Eugene Grygo, Chief Content Editor, FTF News
A new white paper from the Office of Financial Research (OFR), a division of the U.S. Treasury Department, has found that when big banks conduct their stress tests they should be more aware of the dire consequences that indirect counterparties of credit default swaps (CDSes) can have.
In fact, the new research suggests that the indirect results are nine times greater than the direct impacts of CDS counterparty problems.
A piece earlier this month by Stacey Schreft, deputy director for research and analysis at the OFR, cites the authors of a “working paper,” dubbed, “Stressed to the Core: Counterparty Concentrations and Systemic Losses in CDS Markets” as uncovering this problem.
Schreft oversees an interdisciplinary team of researchers and analysts that yield fundamental research, current analysis and policy studies on a financial stability subjects for the OFR.
The authors find that “banks’ exposures in the credit default swap market under stress are concentrated in a small number of counterparties. Banks’ indirect exposures to the same counterparties also are potentially much larger than their direct exposures.”
The OFR authors of the paper — Jill Cetina, Mark Paddrik, and Sriram Rajan — apply the same stress test scenarios that the Federal Reserve used for its stress tests in 2013, 2014, and 2015, Scheft says.
“The Federal Reserve’s test, known as the Comprehensive Capital Analysis and Review (CCAR), stresses the trading books of the largest U.S. bank holding companies (BHCs),” Scheft says. “In CCAR, banks must consider the default of the counterparty that would owe the bank the most money on credit default swaps during a stress event.”
While this CCAR stress scenario for swaps “is relevant given events like those involving American International Group, Inc. (AIG) during the financial crisis,” the OFR working paper has found “two potential limitations to the approach of considering only the largest counterparty.”
“First, CCAR considers BHCs’ direct counterparty concentrations, not indirect ones,” Scheft says. “Access to data on the full U.S. CDS market allowed the authors to stress CDS positions for both BHCs and non-BHCs. The authors compared the direct impact of the default of a BHC’s largest counterparty with the impact of indirect losses of the largest counterparty on the BHC’s other counterparties.”
The authors learned that the “indirect effects can be as much as nine times larger than the direct impact on the BHC. As a result, ignoring indirect effects could understate the stress on banks. The authors also find instances when the BHC’s largest counterparty would not be the source of the largest indirect effects.”
The other limitation uncovered by the authors “compared the risks that BHCs face individually to what they face as a group.”
The authors applied a concentration index “that quantifies how much each counterparty would owe to the banking system as a whole under the 2015 CCAR stress scenario.” The researchers have found that those payoffs would be highly concentrated.
The authors also found a key shift in the U.S. CDS market.
“Between 2013 and 2015, BHCs have moved from being net sellers of protection to net buyers,” Scheft says. “This change suggests a shift of risk from the banking sector to nonbanks. The authors also show that the concentration of banks’ counterparty exposures has increased.”
These findings are disturbing but they may help stress tests to be more accurate.
As the working paper makes the rounds, they might spur a real debate on how protect against credit default swaps. Better yet, the research might cause a discussion of how to get rid of them entirely.
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