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: Banks dial up risk-taking in OTC derivatives trades by using many of the same non-bank counterparties, a study says

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 mostmaterial exposures, suggesting the existence of moral hazard behavior in networkformation,” 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
CS,
+2.01%
.

See: Credit Suisse woes prompt calls to analysts asking if U.S. banks risk a ‘contagion impact’

Overall, banks continue to face some of the toughest economic conditions on some fronts since the collapse of Lehman Brothers in 2008 amid decades-high inflation.

The Office of Financial Stability specializes in spotting potential cracks in the regulatory framework around the U.S.’s six global systematically banks: JPMorgan Chase & Co.
JPM,
-1.64%
,
Wells Fargo & Co.
WFC,
-2.02%
,
Citigroup Inc.
C,
-1.71%
,
Morgan Stanley
MS,
-1.91%
,
Bank of America Corp.
BAC,
-1.21%

and Goldman Sachs Group Inc.
GS,
-1.33%
.

Housed within the U.S. Treasury Department and set up as part of the Dodd-Frank legislation in the wake of the Global Financial Crisis, the Office of Financial Regulation conducts research and analysis for the Financial Stability Oversight Council (FSOC).

The Financial Stability Oversight Council (FSOC) includes U.S. Treasury Secretary Janet Yellen, Federal Reserve Chair Jerome Powell and Securities and Exchange Commission chairman Gary Gensler.

The derivatives study was initially flagged in a report by Wall Street on Parade.

Also Read: ‘The riskiest loans are outside the banking system.’ Regulators worry that hedge funds could spark the next financial crisis.

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