How Do Dealer Banks Price Derivative Products?

Taken together, these and other regulations have been reducing banks’ margins. In some cases, the regulatory environment has even led financial institutions to suspend previously profitable activities, due to both increased compliance costs in the form of staff and reporting, and increased return hurdles from higher capital requirements. Banks have also been evolving independently of new regulations and have learned from previous mistakes in their pricing of credit risk, funding costs, margin requirements, and capital—look no further than the failures of Bear Stearns and Lehman Brothers in the United States.

Thus, dealers have begun to factor a plethora of bilateral valuation adjustments into every derivative quote. In this new reality, the cost of doing business with large dealer banks is permanently higher, and nowhere else will this cost be felt more than by non-bank financial companies and corporate counterparties trading or hedging in the non-cleared over-the-counter (OTC) derivatives market.

Why Derivatives Pricing Is in Flux

The OTC derivatives market has already changed substantially as a result of several key regulatory reforms. Most relevant at the moment is the Basel Committee’s bilateral initial margin requirements on derivatives that are not centrally cleared (BCBS 261).