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Credit derivatives not yet helping banks' risk management, says S&P

Despite a rapid rise in innovation and trading activity in credit derivatives, the instruments have “a long way to go” before fulfilling their promise to become “a significant force in risk management for banks”, says the report by S&P’s credit analyst, Tanya Azarchs.

"As promising as the credit derivatives technology is, it is not yet a panacea for credit problems of banking systems around the world," said Azarchs. "It has not, as is commonly believed, helped banks avoid meaningful amounts of losses in the current credit cycle."

Azarchs says one reason is that most of the activity takes place between dealers, and does not involve end-users. S&P estimates that of the $3 trillion total notional amount of credit derivatives outstanding, only $100 billion represents transference of credit risk from banks’ lending and trading activities to other market participants.

Another reason is that most of the credit protection available is on the lowest-risk names. “This appears to have the effect of shifting the remaining risks in the banking system further towards the riskier, non-investment-grade range of the spectrum,” the report says.

Azarchs also says that for structured transactions, the risks are generally retained by banks.

The report warns that as credit derivatives take increasingly complex forms, they will pose challenges to accounting standards, regulators and analysts.

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