WASHINGTON — The Federal Reserve Board's stress testing methods may not be adequately capturing banks' indirect exposures to credit default swaps — an oversight that could have major implications for financial stability, according to a paper released Tuesday by the Office of Financial Research.

The paper applied the stress scenarios outlined in the Fed's last three Comprehensive Capital Analysis and Review, one of two annual stress tests that bank holding companies with more than $50 billion in assets are required to undergo annually.

The data agency concluded that the CCAR currently only examines direct counterparty concentrations of CDS — one bank holding a concentrated position of CDS contracts related to a single other entity. The paper argues that indirect exposures — the default not only of that other entity, but of the effect of that default on still other entities with which the bank may also have CDS contracts — could be even more significant than the direct exposures examined by the Fed.

Bank holding company "counterparty network losses from a failure of the BHC's single largest counterparty on average is nearly nine times greater than those of the BHC's own losses from its single largest counterparties' failure," the report said. "Thus, consideration of a large BHC counterparty failure that does not take into account second-order effects is likely to significantly understate potential risk to the BHC."

The paper comes as regulators are increasingly focused on identifying and mitigating the potential consequences of interconnectedness between banks and other entities within the financial sector.

The Fed proposed a single credit counterparty limit on Friday that would limit the direct credit exposures that large banks — especially the largest and most globally active banks — can have with a single counterparty. In his prepared remarks at the meeting to discuss the plan, Fed Gov. Daniel Tarullo said that the emphasis on financial contagion would continue to guide the agency's regulatory agenda, particularly as it pertained to the stress tests.

"The broader issue of common large counterparty exposures among the largest banks is one that we should bear in mind as we continue to develop the macroprudential features of our annual stress tests and capital assessments," Tarullo said.

The OFR paper also noted that in the last several years, bank holding companies have shifted from being the primary sellers of CDS contracts to being predominantly buyers, suggesting that the market is shifting outside of the banking sector and toward nonbanks. Moreover, the counterparty credit risk that banks hold has become increasingly concentrated in recent years, the paper suggests, and may be in part due to regulatory pressures.

"CCAR may motivate banks to reduce their provision of credit protection in the CDS market to minimize their losses under CCAR's trading shock," the paper said. "However, the adoption of the enhanced supplemental leverage ratio could also encourage U.S. banks to reduce their CDS exposures."

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