Regulators say that banks have not done enough to work out who owes what to whom. A report by the senior supervisors group of the Financial Stability Board has said: “Five years after the financial crisis, firms’ progress toward consistent, timely, and accurate
reporting of top counterparty exposures fails to meet both supervisory expectations and industry self-identified best practices. The area of greatest concern remains firms’ inability to consistently produce high-quality data.”
The risks that plagued exposure to the derivatives market pre-2008 touched the business models of retail banks (Northern Rock), wholesale brokers (Lehman Brothers) and insurance firms (AIG).
Those risks have not gone away. Exaggerated exposure to an asset’s price movements is exactly what lots of people want. A sudden movement the wrong way could create bankruptcies. It seems shovelling derivatives into the market is overtaking the corresponding
calculation of risk once again.
In 2005 it was pointed out by US central bank the Federal Reserve that a backlog of derivatives trades had built up without them being processed. That meant people were taking money on trades that might need to be cancelled, that might need to be amended
or might even reveal something surprising, like a single counterparty’s massive exposure to risk. However, no-one knew, because nobody had done the work.
The commitment letters written to the Fed reveal the extent of the operational risk that existed. “The Major Dealers commit to providing monthly metrics that will enable our supervisors to measure our progress…and will be made available 10 business days
after each month-end,” reads the first letter in 2005. “By 31 January, 2006, we will each reduce our number of confirmations outstanding more than 30 days by 30%.”
Well, that turned out to be too little too late. By 2007 working out a bank’s own exposure was still incredibly complicated, not helped by their shovelling as many derivatives into the market as possible, without keeping count. Bear Stearns stood waste deep
in them and (not legally being allowed to sell derivatives to the public) tried to publicly float a hedge fund whose assets were these sub-prime backed derivatives. Lehman Brothers sold sub-prime mortgages, then built derivatives based on them, and could not
So the banks could not handle their own exposure, the insurers could not underwrite the insurance they had written, and other firms lost their wholesale market funding as a result.
Fast forward to 2013, and it seems that firms have not been pulling their weight in checking who they are exposed to.
“While some firms have developed their information technology infrastructure further to support improved counterparty reporting, many still rely on time-consuming and error-prone manual processes,” says the report, “If firms cannot produce accurate data
during relatively benign times, they would be unlikely to do so during periods of market stress, when exposures could be volatile and resources are operating under high-pressure conditions.”
Banks are capable of spending the money on risk management technology, but money spent on driving profit creates pay and bonuses. That is not meant as a criticism, but it the most obvious reason why record-keeping suffers as markets boom.
Blog updated: 25 May 2015 17:11:10