Focus on the beautiful things in life. (ukhudshanskiy) wrote,
Focus on the beautiful things in life.
ukhudshanskiy

Why central bankers are so scared of raising interest rates

This is what is meant by interest rate risk. It’s big and it’s real and the banks know all about it. Their answer is to hedge the risk with interest rate derivatives. It’s one of the reasons why there are so many of these contracts in existence. So that’s all OK then.

Just one question though: who have they bought those derivatives from? Why, other banks of course. This creates what is known as counterparty risk. Bank A sells insurance to Bank B. But then Bank A gets into financial difficulties (a significant deterioration in their creditworthiness would be enough) and suddenly Bank B isn’t as well protected as it thought it was.

Indeed, Bank A might start struggling precisely because of the insurance it has sold to Bank B. What if it can’t honour the contract? This creates a potential Catch-22 situation: the derivatives work as long as they’re not needed; calling them into action renders them useless.
This is precisely the kind of thing that occurred during the credit crunch - banks stopped trusting each other. New rules introduced since then require banks to actively manage their counterparty risk. In other words, banks are being asked to hedge their hedges.
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