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Banks learn to shift the risk

In an interesting note published recently by US group Payden & Rygel*, the question as to why US banks appeared to be performing so well in the face of such a long-running stream of bad news is addressed. Ten years ago, today’s mix of prolonged recession, serial corporate bankruptcy and Latin American financial meltdown, then the financial system would itself have been in dire danger of collapse by now.
As well as learning well from previous, very painful, lessons such as over-exposure to Latin America in the mid-1980s and to the commercial real estate sector in the early 1990s (remember the S & L crisis?) banks have done well to greatly improve their risk management and early warning systems. But they have also been hard at work finding ways of either avoiding the risk, hedging it or passing it on to someone who actually wants it.
Bank disintermediation, loan syndication and asset securitisation represent part of this great trend to shift the risk off balance sheets and have been enthusiastically em-braced by banks across the developed world.
Report author, Ranga Ramamoorthy, Payden & Rygel’s bank credit analyst describes some of the newer practises that have emerged over the last few years involving the use of credit derivatives such as credit default swaps, total return swaps and credit-linked notes.
“This is a huge market and we can only make an estimate of its current $1.4trn size because it is unregulated. These instruments have great benefits for their many participants, including: those seeking exposure to the credit risk of an individual corporate name with no bonds/debt or to a diversified basket of bonds/debt such as a bond index, as well as others wishing to get protection from the a credit event such as default enter into credit default swaps for hedging loans or bonds owned.”
Those on the other side of the transactions, giving the protection, are not driven by altruism to their fellow man, but by money: they’re sellers of that protection. Typically sellers are insurance companies, reinsurance companies and hedge funds who receive the periodic payments or upfront premia from the protection seekers. As Rama-moorthy notes, since the seller could lose more than his outlay – for example if the credit does indeed default in a credit default swap – then these transactions can be considered a form of leverage.
Whilst admiring the rapid uptake of this new world of sophisticated risk transferral, Ramamoorthy notes the existence of their ‘dark side’. He explains: “This market is unregulated and there is no disclosure. Although we can examine balance sheets in great detail, credit derivatives are ‘invisible’ and so we cannot really know what is the true risk exposure of a company trading in credit derivatives.”
So banks do indeed deserve praise for their much fitter profiles with much higher risk awareness, and they successfully have withstood a barrage of bad news for several years. But, as Ramamoorthy points out, now is not the time to be complacent about the world’s financial health just because the banks are in better shape. ‘The non-cash, off-balance-sheet, leveraged nature of credit derivatives may be contributing to the broader financial system’s vulnerability to deteriorating credit markets or unforeseen macro-economic developments such as rapid moves in interest rates,” he warns, adding “and unlike banks which are themselves regulated, many of the newer players like the hedge funds are not.”
Payden & Rygel Quarterly Review October 2002, ‘Risky Business’.

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