"Highly interconnected" aptly describes the modern financial system and motivates widely shared concerns about it.
Former banker and fund manager Richard Bookstaber, for example, views the "tight coupling" of various aspects of the financial system as fraught with risk and prone to crashes. Lawmakers and regulators, for their part, do not want institutions to become too interconnected to fail.
But it seems that the evolution of financial markets and the effects of financial reform may result in markets becoming more interconnected than ever. Or least interconnected in new ways when it comes to the all important issue of collateral.
To help make the most out of scarce, high-quality collateral, banks and other financial firms have been increasingly focusing on collateral management. But regulatory reforms mandating the use of high-quality collateral for derivatives trades and other transactions has also spurred the activity known as collateral transformation, which involves trading lower quality collateral, such as risky corporate bonds, for higher quality collateral like government bonds or cash.
Estimates of how much collateral will ultimately be required to comply with new regulations vary greatly and range from $500 million to $2.6 trillion, as noted by Bloomberg. Proposed Basel III bank capital regulations, for example, would require bilateral over-the-counter derivatives trades to be collateralized with cash, high quality bonds and equities, or gold. Firms lacking the qualifying collateral could trade up to comply.
A potential source of high-quality collateral may come from outside the banking system--from corporations flush with cash. In summarizing the November 6th, 2012 remarks of Vanaja Indra, Risk.net reported that
Cash-rich corporates could ride to the rescue...Many of these have enjoyed high profitability over the past few years and have stockpiled cash to defend ratings or build takeover war-chests. Apple, Microsoft, Cisco Systems, Google and Pfizer had a combined cash balance of $276 billion at the end of 2011, according to one report from Moody's Investors Service.
By removing some of the funding risk outside of the banking system, corporate cash lending may reduce systemic risk. But if corporations begin seriously lending their cash in exchange for lower quality assets, the real economy will become interconnected with the financial system in an unprecedented way.
So who knows, maybe sometime soon your next iPhone purchase will help to fund a derivatives trade.
Comments