Commercial Bank Derivatives: A Disaster Waiting to Happen

The Global stock markets, commodity markets and many other asset classes have gone up significantly since the lows of March 2009. But these asset classes might still not be in a bubble stage. However, the global optimism is surely in a bubble stage. Its a bear market for negative and more realistic opinions which is generally avoided or countered with sharp criticism these days.

However, the fact is that the biggest financial crisis that was beginning to unfold has just been postponed for a future date. The Governments and financial institutions are doing their best to make the crisis look even worse when it comes back in a much bigger way.

In this article, I would primarily be discussing the commercial bank derivatives, which is just getting bigger with time and it has the potential to cripple the entire financial system.

The notional amount of total derivatives among the Commercial Banks in U.S. has increased from $95.6 trillion in December 2005 to $190.0 trillion as on June 2009. The chart below gives the details of the same.

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Commercial Bank Derivatives

Source: FDIC

The table above gives the segmentation of the derivatives contract among futures and forward contract, option contracts and swaps.

The current financial crisis took a serious shape from October 2007 when the Federal Reserve cut rates for the first time. So, even when the world was going through one of the worst economic and financial downturns, the derivatives market went up by 27% to $190 trillion from $150 trillion as on December 2007.

One of the functions of economic recession is that it cleans the system of its excesses. However, the unique feature of this recession is that it has laid a solid foundation for a depression and a big financial collapse. The above example is just one of the reasons for saying so.

The interest rate swaps form a major portion of the composition of the commercial bank derivatives.

Composition of Commercial Bank Derivatives

Source: FDIC

As evident from the chart above, 91% of the derivative contract is in interest rate swaps. It might be interesting to study the reason for the high concentration of derivatives in the interest rate swaps. Certain evidences suggest that it might help in artificially supporting bond markets. However, that is still subject to further study and conclusive evidences.

Another interesting statistic about Commercial Bank Derivatives is that it is only for the big players in the market.

Concentration of Commercial Bank Derivatives

Source: FDIC

It must be noted here that the amounts do not represent either the net market position or the credit exposure of banks’ derivative activities. They represent the gross value of all contracts written. Spot foreign exchange contracts of $1,395 billion for the seven largest participants and $85 billion for all others are not included.

The purpose of holding derivatives is also a key factor to look into. There is no doubt that most of it would be held just for trading.

In this respect, I would like to add that the only thing the banks have done with the bailout funds is to trade and speculate. Thus, there is no great reason to cheer when these banks come out with decent profit numbers. One really needs to work hard and be very dumb to be in losses even after getting billions of Dollars of free money.

Major Factors Affecting Earnings (Q2 09 vs. Q2 08)

Source: FDIC

It is clear from the chart above that it is increase in non interest income which has primarily lead to rise in banks earnings. The core banking business is still struggling as evident from the increase in loan loss provision.

As mentioned earlier, the primary purpose of holding derivatives is trading. The chart below confirms the same. Around 99% of the Derivatives have been held for trading.

Purpose of Commercial Bank Derivatives

Source: FDIC

The Derivatives held by Commercial Banks in the U.S. is already over ten times the size of the U.S. economy. This figure is just getting bigger and there has been no effort to put a tab on the same. There is no doubt that it is a big disaster waiting to happen. No one would exactly know the time frame, one day the entire financial system would collapse because of these derivatives. What one saw after the Lehmann collapse can be considered to be just the trailer.

As the above chart showed, it is a exciting game for the big players. But when it will collapse, the effect will be felt even by those who have not heard the word Derivatives.

So, apart from the big derivatives bomb, apart from record high deficits any country ever had in the history of capitalism, apart from rising unemployment and apart from purchasing power vanishing from the massive expected inflation, everything is fine with the world economy.

Comments

[Albertarocks:]

Ok, let's talk for a second about only one tiny portion of the overall exposure, the equity dirivatives component. Would that be puts and calls only, or are there some other instruments available?Just for the sake of argument let's assume the entire $2 trillion is in the form of puts and calls on equities and indexes. I'd say at the very least, I could envision a scenario where an unscrupulous entity (again, just for argument sake, let's say a bank) who has exposure to $2 trillion worth of options, probably a good percentage of which will be expiring on the third Friday of the month might have some incentive to "not lose" any of that money if possible.How would it be possible to ensure he doesn't lose that money? Just putting the question out there for your consideration.

