The costs and benefits of reducing the cyclicality of margin models

Nicholas Vause and David Murphy

Following a period of relative calm, many derivative users received large margin calls as financial market volatility spiked amidst the onset of the Covid-19 (Covid) global pandemic in March 2020. This reinvigorated the debate about dampening such ‘procyclicality’ of margin requirements. In a recent paper, we suggest a cost-benefit approach to mitigating margin procyclicality, whereby alternative mitigation strategies would be assessed not only in terms of the reduction in procyclicality they would deliver (the benefit), but also any increase in average margin requirements over the financial cycle (the cost). Strategies with the best trade-offs could then be put into practice. Our procyclicality metrics could also be used to report margin variability to derivative users, assisting them with their liquidity risk management.

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Procyclicality mechanisms in the financial system: what we know and some open questions

Robert Czech, Simon Jurkatis, Arjun Mahalingam, Laura Silvestri and Nick Vause

Financial markets reflect changes in the economy. But sometimes they amplify them too. Both of these roles were evident as the Covid-19 (Covid) pandemic materialised. As the economic outlook deteriorated, risky asset prices fell in reflection of that. And those falls were amplified as some investors reacted by liquidating assets. That also amplified increases in financing costs for companies issuing new debt or equity, which could have further damaged economic prospects. Various ‘procyclical’ mechanisms contributed to this macrofinancial feedback loop, as shown in Figure 1. This post reviews findings from research about these particular mechanisms, covering (i) how they work, (ii) how strong they are and (iii) how they might be mitigated. And, where there are gaps, it suggests new research.

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Insurance companies: amplifiers or the white knights of financial markets?

Graeme Douglas, Nicholas Vause and Joseph Noss

Risky asset prices plummeted following the collapse of Lehman Brothers in 2008. Whilst driven partly by deteriorations in fundamental news, these falls were amplified by ‘flighty’ investors that sold at the first signs of trouble. Conventional wisdom dictates that life insurers, with their long-term investment horizons, are better placed than most to ‘lean against the wind’ by looking through short-term fluctuations in asset prices. They could thereby stabilise prices when others are selling. But the structure of regulations can greatly influence insurers’ investment incentives. Using our model of insurers’ asset allocations, we find that new ‘Solvency II’ regulations reduce UK life insurers’ willingness to act as the white knights of financial markets, particularly in the face of falling interest rates.

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