OFR: Counterparty Concentrations And Systemic Losses In CDS Markets

CDS Markets

Stressed To The Core: Counterparty Concentrations And Systemic Losses In CDS Markets by Office of Financial Research

Jill Cetina

Office of Financial Research

Sriram Rajan

Office of Financial Research

Mark Paddrik

Office of Financial Research


Supervisory stress testing to date has focused 011 the resiliency of large banks to Withstand the direct effects of a credit shock. Using data from Depository Trust 8; Clearing Corporation (DTCC). we apply the Federal Reserves Comprehensive Capital Analysis and Review (CCAR) supervisory scenarios to evaluate the default of a bank‘s largest counterparty. We find that indirect effects of this default. through the bank‘s other counterparties. are larger than the direct impact 011 the bank. Further. When taken as a Whole. the core banking system has a higher concentration to a single counterparty than does any individual bank holding company. Under the 2015 stress. the banking systems counterparty credit concentration is high and corresponds in diversity to a market With just over three firms. Our results are the first to evaluate the credit derivatives market under stress and also underscore the importance of a macroprudential perspective 011 stress testing.

Stressed To The Core: Counterparty Concentrations And Systemic Losses In CDS Markets – Introduction

Supervisory stress tests provide important insights into the resilience of banks under distressed economic and financial conditions. The Comprehensive Capital Analysis and Review (CCAR) conducted annually by the Federal Reserve, aims to identify the extent and source of capital losses at the largest U.S. bank-holding companies (BHCs) as well as evaluate firms’ capital planning abilities. Firms stress their banking and trading books under instructions from the Federal Reserve regarding stresses for debt securities based on credit rating bucket, among other break outs. This work provides valuable insight about the first-order effects of a. credit shock on large US. banks’ capital adequacy. However, such estimates could have a downward bias as they don’t reflect how the counterparties of the BHC might be adversely affected in stress.

The aggregate impact of a counterparty’s default is a potential systemic risk concern. The failure of a highly interconnected counterparty, such as American International Group, Inc. (AIG) in 2008, could have large and consequential effects and may be difficult to estimate. In 2014, the Federal Reserve instituted under CCAR a counterparty default scenario, as part of stress testing BHCs’ trading books, requiring individual BHCs to attribute sources of loss and gain to their counterparties. Each BHC’s largest trading counterparty is determined by net stressed profit and loss (P&L), estimated by revaluing exposures and collateral using the severely adverse supervisory scenario for the trading book. Across the trading book (including derivatives, reverse repo and securities financing agreements), the counterparty whose positions experience the largest loss to a BHC after the shock is assumed to fail, increasing the BHC’s losses.

CDS Markets

We analyze the question of how to incorporate counterparty risk exposures in supervisory stress tests. We conduct an analysis of the CCAR stress test by using CDS markets as a proxy for banks’ trading books. Credit derivatives exposures were at the core of the 2008-09 financial crisis, and While the market has contracted substantially since 2008, it still is the source of sizable risk-taking among market participants. Transactional data provided to the Office of Financial Research (OFR) from the Depository Trust & Clearing Corporation (DTCC) gives data on standardized confirmed CDS transactions involving U.S. entities and sufficient contractual information to re-estimate the P&L of counterparties based on the severely adverse supervisory scenario for all US. entities. We use DTCC information with the Federal Reserve’s CCAR stresses that vary across asset classes, ratings buckets, and debt priority, to obtain an analogue to the submissions the Federal Reserve receives from the six US. BHCS required to conduct the trading shock portion of CCAREI We refer to these banks as being in the core financial system to emphasize their focal role in the financial system and, indeed, in the CCAR trading shock exercises. Other commercial and investment banks, hedge funds, asset managers, insurance companies, and other market participants constitute what we shall refer to as the peripheral financial system, a nomenclature which distinguishes them as being distinct from the core but does not imply their role in the financial system is unimportant.

CDS Markets

Our research yields important insights about potential estimation bias in evaluating banks’ counterparty risk exposures in supervisory stress tests. The paper proceeds as follows. Section presents background on stress testing of counterparties using networks and how it is currently performed in CCAR. Section describes the data used in the analysis. Section describes the methodology used to price and mark-to-market portfolio positions for all CDS counterparties, consistent with the CCAR severely adverse stress scenarios for 2013, 2014, and 2015, respectively. Section provides summary statistics of the CDS markets before and after incorporation of the stress test scenarios. Section [E analyzes the P&L associated with the stress of a BHC’s largest counterparty, impacts on the BHC’S other counterparties, concentration risks to the core banking system, and consideration of losses to the rest of the financial system. A final section summarizes the paper and concludes.

CDS Markets

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