Greece's slow-motion crash towards default, coupled with the poor health of banks in Spain, have left banks wondering if any of their fellow institutions will end up holding catastrophic losses and will be unable to meet their obligations.
All banks then are becoming increasingly cautious about their dealings with counterparties perceived to be in the firing line - making it harder for those firms to do their everyday business, throwing grit into the cogs of the financial system and ultimately crimping prospects for economic recovery.
"Banks are particularly wary of counterparties at the moment and no compliance officer is going to take on exposure to a counterparty just because historically they have a strong track record," said Christopher Wheeler, an analyst at Mediobanca.
In the fast-moving banking sector, failures can happen quickly. Just ask anyone involved with MF Global, which collapsed overnight in October last year after clients and trading partners pulled back amid rumours of a trading loss in the European sovereign debt crisis.
Three years previously, Lehman Brothers became the largest bankruptcy in U.S. history, after it was brought to its knees by a combination of losses, nervous clients and credit rating downgrades.
Failures like those can leave massive losses splattered across the financial system, reason enough for compliance officers to rein in risky exposures to their peers.
For any bank, loss of trust is potentially fatal and can catch it in a pincer movement where it rapidly finds it harder to borrow money, while being asked to put up more costly security in its daily trading.
There are signs in the market this is already happening.
"Banks are being very cautious over who they do business with. They are avoiding counterparties they perceive to be risky ... and this attitude will become more extreme if market conditions deteriorate further," said Wheeler.
An added problem is that many of the markets in which investment banks participate are virtually invisible to regulators. The $400 trillion market for interest rate swaps, for instance, is largely traded over the phone.
Banks trading these instruments - which offer protection against changes in interest rates - have a direct exposure to their counterparties, which needs to be managed by their in-house risk management teams.
This is not a new challenge, but the function takes on added importance in times of financial stress when firms ask for extra security to be put up on trades, aiming to ensure they are not left on the hook by a counterparty de f ault.
Banks then are raising the so-called margin calls - cash or securities held for the period a trade is live - which they demand from firms they perceive to be risky, piling more pressure on such firms.
If these positions are traded on an exchange, margin contributions are set by the exchange itself, by calculating the industry's exposure to any one trading house. This makes it a reasonably straightforward process.
But in the unlisted over-the-counter markets where the most complex and risky derivative instruments trade, margin calls are determined by individual firms based on their perceived exposure to trading partners - a more arbitrary process.
Given the skittish nature of the markets, trading houses are demanding more and more collateral from counterparties upfront, which piles the pressure on those firms seen as risky.
"Firms are really having to do their homework at the moment and put in place the relevant security against counterparties," said Wheeler.
At the same time as margin calls are on the rise, the European debt crisis has led unsecured lending between banks to all but dry up, forcing banks in turn to put up expensive collateral to get access to money.
WAVE OF DOWNGRADES
Banks' plight could be about to get even worse, with analysts expecting a wave of credit ratings downgrades of major global lenders, making a return to unsecured markets unlikely in the short to medium term. Moody's for instance has said it will conclude a review of financial institutions by the end of June.
All this means a very real pressure to put up more collateral, both to secure funding and to continue trading with counterparties in financial markets.
And the pressure on bank funding will only increase as new regulation forces banks to find and allocate extra collateral against various banks practices.
"A knock-on effect of the credit crisis is that regulators want the financial market to be more resilient and, to that end, they want all credit exposures to be collateralized," said Olivier de Schaetzen at settlement house Euroclear.
Policy-makers in the United States and Europe are keen to pass reforms that will force complex debt instruments to trade more like shares and futures by using exchanges.
From next year, swaps and other derivative instruments - often worth hundreds of millions of dollars - will have to be channeled through exchange-backed clearing houses, which guarantee pay-outs in case any counterparty goes under.
Clearing houses in turn will require trading firms, including banks, to put up extra collateral so as not to expose themselves to heavy losses.
The U.S. national bank regulator has said the regulatory changes could increase the value of collateral by $2 trillion, an increase of 50 percent from current levels.
Said Mark Higgins, managing director of clearing and collateral management at BNY Mellon: "By most estimates firms are going to need many more billions or even trillions of extra collateral to meet their additional requirements." (Editing by Douwe Miedema and David Holmes)
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