Banks shrink from counterparty risk as EU financial crisis gathers steam

Both Reuters and the Wall Street Journal had articles (see here and here) on how banks, including Chinese banks, are reducing their exposure to other banks because they cannot assess the risk of the other banks.

Regular readers know that in the absence of ultra transparency where banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure details that the interbank lending market is prone to freezing.

This is further confirmation of that fact.

From Reuters,

Alarmed by Europe's latest debt crisis and its unpredictable outcome, banks are getting increasingly picky about who they do business with for fear of taking on risky exposures to rivals who could be about to be whipsawed by bad debts. 

Greece's slow-motion crash towards default, coupled with the poor health of banks in Spain, have left banks wondering if any of their fellow institutions will end up holding catastrophic losses and will be unable to meet their obligations.

Only the requirement that banks provide ultra transparency fully addresses this issue.  It is only with this data that can assess whether any of their fellow institutions will end up holding catastrophic losses and will be unable to meet their obligations.

All banks then are becoming increasingly cautious about their dealings with counterparties perceived to be in the firing line - making it harder for those firms to do their everyday business, throwing grit into the cogs of the financial system and ultimately crimping prospects for economic recovery. 

"Banks are particularly wary of counterparties at the moment and no compliance officer is going to take on exposure to a counterparty just because historically they have a strong track record," said Christopher Wheeler, an analyst at Mediobanca.

Being wary translates into a freezing of the credit market and a disruption of the real economy.

This disruption to the real economy was completely preventable.  It has been well known since the beginning of the credit crisis, which also saw the interbank lending market freeze because banks could not tell who was solvent and who was not, that the solution was to require ultra transparency.

The fact that policymakers and financial regulators have not made ultra transparency a requirement is an example of the efforts of Wall Street's Opacity Protection Team as well as regulators gambling with financial stability to protect their information monopoly.

In the fast-moving banking sector, failures can happen quickly. Just ask anyone involved with MF Global, which collapsed overnight in October last year after clients and trading partners pulled back amid rumours of a trading loss in the European sovereign debt crisis. 

Three years previously, Lehman Brothers became the largest bankruptcy in U.S. history, after it was brought to its knees by a combination of losses, nervous clients and credit rating downgrades. 

Failures like those can leave massive losses splattered across the financial system, reason enough for compliance officers to rein in risky exposures to their peers. 

For any bank, loss of trust is potentially fatal and can catch it in a pincer movement where it rapidly finds it harder to borrow money, while being asked to put up more costly security in its daily trading. 

There are signs in the market this is already happening. 

"Banks are being very cautious over who they do business with. They are avoiding counterparties they perceive to be risky ... and this attitude will become more extreme if market conditions deteriorate further," said Wheeler.

An added problem is that many of the markets in which investment banks participate are virtually invisible to regulators.

The problem is not that the markets are invisible to regulators.  The problem is that each bank's positions are not visible to their banking fellows.  Without this data, the other banks cannot make an assessment of each bank's riskiness.

From the Wall Street Journal,

Some of China's biggest banks have cut off a handful of their European counterparts from borrowing and derivatives trading as they seek to reduce their exposure to the simmering crisis on the Continent, people familiar with the matter said....

The moves by the Chinese banks, which occurred late last year and early this year, aren't believed to have had a significant impact on the funding or trading positions of their European counterparts, analysts say, given the still-limited role played by the Chinese in global funding markets and derivatives trading.... 

Many analysts view the Chinese banks' pullback from the European counterparties as a sign of improvement in how they manage risks posed by banks they do business with.

At the height of global financial crisis in 2008, some Chinese banks, including Bank of China, got burned because they failed to unwind their exposure to now-defunct Lehman Brothers Holdings Inc. fast enough.

"The Lehman bankruptcy was a wake-up call to many of us," said a senior Chinese banking executive based in Beijing. "Now we monitor the risks posed by our counterparties all the time, and it's the responsibility of our financial institutions and risk-management departments to adjust the amount of credit extended to our counterparties accordingly."

The European financial crisis has intensified in recent weeks because of fears that Greece will withdraw from the euro. European banks have been largely cut off from public funding markets and are reluctant to lend to one another, though most are under no immediate financial pressure because of the huge loan program implemented late last year and early this year by the European Central Bank.

Big Chinese banks started reviewing the credit profiles of their European counterparts in the second half of last year, with Bank of China—the most international of all Chinese banks—being one of the first to cut back on trading with and counterparty exposure to European banks.

Since late last year, the bank has suspended purchasing derivatives including credit-default swaps—or insurance-like financial contracts—from European banks including Société Générale and Crédit Agricole. ....

In addition, Bank of China also stopped trading certain foreign-exchange derivatives with UBS and BNP Paribas. ... 

Even as they have vowed to further liberalize the domestic financial markets, Chinese regulators have fretted that foreign banks could be a new source of risk to the domestic financial system.

"Risks associated with foreign banks shouldn't be overlooked," Shang Fulin, chairman of the China Banking Regulatory Commission, said in February.