Counterparty credit exposure won't spark the next Lehman

The tenth anniversary of Lehman Brothers’ demise has brought with it speculation on the potential source of the next crisis. Evidence from recent risk disclosures suggests a future panic is unlikely to be triggered by the failure of a bulge-bracket dealer as in 2008. Not only are the biggest banks far smaller and less interconnected than in their pre-crisis heydays, they are also carrying less risk.

Data from the European Banking Authority shows the European Union’s largest banks collectively shed $3.2 trillion in assets in the five years to end-2017, with the top four – Barclays, Deutsche Bank, BNP Paribas and HSBC – alone accounting for $1.74 trillion of the shrinkage.

US banks have also slimmed down substantially, while evidence published by the Federal Reserve in July suggests mid-tier firms are curbing their growth to duck enhanced regulations linked to asset size.

That firms have taken their axe to balance sheets bloated by complex, hard-to-value assets and webs of bilateral derivatives to reduce their risks is old news. There are two post-crisis trends, however, that merit fresh comment.

First of all, dealers on both sides of the Atlantic have focused their asset curbing on those exposures whose required capital cannot be calculated using internal risk models.

Fourteen EU and Swiss global systemically important banks (G-Sibs) have cut credit exposures assessed using regulator-set standardised approaches at twice the speed of those governed by internal ratings-based approaches since 2013.

Meanwhile, of the eight US G-Sibs, all but two have now fallen below the so-called ‘Collins floor’, meaning their risks as measured by their own internal models are lower than those as gauged by the standardised approach.

That could concern regulators: the rapid growth in the proportion of banks’ credit assets capitalised using internal ratings-based approaches is precisely the sort of development that encouraged the Basel Committee on Banking Supervision to floor capital requirements at a set fraction of those dictated by the standardised approach – so as to prevent banks shrinking their prudential buffers according to their own views of the risks they are running.

Data from the European Banking Authority shows the European Union’s largest banks collectively shed $3.2 trillion in assets in the five years to end-2017

The second trend is the sustained length of the post-crisis credit cycle upswing. EBA data shows firms’ estimates of corporate default risk continue to be on a downward slope, almost a decade into the economic recovery.

Elsewhere, counterparty credit risk as reported by UK and US banks continues to be spread across many thousands of entities considered to be at very low risk of collapse rather than concentrating among a handful of large firms teetering on the brink. Several factors may be at play here: counterparties may well be in fine fettle – or it may be that banks have simply junked riskier borrowers, leaving them to non-bank lenders.

Either way, the evidence suggests a counterparty credit calamity such as that triggered by Lehman is unlikely to shake the financial system anytime soon.

Editing by Tom Osborn