A working paper on counterparty choice by major banks in the $12.4 trillion over-the-counter derivatives market offers evidence of systemic risk propagation in bank networks through non-bank counterparties in “opaque” markets. The report, Counterparty Choice, Interconnectedness, and BankRisk-Taking, by the U.S.’s Office of Financial Regulation marks the first study to provide empirical evidence in the OTC derivative markets that “suggests the existence of endogenous risk-taking behavior by banks related to network formation,” said authors Andrew Ellul and Dasol Kim of the Office of Financial Regulation.
“Banks are also more likely to connect with riskier counterparties for their most material exposures, suggesting the existence of moral hazard behavior in network formation,” according to a summary of the study. “We show that these exposures are correlated with systemic risk measures despite greater regulatory oversight after the [Global Financial Crisis.]” The study cited novel confidential regulatory data to illustrate how banks remain more likely to choose “densely connected non-bank counterparties” in their derivatives trades. Banks do not typically hedge such these exposures. The study comes as questions of systemic risk have arisen recently amid speculation about the financial health of Credit Suisse AG
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