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Bankers fear sovereign risk in 2010
By Gillian Tett in London
Published: December 21 2009 18:21 | Last updated: December 21 2009 18:21
In normal circumstances, the question of how banks manage their collateral deals with other financial players is not of interest to ordinary mortals.
However, these are not normal times. In the past couple of years the risk managers of the world’s largest banks have been forced to confront a series of shocking situations, as seemingly remote events, or “tail risks” as they are dubbed, have come to pass.
So, unsurprisingly, those same risk managers are now scouring the horizon for any fresh potential shocks. And as they run scenarios for 2010 – or “try to imagine six impossible horrible things before breakfast”, as one says – an issue that is causing more unease is the matter of sovereign risk, and the related issue of collateral.
Until quite recently, this was not something that banks worried much about in the western world, since it was widely assumed that the credit standing of European countries and the US was ultra secure.
Thus in their day-to-day financial operations, big banks typically treated contracts with western sovereign entities differently than those of private companies.
Most notably, when a bank cuts a foreign exchange or interest rate derivatives deal with another bank or company, it will typically demand the counterparty post some collateral to ensure the bank can recover money owed if the other party goes bust. Until now, banks have not demanded collateral when sovereign entities are involved, since it has been widely assumed a western government would never be unable (or unwilling) to honour a deal.
Similarly, when banks have made loans to western sovereign nations – or simply bought their debt, in the form of bonds – they typically do not post big reserves, since such debt is deemed “zero-risk weighted”, in bank regulatory rules, and most western countries carried a triple A credit rating.
But now some senior bankers are starting to get uneasy. After all, deals that banks have cut with sovereign entities are believed to account for a significant chunk of the derivatives market. Moreover, such contracts can often be 10, 20 or 30 years, which means that the profits and losses in a derivatives deal can fluctuate hugely – and the potential counterparty risk.
Right now there is no sign that any big western government is about to renege on any deals. But the dramas around Greece and Dubai have been one “wake-up” call. Moreover, as Moody’s noted this week that “the context for sovereign risk assessment has changed dramatically since the beginning of the crisis in mid-2007” – and more “turbulence” is forecast in 2010, given that the fiscal positions of western countries are deteriorating very fast.
Right now, large banks are being tight-lipped about how they intend to handle this sovereign risk. Even in good times, banks rarely discuss collateral policies in detail for fear of revealing too much about what they really think of the health of financial and corporate clients. And at moments of financial stress, the banks are extra secretive, since loose talk can fuel market panic.
But some large banks are trying to deal with the risks by using sovereign credit derivatives contracts, which are meant to offer insurance against a government bond default. Most notably, when trading desks see prices on long-term contracts with sovereigns start to fluctuate, they begin demanding traders take out sovereign credit default swaps, to hedge – or lay off – that risk.
Such practices help trading desks meet their internal rules. But it is unclear how effective these contracts would really be if a sovereign default did occur, since these deals are typically written by a small pool of interlinked players. Thus, the top managers of some large banks are now discussing whether they need to go further – and start making more provisions for different forms of sovereign risk, in the same way that they now make reserves for corporate, or emerging market risks.
Few banks want to do this, since most are short of capital. “But when you see stuff like Greece, it is hard to avoid these issues,” admits a board member at a large western banks, who predicts that after two years of worrying about mortgage and corporate risk, sovereign risk “is going to be the big debate for 2010” – both for banks, and the wider investment community.
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