Over-the-counter Derivatives and Systemic Risk to the Global Financial System, Issue 4801
Over the last decade dealing in derivative financial instruments (basically forwards, futures, options and combinations of these), particularly in the over-the-counter (OTC) derivatives market has become a central activity for major wholesale banks and financial institutions. Measured in terms of notional principal amount, OTC derivatives outstanding are near, if not greater than, US$10 trillion, even after deduction of double-counting for intra-dealer transactions. Major new regulatory initiatives, including proposed new capital requirements, are under consideration as a means of reducing systemic risk. This paper examines the concept of systemic risk -- that failure of one firm will lead to the failure of a large number of other firms or indeed the collapse of the international financial system. Alternative proposed definitions are considered and integrated and the effects of OTC derivatives on these risks discussed. The key conclusion is that systemic risk has been reduced by the development of the OTC derivatives market due to shifting economic risks to those better able either to bear the risk or, in many cases, cancel it against offsetting risks. The implications of the Basle II capital proposals for systemic risk are analyzed and shown to increase this risk due to encouraging transactions which increase portfolio risks of the dealers and discouraging transactions which decrease their portfolio risk.
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Accounting Office 1994 activities analysis Basle II proposals billions of U.S. Bureau of Economic capital requirements concept of systemic contracts cost Creative Destruction credit exposures credit risk Darby Derivative Product derivative transactions DERIVATIVES AND SYSTEMIC Derivatives Outstanding Derivatives Study Group dynamic hedging strategies Economic Research end users Federal Reserve System financial institutions firms foreign exchange forward contracts Global Derivatives Study global financial market GLOBAL FINANCIAL SYSTEM Group of Thirty/Promisel growth international financial International Swaps ISDA legal risk list of NBER major manage risk Mark Levonian market linkages market risk National Bureau NBER Working Papers nonfinancial Notional Amount notional principal amount off-balance-sheet OTC derivatives market OVER-THE-COUNTER DERIVATIVES overall Papers and Reprints Partial Subscription percent Policy portfolio insurance potential Procter and Gamble Promisel Report reduce regulators result risk management settlement risk Study Group G-30 Swaps and Derivatives trading book U.S. bank U.S. dollar equivalents U.S. General Accounting US$10 trillion