Derivatives are still out of control

The Reserve Bank governor Glenn Stevens has called out in a speech yesterday that efforts to control financial derivatives trading following the 2008 credit crisis have fallen behind.

It was, in fact, a typical piece of central banker understatement: nothing much is happening on that front at all.

In the speech to a symposium at the Federal Reserve Bank of San Francisco, Mr Stevens said that while the Basel III process to apply new capital and liquidity to banks is “well on track”, efforts to better regulate derivatives are “running behind original timetables”.

And last week the Bank for International Settlements revealed that the amount of over-the-counter (OTC) derivatives outstanding reached $US710 trillion at the end of 2013, a 12 per cent increase on the year before.

Most of that exposure is held by banks. The US Office of the Comptroller of the Currency has just published its quarterly report on bank trading in derivatives, and disclosed that the exposure of US banks to them now totals $US237 trillion.

Of that, the big four -- JP Morgan Chase, Citibank, Goldman Sachs and Bank of America -- account for $US219.7 trillion. And that’s just the Americans.

Meanwhile the other area of bank regulation that is nowhere near being finalised is the problem of ‘too big to fail’ -- that is, where governments can’t allow certain banks to go broke because that would bring down the financial system itself.

There is a move to impose an extra capital surcharge on “globally systemically important banks”, but as Glenn Stevens pointed out that may not be enough.

There’s now a push for something called “going-concern loss absorbing capacity”, in addition to extra capital, but Glenn Steven expressed some doubts about that as well.

“…equity ‘buffers’ may turn out to be illusory in a stress situation. That is, the uncertainty over asset valuations may be such that a presumed equity buffer is not, in fact, there. The ‘illusory capital’ problem is certainly not unknown in the annals of crisis management.”

Indeed.

The problem with OTC derivatives trading, unlike normal lending based on a bank’s balance sheet, is that it involves contracts between two or more consenting adults and is not rooted in one place, so that banks are able to go “regulatory shopping”.

In his speech yesterday, Glenn Stevens said that the efforts to achieve more reporting, more platform trading and central clearing of derivatives have fallen behind because of the “complexity of crafting mutually consistent regulations at the jurisdiction level, for a market that is highly globalised in operation”.

By comparison the new international balance sheet and liquidity requirements are on time, with a few remaining details being ironed out.

Importantly the RBA governor dismissed the idea that financial leverage supports economic growth, and that limiting it will hold back growth.

“It seems more likely, to me, that it was the other way around: a period of good global growth and, in particular, unusually stable growth, led to a rise in leverage (in the lead-up to the financial crisis). The reasons for that growth stability were mainly not, I suspect, things that happened in the financial sector.”

Although central banks and bank regulators are working hard to control banks’ balance sheet leverage before the next crisis hits, the continuing growth in derivatives trading by banks is undermining those efforts.

And as Glenn Stevens points out, when there’s macroeconomic stability and growth, as there is now, leverage tends to increase.

“The big question is not, in fact, what more demanding capital standards will do to economic growth. The question is: what will economic growth, or lack of it, do to banks' capital positions?”

And although Glenn Stevens didn’t say this, it seems that the leverage problem these days is not excessive lending on housing, as it was in 2005-06, but exposure to derivatives.

By far the largest type of derivatives trading involves interest rate swaps, in which two parties agree to exchange interest cash flows, usually with one of them paying a fixed rate and getting a floating rate in return.

It’s simply a way of betting on interest rate movements instead of horses, or flies on the wall, and always involves significant leverage.

It’s true that banks are able to use interest rate swaps to hedge their exposure to a certain movement in interest rates, but for example JP Morgan’s total assets are $US1.5 trillion while its exposure to derivatives is $US70 trillion, or 47 times the assets, so you’d have to think there is rather more gambling going on than hedging.