Reputation Risk

Banks serving as dealers in credit derivatives face a number of reputation risks. For
example, the use of leveraged credit derivative transactions, such as basket default
swaps and binary swaps, raises significant risks if the counterparty does not have
the requisite sophistication to evaluate a transaction properly. As with leveraged
financial derivatives, banks should have policies that call for heightened internal
supervisory review of such transactions.
A mismatched maturity occurs when the maturity of the credit derivative is shorter
than the maturity of the underlying exposure the protection buyer desires to hedge.
Some observers have noted that protection sellers on mismatched maturity transactions
can face an awkward situation when they recognize a credit event may occur
shortly, triggering a payment obligation. The protection seller might evaluate whether
short-term credit extended to the reference obligor may delay a default long enough
to permit the credit derivative to mature. Thinly veiled attempts to avoid a payment
obligation on a credit derivative could have adverse reputation consequences.
The desire many dealers have to build credit derivatives volume, and thus distinguish
themselves in the marketplace as a leader, can easily lead to transactions of
questionable merit and/or which may be inappropriate for client counterparties.
Reputation risks are very difficult to measure and thus are difficult to manage.