Catastrophe bonds for the financial banking systems

We’ve mentioned in the past the potential for catastrophe bonds to be utilised by the banking systems as a way to protect against the failures we’ve seen due to the global financial meltdown. Now, the International Monetary Fund has published a working paper which suggests exactly that as a possible left-field approach to protecting financial institutions from the risks faced in these times of credit uncertainty and financial market turbulence.

The working paper entitled Out of the Box Thoughts about the International Financial Architecture, by Barry J. Eichengreen, takes a look at a number of reforms and innovations to the international financial systems which might be implemented over the next ten years and their benefits or otherwise.

One section looks at the possibility of setting up some sort of global systemic risk facility which would allow banks to protect themselves with an adequate financial buffer by issuing catastrophe bonds. Eichengreen cites this as a better solution than requiring banks to carry adequate capital as for the cost of a premium they would have sufficient cover to weather all but the most extreme financial meltdowns. He cites the use of indexed triggers as another benefit as this means the payout is linked to a systemic event rather than a bank specific event (a definite plus when you are talking about events that would cause multiple banks to have problems or fail).

Eichengreen highlights the biggest issue with the use of cat bonds by banks, finding a suitable counterparty, this will be difficult given that most counterparties of catastrophe bonds are banking institutions or bonds which would be held by banks. The other issue of course is correlation. One of the selling points of natural catastrophe bonds is their non-correlated nature to the wider financial markets. Issue a catastrophe bond on a bank and suddenly you are fully correlated, the risks facing the issuer are the same as the risks facing the bond and even the counterparty.

The paper goes on to discuss the possibility of public-private partnerships working together to set up standardised bonds which could be issued with the IMF’s backing, in a system similar to the Caribbean Catastrophe Risk Insurance Facility. It’s difficult to say whether this would be feasible for the financial system as any effort would need to be global to take into account the fact that financial market hiccups are generally felt globally.

It’s an interesting idea and the paper as a whole is well worth reading if you are at all interested in financial market governance and how this could be improved.

You can download the full paper at this link.