Offsetable Derivative Exposures and Financial Stability

• In Event: Bank Failures, Systemic Risk, and Financial Stability

Abstract

U.S. GAAP allows banks to offset reciprocal derivative assets and liabilities with the same counterparty and present only the net amount on the balance sheet, causing trillions of dollars of derivative assets and liabilities to go unrecognized on banks’ balance sheets. These offsetable derivative exposures create the single largest quantitative difference between amounts presented under U.S. GAAP and those under IFRS, and have led to a long-standing debate about whether offsetable derivative exposures are informative of banks’ risk. In this paper, we examine whether offsetable derivative exposures have implications for financial stability. We find that offsetable derivative exposures are positively associated with banks’ default risk and with banks’ contribution to, as well as exposure to, systemic risk during periods of extreme illiquidity and counterparty credit risk in the financial system. We also find that in these times of severe distress in the financial system, regulatory capital ratios that incorporate offsetable derivative exposures have stronger explanatory power for banks’ default risk and systemic risk than the standard version of regulatory capital ratios currently used by regulators, which largely ignore these exposures.

Authors

• Jed Neilson, Penn State University

• Biqin Xie, Pennsylvania State University

• Christopher Williams, University of Michigan-Ann Arbor

• K. Philip Wang, University of Florida