CVA Lessons: Is it better to charge or to subsidize credit risk?

One often hears that competition promotes the efficient and weeds out the inefficient. Yes, but only insofar as there is a level playing field. Give special privileges to certain players, and the best might end up dominated by the inefficient.

Analysts who overlook the power of privileges may mistake dominance for efficiency, getting backwards the true state of affairs.  They also miss that the distortion reduces the welfare of society and redistributes wealth and power in favor of the inefficient.

That’s true in any industry and especially relevant in the case of the dominance of OTC derivatives markets over exchange trading during the last three decades.

One of our colleagues, presenting his work in a recent seminar, made the offhand comment that the dominance of OTC markets must reflect some efficiency on the part of banks in providing derivatives to end-users. Undoubtedly, other economists without a detailed knowledge of how the game is played draw the same conclusion.  The deeply ingrained idea that markets are free makes them oblivious to the simple fact that markets are institutions, and institutions operate with rules and regulations designed by people.

The logic that OTC markets are superior only works on the premise that banks are competing with exchanges on a level playing field. But prior to the financial crisis of 2007-2008 (and until the effort to reform finance is successfully completed), the playing field has been not level: banks have enjoyed some significant privileges. Key among them was the failure of some banks and regulators to properly price the credit risk embedded in derivatives.

The term-of-art in the banking industry is Credit Valuation Adjustment (CVA), or the money needed to account for the credit risk in a portfolio of derivatives with a counterparty. Over the last three days, the Financial Times’ blog Alphaville has been running a series of posts on CVA by David Murphy, a former head of risk at the trade association International Swaps and Derivatives Association (ISDA) and current blogger at Deus Ex Machiatto. In the first post in his series, he writes that

Whenever you are promised cash in the future by someone who might not pay you back, you have credit risk. In derivatives trading, situations often arise where someone might owe you money in the future, perhaps because you have purchased an option from them, or because a coupon on a swap goes your way rather than theirs. This means that derivatives trading often includes taking some credit risk, along with the more obvious market risks.

In the very early days of over-the-counter derivatives, some banks did not take this lesson to heart, and thus derivatives traders could (effectively) lend money without the banks’ loan officers noticing.

Murphy goes on to note how bankers started recognizing this risk. Regulators, however, remained behind the curve, and did not apply adequate capital charges for the credit risk embedded in many derivatives.

A report of the BIS, the international organization of central bankers, explained that

…one of the key lessons of the crisis has been the need to strengthen the risk coverage of the capital framework. Failure to capture major on-and off-balance sheet risks, as well as derivative related exposures, was a key destabilizing factor during the crisis.  … While the Basel II standard covers the risk of counterparty default, it does not address CVA risk, which during the financial crisis was a greater source of losses than those arising from outright defaults.

Getting the rules right is a tough task, as the blog posts by Murphy help to explain. There are many complications and difficult interactions to take into account.

What is alarming is that certain legislators in the US want to return to the former practice of ignoring the credit risk embedded in a swap. In late March, the U.S. House of Representatives passed a bill (HR2682) directing banking supervisors to overlook the credit risk embedded in non-margined swaps sold to end-users and others. They hope to thereby lower the cost paid by end-users. We explained the problems with this bill in an earlier post. It is an ill informed attempt to preserve a back door subsidy. It risks leaving the financial system unstable, at potentially great cost to taxpayers, households and firms that rely on safe banks.

Our understanding of embedded credit risk has been hard won. It would be a mistake to renounce it.

3 Trackbacks

  1. […] Parsons and Antonio Mello at Betting the Business argue that the dominance of OTC derivatives is not indicative of their efficiency, but instead resulted from […]

  2. […] John Parsons and Antonio Mello at Betting the Business argue that the dominance of OTC derivatives i…: The logic that OTC markets are superior only works on the premise that banks are competing with exchanges on a level playing field. But prior to the financial crisis of 2007-2008 (and until the effort to reform finance is successfully completed), the playing field has been not level: banks have enjoyed some significant privileges. Key among them was the failure of some banks and regulators to properly price the credit risk embedded in derivatives. […]

  3. By FT Alphaville » Further reading on April 13, 2012 at 2:10 am

    […] – Is it better to charge or subsidise credit risk? […]

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