Major Bank Failure Could Spur Losses of Over $1,500 Billion
The failure of a single major financial institution could result in losses to the OTC derivatives market of $300-$400 billion, a new working paper* finds. What’s more, since such a failure would likely cause cascading failures of other institutions, the total global financial system losses could exceed $1,500 billion, according to the paper by International Monetary Fund staff. The paper does not represent the IMF’s official view.
The over-the-counter (OTC) derivatives market has grown sizably in the past two years. Notional amounts of all categories of the OTC contracts reached almost $600 trillion at the end of December 2007. These include foreign exchange contracts, interest rate contracts, equity linked contracts, commodity contracts, and credit default swaps (CDS) contracts.
The paper attempts to quantify counterparty risk that may stem from the OTC derivatives markets. The risk is measured by losses that may result via the OTC derivative contracts to the financial system from the default (or fail) of one or more banks or broker dealers.
If indeed the results of our scenarios are illustrative, counterparty risk is large (and especially large where cascade effects result in more than one bank or prime broker failing).
“In addition, the re-pricing risk following a counterparty failure cannot be easily quantified. Pressure to re-hedge at such times will be enormous and perhaps unaffordable, which could lead to unanticipated pressures on the financial system.”
In light of this, the paper offers the following suggestions to reduce counterparty risk in the OTC derivatives
market:
- “Cross margining” requirements across product silos could be encouraged further. For example, allow cross netting across legal entities for CDS and repo contracts.
- With the Fed offering previously unavailable facilities to prime brokers (e.g.,Term Auction Facility Loans and Primary Dealer Credit Facility), all major derivative players (not only commercial banks) might be induced to go through a central clearing system, irrespective of their idiosyncrasies.
- The recent voluntary “commitment” to reform by the major dealers (now commercial banks) may be a quid-pro-quo for the Fed; this includes 75 percent of OTC equity and derivative trades being on electronic platforms by January 31, 2009 and an auction-based settlement mechanism for CDS contracts.
- Collateral should be liquid securities and not merely of a high credit quality. Moreover collateral should be allowed to be rehypothecated. If collateral could not be rehypothecated, though, the entire financial system would be put at risk, as this is the basis of so much activity in the system.
- Changes to increase the offsetting of new trades against old ones should be allowed. This could be done by increasing the standardization of CDS contracts, by reducing the number of dates to quarterly on all CDS (EM is now monthly) and limiting the premiums eligible for new trades, such as in 25bps or 50bps increments.
*Counterparty Risk in the Over-The-Counter Derivatives Market - by Miguel A. Segoviano and Manmohan Singh.
You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.