In the height of the Great Depression, the Glass-Stegall Banking Act was passed in 1933. This forced banks to separate themselves from brokerage houses and to not get involved in some of the risky transactions that caused the Depression to be as severe as it was. In 1999, Glass-Stegall was repealed by the Gramm-Leech-Bliley Act, thus allowing investment and banking sides to intermingle effortlessly once again.
This change led to the exponential growth of derivatives on the bank’s balance sheet. Derivatives are an opaque financial vehicle that can encompass a wide range of financial products: futures contracts, interest rate swaps, foreign exchange, credit default swaps, etc. Derivatives are popular since they create a large portion of bank earnings. But with any investment, there is a level of risk.
The Office of Comptroller of the Currency identifies some of these risks in their quarterly report on derivatives. “Credit risk is a significant risk in bank derivatives trading activities. The face amount of a derivative contract is a reference amount that determines contractual payments, but it is generally not representative to the amount at risk. The credit risk in a derivative is based on a number of variables, such as whether counterparties exchange notional principal, the volatility of the underlying market factors (interest rate, currency, commodity, equity or corporate reference entity), the maturity and liquidity of the contract, and the creditworthiness of the counterparty.”
Credit risk in derivatives differs from credit risk in loans due to the more uncertain nature of the potential credit exposure. A loan has credit exposure from one source, the borrower. The exposure is limited to the amount of the loan. However, in most derivatives transactions, such as swaps (which make up the bulk of bank derivative contracts), the credit exposure is bilateral. Each party to the contract may have a current credit exposure to the other party at various points in time over the contract’s life. Now since the credit exposure is a function of movements in various market factors, banks do not know, and can only estimate, what will be the value and risk in a specific derivative contract might be at various points of time in the future.
So this makes measuring risk from derivatives a guess at best. A bank has to identify derivatives receivable and net out any derivatives they have payable. Any derivative receivable represents credit risk that bank faces on the instrument, a derivative payable would show the risk that bank poses to the holder on the other side of the derivative counterparties.
The entire system works well as long as there remains trust in the system and the all parties to the derivative can perform their role. But what happens when the glue of trust evaporates and one or multiple parties cannot perform their counterparty risk? You begin to get meltdowns like we saw in 2007-8 with failures in the credit derivative market.
Credit derivatives split a bond, loan, or mortgage into pieces and then reassemble them into new configurations that are sold to different investors or speculators. The problem with this is that the new derivative instrument is not related to the obligation it was based upon and also separates the lender from the borrower and vests economic power in the hands of a party that has little interest in the economic fate of the borrower. Credit default swaps grew to over $60 trillion in size on the eve of the 2008 financial crisis. This was far greater than the volume of the cash obligations it was insuring. The sheer size of this market had a strong negative influence on the real world of cash credit obligations. Values fell to levels that ridiculously low levels, unless you expected the world to end.
For the first 9 months of 2015, derivative trading produced over $41 billion in revenue for our nation’s banks and holding companies. This represents nearly half of the revenue earned by the holding company. Clearly, there is a profit motive for these instruments. At the end of September 2015, US banks held $192 trillion of derivatives, most of these being in the form of interest rate swaps. The top five banks—JP Morgan Chase, Citibank, Goldman Sachs, Bank of America, and Wells Fargo, held $180 trillion at this time. This amount is way more than the $6.4 trillion in assets held by the institutions and also much larger than their capital base. This amount also dwarfs the GDP of the US, which was around $18 trillion in 2015 and the GDP of the entire world, which is around $75 trillion. Sounds like another case of the “too big to fail” syndrome.
Again, as long as trust and all parties can fulfill their roles, the system stays in place. But what happens when that one event: a sovereign debt downgrade, a default of a small insignificant country, or a large company failure—begins another 2008? It could be like the one snowflake that starts an avalanche.