In the world of finance, important things often occur during the weekend, when markets are closed, when negotiations and inside rumours cannot have any repercussions or profit to any insiders, as the media is busy with trivial news and the weather. An important agreement was signed on Saturday, October 11, between the large global banks “under pressure from regulators”, as stated in the AFP news release, and it relates to derivatives and, more specifically, the CDSs, or credit default swaps. These CDSs are like insurance against a country defaulting on its debt or a company going bankrupt.
The idea looks good at first glance, since it constitutes protection against the failure of an asset one owns, so what’s wrong with it? Well, the problem is that these derivatives have been sold in large quantities by the banks and that they might not necessarily have the required funds in case of a default, which would in turn bankrupt them, thus giving rise to a catastrophic domino effect. We’ve seen it already in September 2008 when Lehman Brothers, a large derivatives market trader, went bankrupt, creating chaos in the financial markets.
Regulators in large countries assert that a delay, however short, could give a failing bank time to re-capitalise itself and thusly avoid a panic effect on the financial markets. The International Swaps and Derivatives Association (ISDA), representing the banking sector, has also accepted to abandon the principle of automatic unwinding, or close-outs, of contracts, should a financial institution find itself in trouble. If a “too big to fail” bank is about to fail, regulators will have some time to find a solution in order to avoid an “inordinate” bankruptcy with potentially explosive consequences.
It is not too reassuring to think that this agreement underlines the real risk of big banks going bankrupt. Nevertheless, this agreement is objectively a good thing, since it delays a potential domino effect. But let’s be careful, since we now know how regulators go about solving banking crises: Their new method was inaugurated in Cyprus, in the Spring of 2013, and written in a European guideline that will soon go into effect (January 1st, 2016). Depositors’ accounts are used to make up for the bank’s losses; money is taken directly from their savings in order to restore the bank’s solvability. As happened in Cyprus and is written in the guideline, only accounts over 100,000 euros will be affected, but this won’t certainly be enough should a grave crisis occur, in which case one can be certain that all accounts will be involved.