A group of central bank officials, known as the Committee on the Global Financial System, released a report today recommending changes to market practices and regulatory policy to combat procyclicality in financial markets.

On Tuesday, the group published a report prepared by a study group chaired by Bank of Canada Deputy Governor David Longworth. The report examines the effect of haircut-setting and margining practices in securities financing and over-the-counter derivatives transactions during the financial crisis.

It found that in the run-up to the crisis, “the increasing availability of secured financing, the rising volume of trading in over-the-counter derivatives and the easing of credit terms — including the erosion of haircuts — contributed to the growth in leverage.” Additionally, securitization helped broaden the range of assets eligible as collateral for secured lending.

“High credit ratings, ample liquidity and low financial market volatility during this period increased the level of comfort of borrowers with their reliance on secured funding, and the comfort of lenders with, in many cases, modest and declining haircuts,” it found.

However, when market conditions crumbled, “the gradual erosion of lending terms during the period of high liquidity and low volatility was abruptly reversed” it found. “As valuation uncertainties for many structured products rose in 2007, haircuts on these securities were raised, forcing a few highly leveraged market participants to liquidate their holdings. A further significant and rapid tightening of the secured lending terms on a range of assets took place in 2008 that led to a contraction of the supply of secured financing and exacerbated deleveraging pressures.”

As a result, the report recommends several changes to market practices designed to dampen the build-up of leverage in good times, and soften the system-wide effects during a market downturn. It also recommends that policymakers consider measures that involve countercyclical variations in margins and haircuts, and enforcing higher and relatively stable through-the-cycle haircuts for securities financing transactions.

CGFS chairman, Donald Kohn, said that he anticipates that this report will inform policy deliberations on how to reduce financial system procyclicality.

IE