Banking & Capital Markets

Counterparty Risks under the Lens

"We have no authority whatsoever, but we have a fair amount of moral-suasion," says the chairman of the group behind a new report that aims to redu...
Craig SchneiderJuly 28, 2005

Financial institutions need to find out more about the credit risk of their counterparties, according to a new report by the Counterparty Risk Management Policy Group.

The first report by the group — chaired by Gerald Corrigan, a former president of the New York Federal Reserve, and comprising representatives of Wall Street banks as well as TIAA-CREF, AIG, GM Asset Management, and others — was issued in 1999 following the multibillion-dollar bailout of hedge fund Long-Term Capital Management (LTCM).

The new study, “Toward Greater Financial Stability: A Private Sector Perspective,” differs from its predecessor in that it offers a number of pointed recommendations to financial institutions, Corrigan told Reuters. Among them: that firms gain a better understanding of their own portfolios, that they seek more data to better determine the credit risk of their counterparties, and that trade associations develop accepted standards for how confidential information should be exchanged among market participants, the wire service reported.

The group’s recommendations, though directed at financial institutions in general, follow concerns that arose earlier this year about the stability of hedge funds after General Motors Corp. and Ford Motor Co. were downgraded to junk.

Though the report draws a clear distinction between “financial disturbances” and “systemic financial shocks” and maintains that concerns about systemic problems have declined since LTCM, The Financial Times noted that it warns of the threat posed by “a huge backlog of unconfirmed deals.” (Senior editor Tim Reason notes on the CFO Blog that the flip side of dispersing risk is that you don’t really know where it goes, which can itself be risky. And last year, deputy editor Ronald Fink reported on concerns that the asymmetry inherent in credit default swaps contains the potential for serious abuse.)

The group also urged hedge funds to volunteer more information to regulators, reported The Financial Times, to help head off direct regulation of the investment sector. “We have no authority whatsoever,” Corrigan reportedly said, “but we have a fair amount of moral-suasion. I will be very surprised if regulators don’t now ask [banks and hedge funds] how they are doing relative to this.”