Fact and Fiction Behind Too Big to Fail

BREAK ‘EM UP Reason #6: Derivatives Trading Siphons Capital Out of the Banking Sector

 

Derivatives credit management practices siphon capital out of the commercial banking deposit system, capital that could otherwise be used to support lending. Small and medium-sized businesses face enough headwinds from globalization and technology. They don’t need this assault on their ability to borrow.

Derivative contracts can serve a useful purpose. They just shouldn’t be subsidized by the taxpayer.

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The Growth of Derivatives

Derivatives have grown into a huge segment of financial services. One of the main reasons to separate commercial banking from derivatives trading is the impact of derivatives credit management on the commercial banking industry — that is, on lending. Derivatives counterparty risk management practices siphon significant amounts of capital out of credit markets, capital that might have been lent to Main Street businesses.

First of all, “derivatives” is a broad term in the financial markets. It should be separated into credit derivatives, which are mainly credit default swaps, and all other types of derivatives. Interest rate swaps are the largest sector in the derivatives sphere as measured by the Bank for International Settlements (BIS — the central bankers’ central bank). The table in the next link shows the growth in global derivatives through 2008.

Global Derivatives Growth Through 2008 BIS Data

Derivatives Collateral: Current Cash Behind Promises of Future Performance

The main tool to manage derivatives counterparty risk is posting collateral, or margin. The terms mean the same.

Derivatives are financial contracts that promise future performance. Interest rate swaps involve promises to swap fixed interest rate payments for floating rate interest payments over the multiple years of the swap contract.

In contrast, loans involve immediate “performance”. Performance is a legal concept, meaning the bank actually completed its side of the agreement by making the loan. That’s why a loan is booked on the bank’s balance sheet and derivatives aren’t. Derivatives are “on the books” (a real contract involving legal obligations) but not on the balance sheet unless settling within days.

Large percentages of derivatives contracts extend for many years, beyond five years as can be seen in TBTF bank footnotes to their financial statements and regulatory filings. How can one side of the contract (one “counterparty”) know that the other side of the contract (the other “counterparty”) will have the financial wherewithal to make those promised payments so far into the future? They demand collateral. This is part of counterparty risk management.

Click on the following link to see, for example, how large percentages of Goldman Sachs’s derivatives contracts, including credit derivatives, have very lengthy tenors.

Goldman-Derivatives-Contract-Length-2008-10k-doc

The ISDA, Master Agreements, and the ISDA Margin Surveys

Most derivatives contracts around the globe are booked under an International Swaps and Derivatives Association (ISDA) “Master Agreement”, the primary legal document. It’s what the book and movie The Big Picture call “an ISDA” for short. Only sophisticated institutional players enter into these agreements.

The ISDA Master Agreement requires initial margin at the start of the contract. As market prices change, the value of the respective sides of the contract changes over time. The value for one counterparty goes up while for the other goes down. The counterparty which is estimated to owe its counterparty more money has to post additional collateral to cover that additional amount. It usually goes into a collateral account maintained by a commercial bank. If one counterparty’s credit profile deteriorates below specified thresholds, it will also have to post additional collateral to protect its counterparty on the other side of the contract. These amounts add up around the globe.

The ISDA has posted annual margin surveys for nearly two decades. Originally published in April, publication was delayed in recent years as regulators imposed stricter requirements, including moving the booking of types of derivatives to organized exchanges as required by Dodd-Frank. In fact, the ISDA hasn’t published a survey since 2015. (Click below for the survey history on the ISDA website.)

ISDA Margin Surveys Publication Dates

The ISDA doesn’t explain the disappearance of its annual margin survey, but perhaps it shouldn’t be a surprise. Global regulators are pressuring the derivatives trading establishment to transfer contracts to clearing houses. The clearing platforms add another systemic entity to the world’s mix. They compete. They are not without risk. The clearing houses provide a number of benefits — pricing transparency, liquidity (meaning many buyers and sellers of more standardized contracts), and daily margining. Clearing house members contribute capital to support the clearing house’s financial strength. Trying to measure collateral practices outside the clearing houses may have become too daunting a task that might provide only part of the collateral picture.

What may be an interesting subject for academicians is to look at the capital cushions behind derivatives cleared on exchanges compared with derivative contracts retained directly between two big-bank counterparties (“over-the-counter”, or OTC derivatives). Under Basel II, no regulatory capital was required behind derivatives contracts where an exchange 1) was the legal counterparty and 2) required daily margining. According to the year-end 2016 OCC derivatives report, contracts cleared on exchanges entailed a 2% risk weighting, still a low percentage, but much lower than the percentages the banks themselves must post for direct contracts, which start at 20%. But I digressed, to throw curiosity out there for those with time, incentive, and access to data.

The increase in collateral posted around the globe, both reported by survey participants and estimated by the ISDA, is shown in the following table (next link). The 2015 survey is through the end of 2014 financial year.

derivatives-and-collateral-through-2014

The ABA Warns Fed Officials About the Impact on Lending of Lost Capital Dollars

When an FDIC-guaranteed bank takes a checking or savings deposit, it can lend a portion. When an FDIC-guaranteed bank takes collateral that backs derivatives contracts, it can’t lend it. The collateral flows in and out on a daily basis.

Dollars of lendable capital are very valuable to commercial banks and to the economy, as was stated in a 2008 letter from the President of the American Bankers Association to Federal officials (next link). $1 of capital stands behind $7.6 of loans. This affects the economy. As seen in the table above, collateral backing derivatives is in the trillions around the globe.

aba-letter-to-fed-officials-sept-22-2008

Derivatives with their promises of future performance siphon capital out of the financial system, capital that could be used for current lending. Derivatives have a role, but, given this structural downside, they shouldn’t be subsidized by the taxpayer.

 

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