Office of Financial Research Alert! When Choosing Counterparties, Banks Tend to Pick Riskier Ones.
Office of Financial Research Alert! When Choosing Counterparties, Banks Tend to Pick Riskier Ones. The authors found banks are more likely to choose riskier nonbank counterparties that are already heavily connected and exposed to other banks, which leads to an even more densely connected network.
Source: https://content.govdelivery.com/accounts/USTREASOFR/bulletins/32e9113
What are the financial stability implications?
The question about counterparty choice is central to our understanding of the financial systemโs resilience to contagion. The impact of adverse external shocks may be amplified for networks already weakened by riskier connections. Additionally, a system may come under pressure from a network-intrinsic risk rather than an exogenous shock and counterparty risk is one way this could happen.
Network connections and choice of counterparties is especially important in the derivative markets. Uncleared derivatives account for approximately half of all derivative activities by banks, making them a significant fraction of their trading operations overall. Half of these are represented by nonbank counterparties with multiple bank dealers. Losses on uncleared derivatives are fully borne by the bank, whereas losses for cleared derivatives are mutualized across member firms of the clearinghouse.
