Tail risks with counterparty risk correlation The first category of contracts falls under the broad headline of “wrong-way” risk in tail events, and is purely statistical in nature. The particular issue is focussed on contracts that can be perceived of as providing insurance yet, in a stress scenario, when the contract is sufficiently in the money to be worth calling, there is a significant conditional probability that the insurance provider is no longer in business to pay out. In what follows, we look how such problems arise using practical examples and consider what lessons should be drawn. 1  For example, the Squam Lake Working Group on Financial Regulation, July 2009, “Credit Default Swaps, Clearinghouses, and Exchanges”. BIS central bankers’ speeches  1  When investor “A” decides to buy protection from bank “B” on exposure to a third company “X,” she may or may not explicitly take into account that in the event of default by X, B may in fact also be in trouble. Whether or not she does so would depend on the reason for the trade. If A wants default protection then that default correlation certainly should be taken into account2. But if, for example, the goal is just to reduce the price volatility of holdings of a certain corporate bond issued by X, this default correlation may not be seen as that relevant. As a practical example, take the case of a pension fund managing its corporate bond portfolio.
Despite that initial investor reaction, however, Deutsche was able to keep market access and to successfully issue further capital instruments in the months thereafter. The theme we have encountered in these examples is that many of the decisions taken during times of extreme pressure seem to be affected by (apparent) considerations outside of the immediate financial contract – at least, rejecting options which were perceived to be acceptable when the original contract was struck. Or that the financial consequences of particular decisions were more adverse for the decision maker (or more generally the markets) than anticipated. In that sense they are classic examples of time inconsistency. We have tried to illustrate how acting narrowly rationally when it is perceived to be outside the realm of “what is normally done”, can carry massive risks. The problem that this creates is that when we are dealing with tail events and disaster insurance, it is hard to determine ex ante what such insurance contracts (or options delivering insurance) are worth. How should investors and regulators evaluate these contracts? If the reputation and signalling implications of exercising are too damaging in case of extreme stress, it would be naive to attribute full value to them when determining the risk profile and hence the appropriate capital buffer. It is also worrying from a financial stability perspective if these considerations force possible systemic implications to be more extreme rather than less. Stress tests and contract design considerations So what have we learned?