The Sovereign–Bank Nexus via OTC Derivatives

Manmohan Singh

This chapter focuses on the role of collateral in the over-the-counter (OTC) derivative contracts between sovereigns and large banks. Specifically, due to the sizable volume of business (and associated revenue), most banks do not force sovereigns to post collateral when the sovereigns are “out of the money” on their derivative contracts. However, if banks are out of the money, they generally have to post collateral. The rhetoric about cutting the umbilical cord between banks and sovereigns will not get full traction unless sovereigns post collateral on their derivatives contracts with banks. Estimates of “out-of-collateral” positions are not trivial and thus cannot be ignored when discussing the sovereign–bank nexus. The official sector has largely focused on appropriate haircuts (and risk weights) for the sovereign bonds; the flexibility allows for inconsistency (and thus overvaluation of the bonds) relative to other risk metrics (Hannoun 2011). Furthermore, even research conducted in IMF (2018) did not discuss the derivative-related collateral linkages between sovereigns and banks.

INTRODUCTION

As we have already seen in Chapter 10, present market practices for those using

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