GREENSPAN: SUGGESTS BANKS SET ASIDE MORE CAPITAL FOR DERIVATIVE RISK
By Suzanne Cosgrove
BOCA RATON, Fla. (MktNews) - Speaking to futures markets participants, Federal Reserve Chairman Alan Greenspan Friday morning warned that "the resilience of derivative markets" will not have been fully tested until there is a "significant downturn in the economy overall."
Greenspan also made a somewhat tentative argument that banks are not setting aside enough capital to allow for the degree of risk they are undertaking in their derivatives business.
Perhaps because derivative instruments can serve as a hedge against adversity, the growth of derivatives use has not slowed, "despite the world financial trauma of the past eighteen months."
Greenspan did not include any declarations on the current economy in his speech to the Futures Industry Association convention but acknowledged that there remains a fear that derivatives trading could itself pose a risk to the financial system under some circumstances.
Greenspan also made a glancing reference to his dispute with the Commodity Futures Trading Commission, saying the fact that over-the-counter markets "function quite effectively without the benefits of the Commodity Exchange Act" and so provide a "strong argument" for development of a less burdensome regime for futures trading as well.
CFTC Chairperson Brooksley Born has argued the opposite, that the health of the futures industry argues for some minimum regulation of the so-far unregulated OTC derivatives market.
"Through the past decades' phenomenal growth of the derivative market, there has not been a significant downturn in the economy overall that has tested the resilience of derivative markets," Greenspan said.
He included an interjection that was parenthesized in his text, saying, "I operate on the premise that neither human nature nor the business cycle has been rendered obsolete."
"Despite the world financial trauma of the past 18 months, there is as yet no evidence of an overall slowdown in the pre-crisis derivative growth rates, either on or off exchanges," he said.
"The reason that growth has continued despite adversity, or perhaps because of it, is that these new financial instruments are an increasingly important vehicle for unbundling risks," he said.
Greenspan said that the current approach to bank risk modeling and the attendant regulatory capital requirements for banks that are major derivatives holders "is not altogether satisfactory."
"The most sophisticated derivative dealers parse their derivatives book in more detail," he said. "And certainly a single point estimate (of risk) cannot capture the range of losses that might reasonably be experienced. Hence," he continued, "in evaluating derivatives risk, far more stress testing of the lower probability outcomes is a necessity."
Even if a "one-in-500 occurrence does happen once every 500 times, and if that occurrence could threaten the franchise value of the derivatives counterparty is an important concern for risk aversion," he said.
Greenspan, taking the broadest view of derivatives trading, said that since one counterparty's market loss is the other counterparty's market gain "overall, derivatives are mainly a zero sum game."
But credit exposures, as opposed to market exposure, is "a different issue and the source of much of the systemic concerns."
Credit losses "rose to record levels in the third quarter of 1998," he said. "Nonetheless, the rate of loss remained well below that on banks' loan portfolios."
Moreover, he said, the "counterparty credit losses in the third quarter can be traced primarily to the extraordinary events in Russia, which produced many defaults on ruble forward contracts." In the fourth quarter such losses dropped sharply.
All in all, derivatives instruments "were bystanders" last year in the bulk of losses because of market declines in the underlying trading positions in equities, commodities and emerging market debt. "They may well have intensified the losses in underlying markets, but they were scarcely the major players."
[TOPICS: MNSFED,MMUFE$,MAUDS$,MFU$$$,MGU$$$,MI$$$$,MP$FI$]
10:14 EST 03/19
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