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Netting, financial contracts, and banks: the economic implications

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  • William Bergman
  • Robert Bliss
  • Christian Johnson
  • George Kaufman
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    Abstract

    Derivatives and certain other off-balance sheet contracts enjoy special legal protection on insolvent counterparties through a process referred to as 'close-out netting.' This paper explores the legal status and economic implications of this protection. While this protection benefits major derivatives dealers and derivatives markets, it is less clear that other market participants or markets in general are better or worse off. While we are not able to conclude whether or not these protections are socially optimal, we outline the wide range of issues that a general consideration of the pros and cons of netting protection should take into cognizance, and analyze some of these issues critically. Ultimately the question becomes one of quantifying complex trade-offs.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-04-02.

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    Date of creation: 2004
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    Handle: RePEc:fip:fedhwp:wp-04-02

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    Keywords: Derivative securities ; Contracts;

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    References

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    1. Darryll Hendricks, 1994. "Netting agreements and the credit exposures of OTC derivatives portfolios," Quarterly Review, Federal Reserve Bank of New York, issue Spr, pages 7-18.
    2. RAFAEL LaPORTA & FLORENCIO LOPEZ-de-SILANES & ANDREI SHLEIFER & ROBERT W. VISHNY, . "Legal Determinants of External Finance,"," CRSP working papers 324, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    3. Rafael La Porta & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, 1998. "Law and Finance," Journal of Political Economy, University of Chicago Press, vol. 106(6), pages 1113-1155, December.
    4. Oliver Hart, 2000. "Different Approaches to Bankruptcy," Harvard Institute of Economic Research Working Papers 1903, Harvard - Institute of Economic Research.
    5. Furfine, Craig H, 2003. " Interbank Exposures: Quantifying the Risk of Contagion," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(1), pages 111-28, February.
    6. Robert R. Bliss, 2003. "Bankruptcy law and large complex financial organizations: a primer," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 48-58.
    7. William R. Emmons, 1995. "Interbank netting agreement and the distribution of bank default risk," Working Papers 1995-016, Federal Reserve Bank of St. Louis.
    8. Kaufman, George G., 2002. "Too big to fail in banking: What remains?," The Quarterly Review of Economics and Finance, Elsevier, vol. 42(3), pages 423-436.
    9. George G. Kaufman & Steven A. Seeling, 2002. "Post-resolution treatment of depositors at failed banks: implications for the severity of banking crises, systemic risk, and too big to fail," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q II, pages 27-41.
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