Banks Aren’t Really Much Like Dominoes

Derivatives 20 Jun 2012

Whether the growth of the credit derivatives market caused or contributed to the U.S. centered financial crisis of 2007-08 is an issue that is already passing into the domains of academic economists and economic historians. But the unquestioning public assumption that the answer is “yes” could yet do some real ongoing harm.

Such an assumption may set the agenda for Europeans, as the solvency of EU banks becomes the big global-financial question of the day. Those who see credit derivatives in particular as on the side of the devils include Frank Partnoy and David Skeel, who even before the crisis hit Wall Street wrote, “Credit derivatives help banks reduce risks but in doing so, they create the danger of systemic market failure.”

The underlying idea (sometimes made through the use of a falling-dominoes metaphor) is that the growth of this market links the solvency of every player ever more tightly to that of every other.

Opposing such scary thoughts there is the intuition that credit derivatives let banks manage credit-related risks without actually adjusting their underlying loan portfolios. That’s a good thing.

Empiricism in Spain

But as a recent paper from four scholars at the Universidad de Santiago de Compostela, in Spain, observes: this extra flexibility comes with drawbacks. Perhaps the most obvious of drawbacks is that it creates counter-party risk. The authors: Luis Otero González, Luis Ignacio Rodriguez Gil, Sara Cantorna Agra, and Pablo Durán Santomil, have written “Banking Risk and Credit Derivatives,” in order to take an empirical look at the balance of pros and cons.

The few empirical studies that do exist refer to the U.S. market. González et al. looked at the European market, working from a database consisting of “the consolidated financial statements of 134 European financial institutions during the period 2006-2010.”

González et al. suggest that these instruments are a wash in terms of over-all financial stability. It is by now a common enough observation that financial derivatives as such net out to zero. These authors seem to follow a long road around to that insight, writing of Z-scores, which are ratios of the return on average assets (ROAA) plus the balance of capital-to-total-assets over the volatility of ROAA. A bank’s Z-score can rise then for any of three reasons: because return improves, because the balance sheet strengthens, or because volatility/risk lessens. The Z-score can fall when any of the opposites takes place.

The Z-score serves our authors as “a measurement indicative of the distance to default of a particular entity within a period of time.”

They estimate a Z-score for every financial institution in their sample and for each of the five years under study.

The Z score can be broken down into two components, which González et al call ZP1 and ZP2: portfolio risk and leverage risk. For ZP1 the numerator of the ratio is the ROAA alone. For ZP2 it is the capital-to-total assets balance alone. In both cases, of course, the denominator is volatility.

Buyers and Sellers

They find that the use of credit derivatives has a significant positive impact on the Z-score when the institutions involved are net protection buyers. González et al. take the net buying position to indicate that the institution is using the products for hedging purposes, and they take their data about the Z score to indicate that the hedging is having the desired effect, distance from default is increased.

Unsurprisingly, too institutions that are net protection sellers can experience negative consequences of that speculative position in a time of crisis.

But one of the most common complaints about these instruments is the notion that they create an artificial sense of security even when used to hedge, and that this in turn inspires the institutions who think they are adequately hedged to ramp up their leverage to dangerous levels. González et al. say that their data shows no such tendency.

In general, then, these authors conclude that “based on these data” the current banking troubles in Europe cannot be laid at the feet of the expansion of the credit derivatives market.

Allow a final thought about those dominoes. In terms of the U.S. experience in particular, the metaphor is an extremely poor fit. It was as if someone had painstakingly set up a line of dominoes, only to have an earthquake destroy the whole contraption. The task is to understand the nature of the tectonic plates.

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