Too Interconnected To Fail: Financial Contagion and Systemic Risk in Network Model of CDS and Other Credit Enhancement Obligations of US Banks

Abstract

Credit default swaps (CDS) which constitute up to 98% of credit derivatives have had a unique,\nendemic and pernicious role to play in the current financial crisis. However, there are few in depth\nempirical studies of the financial network interconnections among banks and between banks and nonbanks\ninvolved as CDS protection buyers and protection sellers. The ongoing problems related to\ntechnical insolvency of US commercial banks is not just confined to the so called legacy/toxic RMBS\nassets on balance sheets but also because of their credit risk exposures from SPVs (Special Purpose\nVehicles) and the CDS markets. The dominance of a few big players in the chains of insurance and\nreinsurance for CDS credit risk mitigation for banks’ assets has led to the idea of “too interconnected to\nfail” resulting, as in the case of AIG, of having to maintain the fiction of non-failure in order to avert a\ncredit event that can bring down the CDS pyramid and the financial system.\nThis paper also includes a brief discussion of the complex system Agent-based Computational\nEconomics (ACE) approach to financial network modeling for systemic risk assessment. Quantitative\nanalysis is confined to the empirical reconstruction of the US CDS network based on the FDIC Q4\n2008 data in order to conduct a series of stress tests that investigate the consequences of the fact that\ntop 5 US banks account for 92% of the US bank activity in the $34 tn global gross notional value of\nCDS for Q4 2008 (see, BIS and DTCC). The May-Wigner stability condition for networks is\nconsidered for the hub like dominance of a few financial entities in the US CDS structures to\nunderstand the lack of robustness. We provide a Systemic Risk Ratio and an implementation of\nconcentration risk in CDS settlement for major US banks in terms of the loss of aggregate core capital.\nWe also compare our stress test results with those provided by SCAP (Supervisory Capital Assessment\nProgram).\nFinally, in the context of the Basel II credit risk transfer and synthetic securitization framework, there is\nlittle evidence that the CDS market predicated on a system of offsets to minimize final settlement can\nprovide the credit risk mitigation sought by banks for reference assets in the case of a significant credit\nevent. The large negative externalities that arise from a lack of robustness of the CDS financial network\nfrom the demise of a big CDS seller undermines the justification in Basel II that banks be permitted to\nreduce capital on assets that have CDS guarantees. We recommend that the Basel II provision for\ncapital reduction on bank assets that have CDS cover should be discontinued.

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