Banks Bracing for 2012 Euro Financial Apocalypse

As the European debt crisis threatens to spiral out of control, banks are scrambling behind the scenes to protect their balance sheets and hedge their exposure to ride-out an increasingly scary 2012. 

But while some of the moves may help mitigate the losses from Armageddon, market watchers say certain financial insurance policies — particularly credit default swaps on sovereign debt — may not work in a new financial crisis. 
 
Banks are loading up on hedges against a possible European financial collapse. The notional amounts outstanding of over-the-counter derivatives rose 18 percent in the first half of 2011 to $708 trillion as of June 2011, a record high, according to a report by the Bank of International Settlements released Wednesday. In the second half of 2010, the notional value rose only by 3 percent. 

Over the counter derivatives are private agreements between parties, different from derivative contracts that are traded through exchanges. The notional value of contracts provides a measure of market size, but not the actual measure of the value that is at risk among participants. 

"Given all the increased volatility — the unusual conditions with the dollar and the euro, the debt crisis in Europe, the debt problems of the U.S. — you are seeing an increase in hedging," says Steve Wyatt, professor and Chair of the Finance Department at the Farmer School of Business at Miami University, Ohio. "The more astute observers in the market have come to the conclusion that the ECB will not buy enough paper to change the market view on this because of inflation fears. The only way out of this is fiscal integration or some modification of the membership in the Euro. That is not going to be quick or clean. That is the risk participants are hedging against."

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