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Netting, financial contracts, and banks: the economic implications

  • William Bergman
  • Robert Bliss
  • Christian Johnson
  • George Kaufman
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    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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    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
    Date of revision:
    Handle: RePEc:fip:fedhwp:wp-04-02
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    1. Rafael LaPorta & Florencio Lopez de-Silanes & Andrei Shleifer & Robert W. Vishny, 1997. "Legal Determinants of External Finance," Harvard Institute of Economic Research Working Papers 1788, Harvard - Institute of Economic Research.
    2. Oliver Hart, 2000. "Different Approaches to Bankruptcy," NBER Working Papers 7921, National Bureau of Economic Research, Inc.
    3. William R. Emmons, 1995. "Interbank netting agreement and the distribution of bank default risk," Working Papers 1995-016, Federal Reserve Bank of St. Louis.
    4. 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.
    5. 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.
    6. 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.
    7. 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.
    8. 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.
    9. 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.
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