Who’s Holding the Bag?

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

What Is Operational Risk?

Several observers, notably the Bank for International Settlements, have warned that the market’s relatively painless absorption of General Motors’s and Ford’s downgrades might not be a true stress test. For one thing, GM and Ford didn’t default. In other words, while the value of existing credit-derivative contracts referencing the automakers probably fluctuated wildly, their downgrade didn’t necessarily trigger payouts, as a default would. And while “operational risk” may sound relatively mundane, it refers in part to the fact that the majority of credit-derivative contracts are still paper transactions. A June survey by the International Swaps and Derivatives Association — citing “important advances” — noted that 40 percent of contracts are now confirmed by automated systems, up from 24 percent the year before. That’s still less than half.

Indeed, despite the financial industry’s success in rewriting the bankruptcy code to allow immediate termination of almost all types of derivative contracts in the event of a default (see “The Banker’s Protection Act“), the ISDA survey showed that it still takes hedge funds and banks an average of 11.6 days to even properly record the new owner of a resold credit-derivative contract. If corporate defaults rise in the coming year, as many suspect they might, operational risk could become very serious indeed. —T.R.

What, Me Worry?

A slew of recent reports frets about growing systemic risk. While few of the reports focus directly on corporations, all have profound implications for banks that serve them.

May 14, 2004
“Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities”

Issued by the Office of the Comptroller of the Currency, Office of Thrift Supervision, the Federal Reserve, the FDIC, and the SEC

Proposes ways for banks to monitor structured-finance transactions set up for corporate clients to avoid legal and reputational risks (to the banks). The banking industry responds with strong objections. A revision is still expected.

May 5, 2005
“Risk Transfer and Financial Stability”

Issued by Federal Reserve chairman Alan Greenspan

Seeming to hedge, though not reverse, his previous praise for derivatives, Greenspan says that regulators can’t track credit risk transferred outside the banking system (typically to hedge funds), that risk-mitigation benefits of derivatives could be undermined by contractual failures, and that some market participants are not exercising sufficient care.

May 12, 2005
“Remarks before the Foundation Financial Officers Group”

Issued by SEC chairman William Donaldson

In remarks on “staving off future crises,” Donaldson defends requiring hedge-fund registration, citing the size of the market and the difficulty of detecting fraud.

June 1, 2005
“Operations Benchmarking and FpML Use Survey”

Issued by the International Swaps and Derivatives Association

Citing “advances,” the ISDA reports the average backlog for credit-derivative confirmations is 11.6 days. Only 40 percent of such contracts generate automated confirmations.

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