There’s No Going Back! Derivatives in the Long Run

Very cool overview of derivatives and the banking system. Take a look at the excerpts below.

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Abstract (Via SSRN)

Many of the difficulties during the credit crisis have been attributed to derivatives, particularly the use of credit derivatives in structured products built on sub-prime mortgages. Derivatives also played an important role in the leveraging and risk-taking process prior to the crisis. These were very difficult to unwind, and added to liquidity and credit problems. There are also ongoing concerns about settlement rules and counter-party risk in the market for CDS. A key concern is that when hedge funds and other net providers of credit protection default, their counterparties will be left without insurance against credit exposures. Of particular concern is the downgrading of bond insurers, putting at risk the cover on risky debt (via CDS contracts issued by these bond insurers) related to payments on collaterised debt obligations (CDOs). Nonetheless, there are also important differences of view. For example, some analysts have used the demise of Bear Stearns (and before that the collapse of LTCM) as an indication of structural weaknesses in the OTC derivatives market, while others argued that the OTC market had ‘coped quite well’ at a time of heightened price volatility. These opposing opinions can be explained to an important degree by the so-called risk paradox (section 2). The crisis raised also doubts about the effectiveness of risk management systems used by banks. Highly sophisticated banks were confident that their risk management system would be able to deal with market corrections. But risk management systems failed to anticipate the devastating effect of the loss of market liquidity, severely estimated banks’ exposures, and the extent in which institutions would be affected by heightened market stress. Against this backdrop, I will assess in this paper the reasons why banks’ business plans and risk management systems failed (section 3), as well as the required pre-conditions that need to be in place for fully benefitting from complex derivatives for the long run (section 4).

Excerpts (via SSRN)

The widespread and still growing use of derivatives is shaping a revolutionary new banking landscape, characterised by new and complex links with capital markets. The new global financial landscape enables an ever wider range of financial and non-financial companies to manage risks more effectively. This more efficient allocation of risk, driven by the incentive to equalise risk-adjusted rates of return on investments globally, has led to a strong increase in the creation of value and standards of living.

However, this more efficient financial landscape is characterised by more complex products and markets, a higher level of systemic risk and increased financial fragility. The growing importance of derivatives for risk management and the leveraging of investment positions is a driving force behind the stronger and more complex links between cash and derivatives markets. This complex, multi-layered intermediation system includes offbalance- sheet market value structures, which constituted an important part of a lightly regulated, ‘shadow’ banking landscape. A recent study estimates the size of this shadow portion of the US banking system was around $5.9 trillion in 2007, compared with $9.4 trillion for the regulated part.

6 Pillars For Sustainable Complex Financial Derivatives (Via SSRN):

1. Banks and other financial institutions need to continue to move to high(er) standards of risk awareness and risk management, which means having in place systems for risk monitoring and control that allow financial institutions to deal effectively with all sorts of risks in the complex financial landscape. This includes the use of consolidated (also called integrated or enterprise-wide) risk management systems.

2. The infrastructure of the OTC derivatives market warrants special attention due to its size and ultra-complex links to all parts of the financial system. This includes management of counterparty risk, cash settlement of credit derivatives contracts and delays in trade confirmations. The industry and regulators face, to some degree, a trade-off between efficiency and stability in the OTC market.

3. More effective tools and procedures for risk-managing derivatives positions are also necessary to mitigate the seriousness of the risk paradox. The following are essential for market participants to benefit from derivatives: operational aspects such as a well-functioning clearing, trade matching and confirmation infrastructure, and an adequate legal and regulatory framework. Market participants should ensure transparency, product suitability, prevention of market abuse and best execution.

4. Supervisory and regulatory agencies need to have the necessary capacity to monitor risk-taking by banks and assess the quality of the management of that risk in a more complex market environment. They have a great interest in controlling systemic risk via mitigating moral hazard associated with too-complex-to-fail situations. The move to more risk-sensitive capital regimes such as Basel II is therefore a response to managing risks in the new banking landscape more effectively. The main objective of a more risk-sensitive capital framework is to produce meaningful measures of risk relative to capital. A related goal of prudential oversight is to ensure reliable information is available to support the efficient functioning of the price discovery process

5. International accounting standards should be able to support sophisticated risk management procedures used by banks. Not only should these new accounting guidelines be aligned to sound risk management procedures, but they need to be consistent with the supervisory objectives across the financial services sectors.

6. A more robust financial system also requires that banks and other players strengthen all aspects of their business
models, including the structured finance and securitisation businesses. This includes avoiding reward practices that encourage extreme risk-taking, as well as eliminating perverse incentives that may lead to insufficient screening and monitoring of borrowers.

Click Here To Read: No Going Back – Derivatives In The Long Run