Who’s Holding the Bag?

Everyone knows banks are shedding more risk these days. So where does it go?

Seven years ago this month, bankers across Wall Street breathed a sigh of relief. Two rate cuts in two weeks by the Federal Reserve had finally stanched the bleeding at Long-Term Capital Management — but not before the Fed cajoled some 14 banks into buying pieces of the collapsing hedge fund to stave off a larger financial collapse.

“Investors have a pretty good idea about balance-sheet risks; they are completely befuddled with regard to derivative risks,” concluded Roger Lowenstein in When Genius Failed, a chronicle of LTCM’s fall. “As the use of derivatives grows,” he warned, “this deficiency [in disclosure] will return to haunt us.”

Could that time be now? Just last month, in a move eerily reminiscent of LTCM, representatives of 14 banks arrived at the offices of the Federal Reserve of New York in response to a Fed invitation to discuss hedge fund practices. And a slew of reports by regulators and market participants over the past six months have fretted over the operational risks that have swelled with the explosive growth of derivatives (particularly credit derivatives), credit-oriented hedge funds, and structured finance in the years since LTCM (see “What, Me Worry?” at the end of this article). Yet, most of this attention focuses on the mounting interdependence of banks and hedge funds. Corporations — the so-called reference entities, whose financial survival is the subject of most of these derivative bets and counterbets — are largely ignored.

A Great Advance?

Does that mean companies shouldn’t worry? At a minimum, they certainly feel the changes these financial innovations have wrought in their banking relationships. “Banks’ risk aversion has increased,” notes one respondent to CFO‘s banking survey (see “Last Banks Standing“). So has their “need for fee business,” says another. Led by JPMorgan Chase & Co., banks have become adept in recent years at reducing the amount of lending against their own balance sheets, even as they seek to increase fees. Between 2001 and 2003, the percentage of bank assets made up of corporate loans fell from 20 percent to 17 percent.

Banks serve both goals — lowering their balance-sheet risk and increasing fee revenue — by packaging debt into various forms of structured securities and selling them to investors (including hedge funds, which often buy the riskiest slices). Banks also buy derivatives themselves to lay off risk (often, again, to hedge funds) from their loan portfolios. And, increasingly, banks market the same risk-management techniques to corporate customers in the form of credit-default swaps, not to mention a wide variety of other swaps and derivative contracts.

Many in the banking industry — including its regulators — consider the resulting dispersion of risk to be a great advance in managing threats to the world financial system. Indeed, speaking at the Federal Reserve’s Jackson Hole conference in August, Fed governor Donald L. Kohn described support for risk dispersal as a key pillar of the “Greenspan doctrine.”

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