Derivatives dealers are beginning to make a market for credit derivatives, a relatively new type of contract designed to solve banks' perennial problem with loan concentration.
Commercial banks have repeatedly fallen victim to their geographic focus, which leads to concentrations of loans to a particular industry or company.
Now the dealers have begun to offer credit derivatives as an inexpensive way for regional institutions to diversify their portfolios without harming long-term relationships with borrowers.
Although the new techniques are becoming more commonplace - credit derivatives contracts with a notional value of $2 billion are in place - risk managers say bureaucracy at banks is working against the market's growth.
Ultimately, however, they argue that competitive pressure will force more bankers to consider using the instruments.
"Banks will continue to make loans for relationship purposes whether they make economic sense or not," said John Paganucci, a vice president with Bankers Trust Co.'s credit swaps group. "Now they can get out of these exposures through swaps, and it looks seamless to the borrower."
The three-year-old market is moving toward allowing banks and other companies to directly swap their credit exposures.
Richard Timbrell, risk manager for J.P. Morgan & Co.'s credit swaps group, identified credit default swaps as one of the most common credit instruments currently in use. These products allow a counterparty to buy protection against default of a loan or receivable by paying the derivatives dealer a periodic fee, expressed as a percentage of face value in basis points.
The protection is often based on the value of a publicly traded bond, called a reference security. Reference securities can be issued by a government, a corporation, or a financial institution.
"The protection buyer may be interested in this as a way to hedge out an exposure to a particular company," said Mr. Timbrell. "It's a vehicle for passing credit risk from one organization to another."
In these transactions, the dealer bank is required to make a payment to the counterparty only in the event of a default. However, payouts are usually restricted to cases where there is a true default event. While the definition of such an event is negotiable, the market standard is typically limited to bankruptcy, insolvency, or failure to make timely payments.
Following such an event, the payout is determined by the percentage decline in price from par on the reference security. The price decline measures the amount of credit loss.
For example, if a bank had a 10-year interest rate swap exposure to a company and it wanted to hedge that exposure for the next two years, the bank and a swaps dealer could enter into a credit default swap. The swap would link the protection to the performance of a publicly traded bond issued by that company, provided the bond has maturity, credit, and other characteristics similar to the hedged exposure.
Without this kind of mechanism, the bank has few viable alternatives. Besides holding on to the exposure and hoping the credit remains solid, the bank could hedge the exposure by shorting the reference security in the cash market.
But this strategy has some potential problems. First, there is a small market for corporate debt and it is expensive to short the bonds. Second, just when the credit starts to fall, the lender of the bonds is likely to call back and try to eliminate the short.
For their part, the dealers who have taken on the risk will search for ways to offset their positions in secondary transactions, Mr. Timbrell said.
Often, he said, dealers in this market can find institutional investors like insurance companies, pension funds, and international funds that are willing to take on this risk in the form of a credit swap or credit-linked note. The attraction of credit swaps for these sophisticated investors is the ability to earn higher returns, diversify their portfolios, and obtain greater balance sheet flexibility.
The investor also gets more income from these swaps and notes than is available from many other instruments with comparable risk.
But while investors and lenders alike have expressed interest in this market, dealers said the management structure of commercial banks is an obstacle to the immediate use of these instruments for asset/liability management.
"One of the barriers to use of these products at domestic banks is that they're not set up for it yet," Mr. Paganucci said. "When we talk to regional banks, they say it's a great idea, but come back in five years. So you have to get into the institution at a high enough level so they can see the need to put on macro hedges like this."
Part of the problem is that the products are designed to affect risks that overlap the lending and treasury functions, he added.
Nonetheless, competitive pressures may give the market the needed push. Mr. Paganucci said the first question most bankers ask about these products is: "Are my competitors doing it?"
