Dear SAP Banking Community members,
In the last post we commented that the risk on the interest rate swap bubble should have been limited by the Capital Requirements stated on the Basel II agreement.
The Basel II agreement defines the Capital Requirements associated to a derivatives contract with the calculation of the Exposure at Default of those derivatives by determining the Credit Equivalent Amount of them.
According to a basic definition of the Credit Equivalent Amount, it's the amount that results from translating a bank or investment bank's off-balance-sheet liabilities into the risk equivalent of loans.
So, according to the regulation, the Credit Risk of a derivative liability has the same importance of the most common Credit Risk associated to a Loan.
Then, why are we suffering the lack of control on the Derivatives Market which has permitted to inflate that bubble?
On my opinion, there’re several reasons for that.
1. Derivatives are off-balance sheet transactions. I remember a conversation with a Bank Executive months ago in which he told me; “The Financial System we’ll be under risk till the regulator makes mandatory to have every transaction on-balance”.
Theoretically, this shouldn’t be necessary, as for Banks the solvency regulation is a requirement as important as the accounting principles. Nevertheless, I will not deny, that the whole Banking control system, from the regulators to the shareholders look carefully at the Balance Sheets and Profits Accounts of the Bank, but historically have looked less carefully at the Solvency Reports than the Accounting results. That of course gives an opportunity of “hiding” part of the credit risk supported by the Bank.
2. Additionally on the chain of Financial Transactions that we describe on the Chapter I of this post, usually non Banks Financial Institutions play an important role. Those institutions are much less regulated than Banks and represent a “hole” on the solvency of the system, and an opportunity for hiding risk exposures.
3. Also the own nature of the Derivatives contract makes difficult to track the Risk Exposures. Every Business activity requires manage risk. Nobody would deny that on the Financial Business risk management is a critical activity. Nevertheless, there is a significant difference on the risk management of a Loan, a Bond, or any traditional core-banking product, and the risk management of a derivative contract. On a derivative contract, the main objective of the Business Transaction is the opportunity of risk management. Risk hedging or risk transferring are the main purposes of the Business Transaction. That makes those OTC derivatives very powerful if they’re correctly handled, but also, as Warren Buffet pointed out, very dangerous if not.
What do you think?
Kindest Regards.
Ferran.
In the last post we commented that the risk on the interest rate swap bubble should have been limited by the Capital Requirements stated on the Basel II agreement.
The Basel II agreement defines the Capital Requirements associated to a derivatives contract with the calculation of the Exposure at Default of those derivatives by determining the Credit Equivalent Amount of them.
According to a basic definition of the Credit Equivalent Amount, it's the amount that results from translating a bank or investment bank's off-balance-sheet liabilities into the risk equivalent of loans.
So, according to the regulation, the Credit Risk of a derivative liability has the same importance of the most common Credit Risk associated to a Loan.
Then, why are we suffering the lack of control on the Derivatives Market which has permitted to inflate that bubble?
On my opinion, there’re several reasons for that.
1. Derivatives are off-balance sheet transactions. I remember a conversation with a Bank Executive months ago in which he told me; “The Financial System we’ll be under risk till the regulator makes mandatory to have every transaction on-balance”.
Theoretically, this shouldn’t be necessary, as for Banks the solvency regulation is a requirement as important as the accounting principles. Nevertheless, I will not deny, that the whole Banking control system, from the regulators to the shareholders look carefully at the Balance Sheets and Profits Accounts of the Bank, but historically have looked less carefully at the Solvency Reports than the Accounting results. That of course gives an opportunity of “hiding” part of the credit risk supported by the Bank.
2. Additionally on the chain of Financial Transactions that we describe on the Chapter I of this post, usually non Banks Financial Institutions play an important role. Those institutions are much less regulated than Banks and represent a “hole” on the solvency of the system, and an opportunity for hiding risk exposures.
3. Also the own nature of the Derivatives contract makes difficult to track the Risk Exposures. Every Business activity requires manage risk. Nobody would deny that on the Financial Business risk management is a critical activity. Nevertheless, there is a significant difference on the risk management of a Loan, a Bond, or any traditional core-banking product, and the risk management of a derivative contract. On a derivative contract, the main objective of the Business Transaction is the opportunity of risk management. Risk hedging or risk transferring are the main purposes of the Business Transaction. That makes those OTC derivatives very powerful if they’re correctly handled, but also, as Warren Buffet pointed out, very dangerous if not.
What do you think?
Kindest Regards.
Ferran.
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