Oct 22 08:45 PM

[Mr. Big:]

"It might be interesting to study the reason for the high concentration of derivatives in the interest rate swaps. Certain evidences suggest that it might help in artificially supporting bond markets."


Interest rate swaps are a primary tool used by corporates (and financial institutions) to manage interest rate risk. Speculative swap positions form a small minority of the total. As well, the lion's share of interest rate swaps involve no exchange in notional principle at all so really, the real risks of swaps are generally a small fraction of the principle (equal to the difference in interest flows of the two legs of the swap). Finally, CSA agreements (credit support agreements) are generally now mandatory in ISDA contracts to help mitigate the credit risks. The CSA requires the pledging of liquid assets when the mark-to-market of the swap exceeds a certain threshold.

While I'm not debunking the potential dangers of the current derivatives situation (CDS market is where the true danger is), I just wanted to add some perspective so that people won't think that there's really $190 trillion in value can potentially be wiped out if things go sour.....that is simply not true.

Oct 22 08:59 PM

[GrantQ:]

I'm sorry, but i missed the part that explained what the "disaster waiting to happen" was exactly, what will trigger it, and what the actual results of this disaster will be.

If this is just a "here are some random thoughts, enjoy" article, that's fine, but then the topic should reflect that.

Oct 22 09:25 PM

[Vuke:]

Mind boggling. All those traders profiting on this stuff.

And who are the losers? No answer as yet.

Oct 22 10:30 PM

[Roger Knights:]

"So, apart from the big derivatives bomb, apart from record high deficits any country ever had in the history of capitalism, apart from rising unemployment and apart from purchasing power vanishing from the massive expected inflation, everything is fine with the world economy."

... and the play was wonderful too.

Oct 22 11:24 PM

[Bronze pencil:]

It's pleasing to find that the Interest Rate derivatives are amongst the least volatile of the hedging tools. Regarding the farming-out of the 'credit support' obligation, I would have to question whether that would be considered a good banking practice, no. At these volumes it may be systemically unsound.
I expect that the activity brings profits unencumbered by asset provision.
The matter of policy functions to be valued at these systemically important banks might well be raised at some later date.

Oct 23 03:03 AM

[kwtIt:]

Interest rate swaps (IRS's) are primarily a tool to manage long term interest rate exposure. Generally the principal (notional) is not exchanged between the contraparties. The ~170 trillion number is really meaningless.

A typical IRS works like this: 1 party agrees to pay a fixed percentage of the notional (eg 4%) and another party agrees to pay a floating interest rate (Eg 3 month LIBOR + 50BP). Every six months the two parties exchange cash flows. Lets say on a 100,000 swap with a fixed side of 4% and 3M libor at 3.2 then the fixed side would pay the floater side $300 (4% 100,000 = 4000, 3.7% * 1000 = 3700; 4000-3700=300). They would then meet again in 6 months and exchange cash again ( libor would have moved so maybe now the floater side would have to pay to the fixed. Eventually the contract gets terminated or matures.

Why do you do this? Why is it primarily the big banks? Why is it a _good_ thing and not a bad thing? Banks tend to have large long term bond portfolios. The more long term they are, the more their value fluctuates due to interest rate changes. Your positions can easily lose millions of dollars a day with a very small interest rate move. Thats bad. Enter IRS's. They're allowing the banks to take a portion of their long term bond's fixed coupons and swap them with floating coupons. This effectively erases much of the interest rate exposure the position faces. It makes their returns more predictable. On the other side of the trade is the banks need for certain assets that pay floating rate cash flows to generate fixed cash flows. Again this stabilizes markets.


There's a lot of bad stuff in the world - but IRSs arent one of them. In general (esp - intra bank IRS swaps, lets not talk about swaptions municipalities are entering into with banks) are non-speculative and mutually beneficial to both sides.
Be more worried about CDS, swaptions, synth-CDOs, etc. Nothing to see here, move along.

Oct 23 03:25 AM