central clearing and resolution – learning some of the lessons of lehmans speech given by sir jon cunliffe, deputy governor financial stability, member of the monetary policy committee, member of the financial policy committee and member of the prudential regulation committee fia international derivatives expo 2018, london tuesday 5 june 2018 all speeches are available online at www. bankofengland. co. uk / speeches when lehman brothers failed in september 2008, the bank was a major player in the worldwide derivatives market. its $ 35 trillion portfolio of both cleared and uncleared derivatives represented around five percent of the global derivatives market. following its collapse, lehman ’ s uncleared derivative counterparties filed claims totalling $ 51billion in relation to its derivatives business. in the event, it was four years before the first payments were made to these uncleared derivative creditors, and claims against lehman ’ s are still ongoing. the contrast with lehman ’ s cleared derivatives portfolio in ccps is stark. lehman brothers uk subsidiary had a $ 9 trillion cleared interest rate derivatives portfolio at lch, comprising over 65, 000 trades. in the period of extreme market turmoil following the firm ’ s collapse, it took three weeks, rather than four years, for lch to hedge and close out the entire $ 9 trillion position. it used only around a third of the collateral margin lehman had deposited at the clearing house. lch was only one example of the ability of ccps to dampen the shock of a major credit counterparty failure. the firm had derivative portfolios at a number of ccps across europe, the us and asia. all were auctioned, liquidated or transferred to other clearing participants by the ccps in weeks, not years. and, with only one minor exception, this was achieved without exhausting the margin collateral the ccps held. i mention this aspect of the lehman failure because it illustrates the drivers behind two of the key regulatory reforms we have made as a result of the financial crisis. first, incentivising and where appropriate mandating the greater use of central clearing for derivative transactions. and second, putting in place resolution regimes to ensure banks, particularly large, highly interconnected, wholesale market players, can fail without unleashing the disruption that followed the lehman insolvency. i want to look today at the progress we have made in the post crisis reforms around derivatives and how we address the risks around the concentration of counterparty risk in ccps – including what the objectives should be for

time, if better risk measurement or other techniques lead to a reduction in the risk taken. that said, looking at the appropriate level of capital in this way still means that we have to be able to measure the current confidence level for g10 bank insolvency which is established by the existing accord. this is not an entirely straightforward task. one starting point could be the ratings of g10 banks. the median rating of banks, taking the entire rated g10 population of more than 300 banks, is a1 on the moody ’ s scale, or a + on the standard and poor ’ s scale. this would indicate a near - invisible insolvency probability for such banks over a 1 year horizon. however, this very small insolvency probability does reflect two factors which ideally we would wish to discount. first, the ratings reflect the bank ’ s actual capital level which will in most cases be significantly above the regulatory minimum. and second, in some cases the rating also reflects the agency ’ s expectation that public support would be forthcoming for the bank, which of course we would wish to strip out. a more accurate measure of the confidence level established by the basel 8 % would be the “ standalone ” ratings produced by some agencies, for those banks whose capital is at or close to the basel minimum. even on this basis, nearly all such banks are rated above investment grade. the message therefore from this view of the matter is that under the new accord we should be targeting a minimum level of regulatory capital for our g10 internationally active banks that is at least consistent with an investment grade rating. an alternative way of assessing the regulatory soundness standard would be on a “ bottom up ” basis, that is by modelling the probability of default arising from a typical credit portfolio if the bank held only the basel minimum capital. the advent of credit risk modelling techniques such as creditmetrics allow such an exercise to be attempted. any results under this sort of approach need to be treated with a fair amount of caution, given the number of assumptions involved. the work we have done at the bank, experimenting with these models and using different parameters, at least supports the proposition that g10 international banks ( the target constituency for the accord ) should have capital on the basis of a one - year default probability that is consistent with an investment grade rating. assuming that we can somehow identify the current confidence level implicit in the existing capital accord, we may, as i suggested above, nevertheless want to debate the question of