This entails counterparty credit risk and, taking account of collateral, is akin to writing out-of-the-money put options. So, for me, the question is not so much “where is the risk?”, as “in what circumstances could risk flow back to the banking system?”; and “do banks have enough capital and liquidity to absorb such flows without stress?” This is relevant not only to credit risk, but also to transfers of complex market risks. In providing bespoke “solutions” to their corporate and investment management clients, investment banks accumulate complex market risk exposures that are hedged largely in public, and so relatively “vanilla” wholesale markets. These hedges are inevitably imperfect. Some of the residual market risk is now occasionally transferred to the fund sector, via for example variance swaps or correlation swaps, transforming market risk into counterparty credit risk – underlining the importance of the work of the industry’s Counterparty Risk Management Group in debating and promulgating prudent practices. 10 Other imperfectly hedged risks are retained, leaving intermediaries with so-called “basis risk” – or, more prosaically, the risk that assumed correlations break down. Put bluntly, if instruments A and B have subtly (or not so subtly) different characteristics but are nicely correlated for a while, B might be employed as a “hedge” for A, without the implicit risk exposure turning up in Value At Risk measures.
Even country workouts in the early 1980s had that broad shape, albeit with the IMF holding the ring. One might wonder how on earth it would work today, in a world of traded debt, synthetic risk transfer, and vehicular finance. Much thinking remains to be done on this, but a policymaker has to form a preliminary view, just in case the music stops tomorrow. My provisional view is that some investors in credit risk would find themselves without the skill set to participate in a workout. In a “covenant-lite” world, they might also find themselves with fewer protections as conditions deteriorated than they would like ex post. Unless markets seized up, however, they might be able to crystallise their losses by selling out to funds and bank desks who trade in “distressed credit”; and they in turn might be able to sell on to funds and banks with specialist workout skills and risk appetites. By such transfers, the end-game co-ordination problems might be reduced. On the way, some hard bargains would be struck, and some participants would no doubt be surprised by their losses. But this relatively benign scenario is not guaranteed. It depends on markets continuing to function; on the infrastructure holding up through volume surges and stress; on the shadow of the insolvency regimes in various jurisdictions establishing productive incentives; and on lack of uncertainty in the terms and conditions of market contracts. That last point needs underlining.