Week InReview | Dodd-Frank mandated the Fed conduct annual stress tests, which produce a set of challenging, hypothetical conditions each year. The Fed then speculates on how the largest banks would cope, and whether banks have enough capital to pay dividends and buy back shares. This week, after its review of a market that created some of the biggest concerns during the 2008 financial crisis, Treasury's Office of Financial Research (OFR) published a working paper which shows that, years after the 2008 financial crisis, trading risk in the industry is still highly concentrated among a small number of firms. OFR researchers also noted that the banks have migrated from being net sellers of credit default swap protection to net buyers.
Friday, March 11, 2016
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In case you missed it . . .
Interconnections in the CDS market
OFR:  Fed stress tests may mask indirect pain of defaults
(Mar 8) What would happen if the largest counterparty to a specific bank failed? And what would happen if that counterparty was acting as the counterparty to other systemically important banks? 

Four days after the Fed proposed a rule to address the risk associated with excessive credit exposures of large banking organizations to a single counterparty, the Treasury's Office of Financial Research (OFR) published a study examining stress tests.

The government researchers found that when the Fed evaluates how banks would fare during a crisis, it may not be facing the indirect damage of a trading partner defaulted.

The Fed's annual stress tests ignore how the failure of a single big trading partner could affect all of the other entities a bank trades with. Those indirect exposures could have nine times the impact on a bank as the direct relationship with a failed party. Most big banks have concentrated exposures to just a few trading counterparts, the researchers found.

The Fed's annual assessments are "likely to significantly understate potential risk" from the hypothetical failure. Given a wider perspective, the tests "would inform supervisors and regulators of risk that may not be studied and may be greater than those which are commonly understood," they said.

"A [bank holding company] may be able to manage the failure of its largest counterparty when other BHCs do not concurrently realize losses from the same counterparty's failure. However, when a shared counterparty fails, banks may experience additional stress. The financial system is much more concentrated to (and firms' risk management is less prepared for) the failure of the system's largest counterparty. Thus, the impact of a material counterparty's failure could affect the core banking system in a manner that [Comprehensive Capital Analysis and Review] may not fully capture."
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