It’s addition by subtraction. Over-the-counter derivative reform will actually add to gross domestic product by virtue of decreasing the “frequency of financial crises propagated by OTC derivatives exposure.”
That’s the conclusion of the Financial Stability Board’s recent report on the impact of OTC reform. The group of central bankers and supervisors created by the Bank for International Settlements (BIS), the FSB concluded that after all is said in done, OTC reform, including central clearing, will add about 0.12 percent to GDP.
The group arrived at this figure using several assumptions. First, the FSB estimated the cost of a crisis to gross domestic product. “We know from a previous macroeconomic assessment of regulatory reforms that the median cost of [an OTC-induced] crisis is about 60 percent of annual GDP,” the group said in its report. And using CDS spread data, the FSB estimated that the annual probability of such a crisis is 0.26 percent. Multiply 0.26 times 60 and the group comes up with a figure of approximately 0.16 percent. Pre-reform, this 0.16 percent would actually be a cost; however, once reforms kick in (and exposures are “sufficiently collateralised” with “no plausible increases in default probabilities”) the chance of an OTC-induced crisis is negligible. “Hence, the expected benefit of the reforms is around 0.16 percent of GDP,” the FSB said.
Getting to the final 0.12 percent added to annual GDP, the FSB acknowledges the costs.
“While these [OTC] reforms have clear benefits, they do entail costs. Requiring OTC derivatives users to hold more high-quality, low-yielding assets as collateral lowers their income. Similarly, holding more capital means switching from lower-cost debt to higher-cost equity financing. Although these balance sheet changes reduce risk to debt and equity investors, risk-adjusted returns may still fall. As a consequence, institutions may pass on higher costs to the broader economy in the form of increased prices.” The FSB puts the total cost at 0.04 percent of GDP and arrives at this figure by estimating the impact of increased bank lending spreads. Therefore, 0.16 minus 0.04 is 0.12.
The FSB’s report goes on to acknowledge many uncertainties that can distort its calculations, among these are non-uniform cross-border rules that can lead to regulatory arbitrage, increase systemic risk and possibly market fragmentation, increase the cost of indirect clearing, make netting less efficient, create margining and market volatility, and choke off collateral.
“As with any statistical exercise, especially one focusing on impact assessment, there are a number of uncertainties,” the FSB said. “In particular, there are a number of factors that may influence the impact of OTC regulatory reforms, but that are impossible to explicitly incorporate into the macroeconomic models used by Group members.”