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Acording to a new white paper from CME Group (NYSE:CME) the world's largest derivatives exchange, banks need to increase the amount of money backing derivative positions. In September, JP Morgan Chase (NYSE:JPM) had said that the CME Group should increase its contribution to the default fund from 5.25% to 10%. There is little agreement about who pays for bank default. This is a big exposure, as recently demonstrated:
The unregulated swaps market contributed to the 2008 financial crisis and worsened its aftermath in large part because the trades were done between private parties where unfunded risk was allowed to build. For example, in 2008 American International Group Inc. had to be rescued by the U.S. government with more than $180 billion after its swaps business blew up.
Ultimately, what will happen in the event of a bankruptcy of a major bank? They will shed assets, according to bank analyst Chris Whalen in the following Bloomberg video. But what is the definition of bankrupt? Isn't it that liabilities exceed assets? So a bank break-up under stress conditions would leave some entities 'holding the bag'. And Whalen implies that the bag could be big and very empty when he says the Fed stress tests are meaningless:
"You don't need an economist to design a stress test."
Econintersect: Who will be left holding the bag? It is better to ask who won't. With new policy being that derivatives are the top ranking claims in a bankruptcy it won't be the counterparties. And yet the CME is arguing that a greater fraction of derivative risks should be backed with cash. Which brings us back to Chris Whalen. Listen to the final sentence uttered at the end of the video, talking about return on equity for major banks:
"On a real risk adjusted basis they are negative."
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