our measure to two large CCPs, we analyze how they can transmit and amplify shocks across borders, conditional on the exhaustion of prefunded resources. Our results highlight how the network created by central clearing can act as an important transmission mechanism for shocks emanating from Europe.
For context, a CCP is a financial institution that functions as a sort of middleman between buyers and sellers in a financial market. CCPs have grown significantly since the 2008 financial crisis. Unlike “over-the-counter” trading, where buyers and sellers interact directly, a CCP will process the transactions while assuming much of the risk from the underlying assets or one party’s inability to pay.
CCPs are also massive. The largest CCP in Europe, LCH Clearnet, holds $330 trillion in gross contracts outstanding.
The paper shows that because CCPs are used by many financial institutions to execute trades, they create networks that resemble a “hub-and-spoke” network (though the overall web of the financial sector is far more complex). While this model mitigates the risk of any one financial institution’s collapse directly affecting other banks, stress to the CCP has ripple effects that could throw the entire financial system into turmoil. And, while stress testing of the CCPs has progressed significantly, the authors recommend better incorporating the “topography” of these institutions into the models.
While stress testing is important, it’s important to keep in mind future crises may not resemble those of the past (or even those anticipated by the stress tests). When taking into consideration the nature of financial networks and CCPs, raising capital requirements becomes even more important for CCPs and banks, as the failure of the latter could spark a crisis at the former.