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Dodd Frank ‘little effect’ on counterparties

Friday 5 August 2011 – by Andrew Hickley

The Dodd Frank Act will have “very little effect” on reducing bank exposure to counterparty credit risk, the International Swaps and Derivatives Association has warned.

In a report, the global securities body argues that heightened risk management practices such as netting and the posting of collateral have severely limited counterparty exposures for US banks.

While over 350 banks have failed since 2007, the report finds that losses stemming from counterparty defaults have totalled less than $2.7bn (€1.9bn) since the start of the financial crisis.

“The Office of the Comptroller of the Currency reports and Isda’s analysis demonstrate that the credit risk losses and exposure of US banks related to derivatives are quite manageable,” said Conrad Voldstad, ISDA chief executive officer.

“It is also clear that a renewed focus on robust risk management practices – including netting, collateralisation, clearing and portfolio compression – is helping to increase the safety and efficiency of OTC derivatives markets.”

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Isda quotes an OCC report showing that exposures have been reduced by more than 90 per cent by netting, leaving the net current credit exposure related to OTC derivatives at $353bn (€250bn) for the US banking system.

Netting allows for contracts between the bank and the defaulting counterparty to be aggregated into one single net payable amount.

Among the benefits of netting is that it allows parties to exchange payments on the same day and in the same currency, though it may only partially cover the amount that is owed.

Isda argues the net current currency exposure, or NCCE, figure as small given that the banking system currently holds around $12tn (€8.5tn) of outstanding assets. NCCEs stand at just 0.14 per cent of the $244tn (€173bn) gross notional outstanding of banks assets, it says.

This figure is further reduced to $107bn (€79bn), or 0.04 per cent of gross notionals, by the use of collateralisation in deals, it argues.

“The Dodd Frank Act will have very little effect on reducing NCCE,” the report says.

“In fact, Isda believes there may only be $30bn (€21bn) of uncollateralised exposure that US banks have to counterparties that may be subject to the Dodd Frank Act’s requirements.”

Despite these seemingly small figures, it is grateful to the Federal Reserve’s move to bailout AIG, which it said prevented losses of over $60bn (€42bn) of sub-prime mortgages from hitting the market.

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