Warding Off Financial Market Failure: How to Avoid Squeezed Margins and Bad Haircuts

Regulators aiming to ward off the next financial market failure need to implement rules to smooth the boom-bust cycle in margin requirements and haircuts used in securities financing and derivative transactions, which seriously exacerbated the last financial crisis. In this study, the author argues that key elements in a system-wide regulatory framework should include rules to mitigate swings between loose terms for margins and haircuts in boom times, and tightened terms during busts. Longworth emphasizes “through-the-cycle” haircuts and initial margins, the potential use of add-ons to haircuts and margins by macroprudential authorities, and market practices that are less procyclical than they were before and during the crisis.