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Financial Stability Paper No 29: An investigation into the procyclicality of risk-based initial margin models

Author

Listed:
  • Murphy, David

    (Bank of England)

  • Vasios, Michalis

    (Bank of England)

  • Vause, Nick

    (Bank of England)

Abstract
The initial margin requirements for a portfolio of derivatives are typically calculated using a risk model. Common risk models are procyclical: margin requirements for the same portfolio are higher in times of market stress and lower in calm markets. This procyclicality can cause liquidity stress whereby parties posting margin have to find additional liquid assets, often at just the times when it is most difficult for them to do so. Hence regulation has recognised that, subject to being adequately risk sensitive, margin models should not be ‘overly’ procyclical. There is, however, no standard definition of procyclicality. This paper proposes two types of quantitative measure of procyclicality: one that examines margin variation across the cycle and one that focuses on short-term margin increases. It then studies, using historical and simulated data, various margin models with regard to both their risk sensitivity and the proposed procyclicality measures. It finds that models which pass common risk sensitivity tests can have very different levels of procyclicality. The paper recommends that CCPs and major dealers should disclose the procyclicality properties of their margin models, perhaps by reporting the proposed procyclicality measures. This would help derivatives users to anticipate potential margin calls and ensure they have adequate holdings of or access to liquid assets.

Suggested Citation

  • Murphy, David & Vasios, Michalis & Vause, Nick, 2014. "Financial Stability Paper No 29: An investigation into the procyclicality of risk-based initial margin models," Bank of England Financial Stability Papers 29, Bank of England.
    • Handle: RePEc:boe:finsta:0029
    Note: http://www.bankofengland.co.uk/financialstability/Pages/fpc/fspapers/fs_paper29.aspx
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    derivatives; financial regulation;

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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