Derivatives: have we let our guard down?

We must not lose sight of this potentially critical risk to the financial system, at a time when sovereign credit risk is impacting banks in Europe, mortgage related liabilities still affecting US banks, and declines in world economic growth risks further debt default and asset price declines.  It is at these points in time that counterparty and hence derivative risks sharpen.

A recent report by the US Comptroller of the Currency (Thanks to Zero Hedge for bringing this report to my attention) stated that “Five large commercial banks represent 96% of the total banking industry notional amounts and 86% of industry net current credit exposure”.  

Net current credit exposures (the net amount that would be owed to all banks should all contracts be settled at a point in time) were 364bn in the second quarter and it is worthwhile noting that this is not the net amount that banks owe, but the net amount that banks are owed by counterparties.  This is the relevant credit risk where no counterparty fails and if all contracts were settled immediately.  Banks held collateral against some 73% of this credit exposure.

In the event of counterparty risk, that is the risk  of one of the major players being unable to value for derivative based risk, gross positive fair values (3,942bn) and gross negative fair values (3,829bn) may be the more representative risk boundaries, especially if one of the large counterparties were to be unable to honour its derivatives payables.

Moody’s had recently downgraded a number of US banks, among which is Bank of America, one the main derivatives counterparties.  Total credit exposure of Bank of America (net current credit + potential future exposure of current contracts) was 182% of risk based capital and it is worth noting the Bank of America has other potential calls on this capital. 

If fully implemented, the provisions of Dodd-Frank could further lower systemic risk by reducing interconnectedness among large institutions and could further strengthen regulators’ abilities to resolve such firms.  However, the final form of several critical components of Dodd-Frank intended to reduce such interconnectedness, such as resolution plans or changes to the over-the-counter derivatives market, are still pending. There is also no global process yet in place whereby regulators could resolve a global financial company such as Bank of America in an orderly fashion. As a result, Moody’s believes that it would be very difficult for the US government to utilize the orderly liquidation authority to resolve a systemically important bank without a disruption of the marketplace and the broader economy.”  Taken from Moody’s Rating Action on B of A.

The average total credit exposure of the 5 main banks was some 323% of risk based capital.   This also means that net current credit exposure is some 100% of risk based capital.

These overall figures give no real indication of the underlying dynamics of derivative contract risk management and the “reinsurance type spirals” that likely exist between the main counterparties – if they represent 96% of all business, then these relationships are likely to be fairly dense.  If one bank were unable to meet a sizeable portion of its derivatives payables, this would likely affect another in a similar way.  Counterparty risk is a very real risk in the present environment. 

I produced an in depth report on the risks derivatives posed to the financial system in 2006 and stated that far from reducing risk, derivatives concentrated risk that would likely come through the financial system in a crisis.   This risk still applies.

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