Counterparty Risk and the Potential Losses from OTC Derivatives

Nov.21.08 | About: Financial Select (XLF)

In February, Barlcays estimated that if one major institution went down, there would most likely be between $36-$47 billion in losses due to counterparty risk in the credit default swap market as risk was repriced. A similar CDS study by BNP Paribas put the figure at $150 billion in potential losses.

But the repricing of risk extends just beyond the CDS market, IMF economists Miguel A. Segoviano and Manmohan Singh argue in a new working paper. Using data on banks' counterparty positions before the Bear Stearns collapse, the pair calculate the potential loss to the financial system from a repricing of risk across the entire OTC derivatives market:

in the case of a single institution failure, the total loss could be as high as $300-$400 billion depending on the [institution]; but when cascade effects are taken into account, the total loss could rise to over $1,500 billion.

And that's just the potential losses from the derivatives and not the underlying assets. The IMF said in October it expects banks around the world to need $675 billion in order to recapitalize.