BIS Review 53/2009  21  Table 3: Range of CDS Premia (bp) and Central Counterparties  Low uncertainty around counterparties' inter-linkages  High uncertainty around counterparties' inter-linkages  Probability of counterparties defaulting  Number of counterparties 1  2  10  50  1%  0  2  0  0  5%  0  10  2  0  10%  0  18  6  2  30%  0  42  44  43  1%  0  3  9  18  5%  0  14  39  60  10%  0  27  68  87  30%  0  63  127  136  Probability of reference entity defaulting = 10%; Loss given default rate = 50%;  Charts: Chart 1: Global Financial Network: 1985  22  BIS Review 53/2009  Chart 2: Global Financial Network: 1995  Chart 3: Global Financial Network: 2005  BIS Review 53/2009  23  Chart 4: CDS Premia and Network Uncertainty – Pre-crisis  Chart 5: CDS Premia and Network Uncertainty – Post-crisis  bps 500 Size of range of CDS prem ia  S ize of range of CDS prem ia  bps 500 400 300 200 100 0 50  400 300 200 100 0 50  40  0.5 30  0.4  20 Number of counterparties  10 0  40  0.5 30  0.3 0.2 0.1 0 Default probability of reference entity (p)  0.4  20 Number of counterparties 10 0  0.3 0.2 0.1 0 Default probability of reference entity (p)  Chart 6: Financial Contract Design  CDO  FINANCIAL ECONOMY  ABCP Senior ABS/CDO tranches  Senior AAA  (and bank debt/ capital)  Capital Notes  CDO2 Senior Mezzanine Equity  CDO mezzanine tranches  Mezzanine tranche Equity  Principal protected notes  CDO equity tranches  Leveraged loans  Mezz/second lien debt HY bonds  MTNs  Corporate assets  Mezzanine Equity HY bonds  CDO of ABS  HEL ABS/CMBS  Senior Senior  CPPI on CDO equity  24  Leveraged loans  LBO’d company  REAL ECONOMY  SIV  BBB- rated HEL ABS/ CMBS or synthetic  Sub-prime mortgages/ Mezzanine Commercia (often BBB-) l mortgages  Mezzanine Equity Equity  BIS Review 53/2009  Chart 7: Weighted-average Cumulative Total Returns Large Complex Financial Institutions Banks excl.

In addition, expectations for increased investor demand for euro-denominated investments, together with the possibility of reduced participation by speculative and arbitrage trading accounts, are likely to have an effect on spreads of fixed-income securities to Treasuries. Traders in various fixed-income markets already have begun to note increased levels of spread volatility and expectations for higher absolute spreads relative to historical levels in response to these market dynamics. In this environment, managing market risk will become more difficult as the nature of fixedincome spread products changes. As we recently have learned, spread relationships that had endured for many years can break down suddenly, thereby increasing the already complex task of hedging positions. The increase in the liquidity premium for on-the-run Treasury securities last fall resulted in increased hedge-related activity in both the interest-rate swap and Treasury futures markets. Traders have continued to explore the usefulness of non-Treasury fixed-income securities as hedging vehicles. Risk managers must, therefore, be especially rigorous in analyzing their firms’ positions and hedging strategies, particularly when historical experience may not be as predictive a guide as it once seemed to be. I am encouraged by some recent market efforts to improve risk management practices. In lending, the risk-return discipline has been greatly enhanced at some international banks. These institutions have introduced measures to compare credit spreads with historical loss rates on well defined categories of credit. They also have enhanced the methods they use to assign internal risk ratings to individual credit exposures.