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Price-makers seeking above-average profits in the OTC derivatives marketplace invariably find themselves entering arenas which defy consensus risk assessments: thinly traded foreign currencies, extended contract maturities, non-existent benchmark instruments, variable contractual terms, multi-jurisdictional exposure and diverse counterparties. One component of risk in OTC trades lies in fluctuating at-liquidation prices.

But it is the second component, broadly termed “counterparty risk”, which continues to defy quantification.

Price-related risks on bank balance sheets are disclosed on the basis of fair value measurements (SFAS-157). But counterparty risk assessments are rarely debated. “This is a slippery slope involving any number of local and foreign participants, the overwhelming majority of whom are unrated,” a Wall Street treasury head recently conceded to the writer. “The more you dig into counterparty risk, the more you stray into the bizarre arena of systemic risk.” Bizzare?

Fed Chairman Ben Bernanke has been talking of the systemic risk phenomenon ever since Lehman Brothers declared bankruptcy. According to the official position adopted by regulators, systemic risk is that risk which threatens the entire financial system (or marketplace); therefore the focus on financial institutions which are “too big to fail”.

But are the regulators suffering from an overdose of simplicity?

Bizzare may be too extreme a categorization; but there is little doubt that systemic risk today stems not from leveraged balance sheets but from a dramatic decline in the capacity of contracting parties to remain settlement-compliant on one hand and from inherent weaknesses in the international regulatory and legal framework on the other.

Because a rise in systemic risk is usually offset by economic turnarounds, there is arguable merit in the finger-in-the-dyke strategy adopted by Chairman Bernanke and Treasury Secretary Hank Paulson. The problem is that both czars misconstrued the source of systemic risk last September. Just keep the financial sector long enough and it will repair itself, they surmised. But they failed to account for the fact that the financial sector had already gambled on the healing powers of time, and lost.

For many months before September 2008, property developers were in dire straits, export orders were drying up, household surpluses were disappearing, real unemployment was rising and debt default ratios were approaching historic levels; the systemic risk caused by excess leverage and overpriced assets had already cast a dark shadow over all sectors of the economy.

And counterparty risk had acquired phenomenal across-the-board proportions. At the end of one of those many dreadful days on Wall Street, one hedge fund manager asked a rather disturbing question on CNBC: Does our economy really have the resilience to meet this highly complex challenge?

What followed were bailouts and stimulus packages. But has government intervention succeeded in decisively curtailing, if not eliminating, counterparty risk? If not, bank balance sheets (BAC, C, GS, JPM, MS, WFC) remain extremely vulnerable, with non-U.S. assets and contractual obligations adding new and complex dimensions to the systemic risk equation.

This writer is committed to the view that, insofar as the identification of the true nature of counterparty risk on dealer books is missing, the entire OTC matrix suffers from pricing inconsistencies. To a large extent, such counterparty risk is shaped by systemic risks which, in turn, are a direct consequence of flawed asset valuation methodologies, e.g. the parameters applied to the steady flow of appraisals generated for mortgages, for credit facilities and for asset acquisitions. Perhaps there is an urgent need to upgrade FSAS-157 before the government embarks on another round of intervention during the first half of 2010.

Or, perhaps, somebody in authority will bite the bullet and recommend a thorough de-leveraging and asset write-down in all core areas of the economy. The truth is that, in the context of a vastly-changed global economic framework, the economy does not have the resilience Wall Street has been banking on for one full year.

Source: Will the Counterparty/Systemic Risk Relationship Undermine Banks?