Academic journal article The Journal of Bank Cost & Management Accounting

Quantifying the Potential Credit Risk Exposure of an Interest Rate Swap

Academic journal article The Journal of Bank Cost & Management Accounting

Quantifying the Potential Credit Risk Exposure of an Interest Rate Swap

Article excerpt

A commercial bank's participation in the interest rate swaps market is a natural outgrowth of its role as an intermediary in financial markets and its intimate relationship with the concept of interest rate risk. Some banks offer interest rate swaps primarily as a convenience to customers as part of a package of financial services, while others view a swap portfolio as part of their capital markets' dealing activities. As a dealer or market maker in interest rate swaps, a bank is a true intermediary in the sense that it is a principal (counterparty) in the transaction, in contrast to brokers, who bring counterparties together, but are not themselves counterparties and assume no risk. And just as depositors of the bank do not contract with debtors of the bank, offsetting interest rate swap counterparties with the bank are not connected to each other in any direct way. Due to the rapid growth in the market, which has led to demand for swaps such that transactions take place with a phone call, the dealers dominate the activity and the brokers service the dealers. The most active interest rate swaps dealers are large commercial and investment banks that hold portfolios of swaps and typically offer a range of derivative products.

NOT SO HUMBLE BEGINNINGS

The concept of swaps originated from efforts to evade currency exchange controls imposed by the British in the 1970's. In an attempt to make foreign investment less attractive, a tax was levied on the outflow of British currency. Through the use of what were called parallel and back-to-back loans, businesses in the U.S. with British parents and firms in Britain with U.S. parents arranged to "exchange" loan obligations, avoiding the transfer of currencies between the countries. In some cases, both parties had loan agreements with a third party lender, but in all cases, there were two separate agreements for the payment of both principal and interest to each other. Under these independent agreements, the default of one party did not release the other party from its obligation to pay. The need to design a single agreement to provide for the release of the non-defaulting counterparty, along with the appearance of brokers and dealers to facilitate the exchanges, set the stage for the first notable currency swap, consummated between IBM and the World Bank in 1981. Soon after, the first interest rate swap was transacted in London, and in 1982, Sallie Mae executed the first interest rate swap in the United States.(1)

U.S. dollar interest rate swaps grew more quickly than currency swaps as their value as portfolio risk management tools were recognized. In 1985, in response to the need for standardized documentation and language for interest rate swap agreements, the International Swaps Dealers Association (ISDA) introduced the Code of Standard Wording, Assumptions, and Provisions for Swaps (revised in 1986). By 1987, after barely five years of activity, the value of U.S. dollar interest rate swaps measured by notional principal amounted to $540.5 billion, compared to $162.6 billion in currency swaps.(2) Growing at an annual rate of about 50%, interest rate swap outstandings measured over $1.5 trillion by 1991.(3) Estimates are that current outstandings are in the $3 trillion range. Today, a large percentage of interest rate swaps transacted have standard characteristics and documentation, and the market is considered quite liquid.

WHY THE BANKS NEED TO PAY CLOSE ATTENTION TO SWAPS

Despite the growth in size and sophistication of the market for interest rate swaps, there is a general lack of understanding of the potential for losses, both on an individual and a market-wide basis, should a financial crisis occur. The financial crisis may be the bankruptcy of a counterparty with significant exposure, or a large unexpected swing in interest rates. These are concerns for the bank as a writer of swaps and as a lender to firms with swap exposure. As with any other off-balance sheet activity, lenders should have an understanding of the implications of a swap contract, whether purchased from the bank with respect to new debt, or previously contracted with a third party. …

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