I usually don’t get overly concerned about derivatives and bank exposures, but this caused me to pause:
A proposed accounting change spotlights the problem. The draft rule issued in January would require companies to show the total value of derivative assets and liabilities on balance sheets, rather than netting them off against each other. Already used internationally, this would cause the balance sheets of those using derivatives to balloon. Those include banks and nonfinancial companies using derivatives to hedge against things like changes in interest rates or currencies.
Yet an examination of how the change will play out shows just how concentrated derivatives use remains within just a handful of the biggest banks.
In a recent report, Credit Suisse analyst David Zion estimated S&P 500 companies would show $7.5 trillion in derivative assets, if they weren’t netted off against liabilities. Of these assets, about 98%, or about $7.37 trillion, are held by financial firms. The biggest nonfinancial holders, by comparison, are utilities with $52 billion in gross derivative assets, energy companies with $31 billion and industrial concerns with $18 billion.
The disparities are striking. So, too, is the concentration of the instruments among the biggest banks. Mr. Zion notes that J.P. Morgan Chase, Bank of America,Citigroup, Goldman Sachs Group and Morgan Stanley account for about 95% of the derivatives total, in line with data from the Office of the Comptroller of the Currency.
The excerpt above is from the WSJ. I looked for the actual report but could not find it, so I don’t know a lot of the details behind Mr. Zion’s numbers. For instance, I have no idea what universe of derivatives he is using. There could be lots of plain vanilla interest rate swaps in the $7.5 trillion number being bandied about, so I have some doubts about just how much risk is embedded in the numbers.
Thomas Hoenig, the Kansas City Fed President, uses these numbers to argue that the only way out of this concentration of risk is to break up the banks. His argument is that new regulation, Dodd-Frank and expanded resolution authorities are not going to prevent the next collapse simply because you can’t wind down institutions while there is this much interconnectedness. He has a point.
Maybe the only solution is to break up these guys before they really do bring things down on everyone's head.