Derivatives and Systemic Risk: Jobs Reducers

Mitt Romney got one thing right and one thing wrong about systemic risk, regulation and job creation. He was right that small- to mid-sized banks are the lenders to small businesses, the major creators of new jobs. But he was wrong in saying we don’t need to break up the biggest banks. The biggest banks are about trading. Before the bubble burst, they bought and sold trillions of dollars of residential mortgage-backed securities and derivatives.

The biggest banks still heavily trade derivatives. The Bank for International Settlements, the central bankers’ coordinating bank, reported that $633 trillion in notional amount of derivatives were outstanding globally at the end of 2012, down only slightly from the $707 trillion at the end of June 2011. Derivatives tie up cash in ways never envisioned by the Congressmen that established the Federal Deposit Insurance Corporation and its federal guarantee of bank deposits back in 1933.

Breaking up these behemoth banks requires a strategy. Separating the FDIC deposit guarantee from investment banking trading risk should top the list of goals within that strategy. This federal guarantee needs to be re-focused on the smaller commercial banks that support job creation. It shouldn’t promote derivatives trading and its associated systemic risk as public policy.

Small Banks Lend to Small Business — the Job Creators

Small businesses create jobs, and they depend upon smaller banks for their financing. Statistics recently published by the U.S. Small Business Administration illustrate this relationship. “In 2010 there were 27.9 million small businesses, and 18,500 firms with 500 employees or more.” “Small firms accounted for 64 percent of the net new jobs created between 1993 and 2011 (or 11.8 million of the 18.5 million net new jobs).” (SBA Office of Advocacy FAQs about Small Business, September 2012)

The SBA’s September 2011 publication showed the critical role of bank credit for these job-creating businesses and the economy. They stated that small businesses borrowed about $1 trillion. 2010 data showed that bank loans to small businesses totaled $652 billion and that finance companies extended credit of $460 billion to this sector.

Public bank regulatory reports and Congressional records illustrate the sharp contrast between bank capital behind loans and bank capital behind derivatives  .

The biggest banks’ clients are not small businesses. Instead their clients are large businesses, insurance companies, private equity firms, hedge funds and other banks of varying sizes. The largest aren’t the banks who take the time to understand the needs and creditworthiness of a small business owner. Even the senior economist of the Federal Reserve Bank of Atlanta, Mike Bryan, stressed the critical role of smaller banks who get to know and lend to small businesses.

In contrast, the biggest banks are deeply involved in trading. Their role in packaging and selling residential mortgage-backed securities is well-known. But their derivatives activities are poorly understood.

Derivatives Trading Is Heavily Concentrated in the Biggest Banks

The chart below (click on the next PDF link) shows the widely differing degrees of derivatives trading between the largest and the smaller banks. Derivatives trading is concentrated in the largest of the large U.S.-headquartered banks.  The asset size ranking, from the Federal Reserve’s list of the top fifty bank holding companies, reveals their massive size by assets to start with. The Fed also publishes a peer report that shows each bank’s derivatives portfolio as a percentage of its asset base. (It can be found by clicking on the bank’s name in the ranking — a hyperlink to the bank’s Federal Reserve reports.) The largest banks’ derivatives portfolios are even more massive.

The chart presents six years of history showing the size of the biggest banks’ derivatives portfolios compared to assets along with the percentages for smaller bank holding companies. The biggest, with asset bases of one or two trillion dollars, have derivatives portfolios that exceed two thousand percent of those asset bases — excluding Wells Fargo. Trading-intensive Goldman Sachs’s and Morgan Stanley’s derivatives portfolios exceed  their asset bases by over four thousand percent. The chart also shows each bank’s percentage of derivatives held for trading (as opposed to hedging). The largest hold nearly all their derivatives for trading purposes. These numbers show that they trade heavily with each other.

Finally, the chart illustrates the concentration of credit default swap underwriting in the largest banks. Credit default swaps are insurance contracts on credit defaults and were a major factor in AIG’s collapse. Banks still do not keep reserves against credit default swaps the way state regulators require insurance companies to keep reserves to back their insurance policies.

Here’s the link to the chart with all these comparisons.

  Peer_Group_1_Indiv_Bank_Credit_Derivs_as_Percent_of_Assets_thru_2012.pdf (28.6 KiB, 1,265 hits)

Note also the Peer Group 1 (the largest bank holding companies) average, which rose in 2009 as investment banks were made bank holding companies reporting to the Fed. Morgan Stanley was deemed “atypical” and categorized in Peer Group 9 so its numbers aren’t in the Peer Group 1 average. Goldman Sachs was moved from Peer Group1 to Peer Group 9 (“atypical”) in 2012, causing the Peer Group 1 average to fall. An unsophisticated person might look at the chart and say that all the biggest banks at the top are pretty atypical.

The Largest Banks Use Capital Differently — for Trading

Derivatives place substantial demands upon cash in the financial system. It differs from what the public understands about commercial banking.

Congress intended the original FDIC deposit guarantee to shore up confidence in a bank so that frightened depositors don’t cause a run on the bank. The U.S. commercial banking system is a fractional banking system, meaning that deposits aren’t held solely for safekeeping. Large percentages of deposits are lent out as business, personal or mortgage loans. Only a small percentage is kept on hand to meet normal levels of withdrawals. If extraordinarily high levels of deposits were withdrawn, the bank would have to call their loans to raise the cash to pay depositors. Borrowers typically do not have the cash to repay loans much quicker than promised. Hence Congress’s creation of the FDIC deposit guarantee.

There are promises and then there are promises. The promises in a derivatives contract are different from the promises in a loan contract.

A loan involves the promise by the borrower to repay principal and interest. The cash is out the bank’s door on Day 1. The cash is used to grow or manage a business by financing inventory purchases, meeting payroll or investing in buildings and technology. A loan affects the economy directly, on Day 1.

A derivative contract involves promises to make payments or transfer risk in the future, promises made by each party to the contract. Cash rarely flows at the beginning. The promises extend often far out into the future, as disclosed by the biggest banks in their annual reports to the Securities and Exchange Commission.

Here is how bank capital is used differently in derivatives trading — as collateral. The parties to derivatives contracts are sophisticated financial players and do not want to rely solely on the good graces of the counterparty to make those payments in the future. Much as a home mortgage borrower pledges the underlying home as collateral for the home mortgage, a derivative counterparty can demand collateral to back the derivatives promise. The next chart (click on the PDF link below) shows global derivatives balances and the amount of collateral outstanding against those derivatives. The derivatives balances are those reported by global dealers to the Bank for International Settlements. The collateral data is from the 2013 margin survey published by the International Swaps and Derivatives Association. ISDA publishes both reported collateral and its estimate of the real amount of collateral outstanding.

  Derivatives_and_Collateral_thru_2012.pdf (30.4 KiB, 1,154 hits)

The ISDA survey estimated that there was $3.7 trillion in collateral outstanding at the end of 2012, about 80% in cash. It also stated that 32% of the reporting firms were located in the Americas without being more specific. If 20% of the reporting firms were in the U.S. (a reasonable assumption given that the reporting firms are shown at the end of the report), the amount of cash stashed in collateral accounts supporting derivatives approached in size the amount of bank loans made to small businesses in the U.S. ($3.7 trillion x 80% x 20% = $592 billion).

The significance of a dollar of bank capital to bank lending was stressed to top federal regulatory and treasury officials in a September 2008 letter from  Edward Yingling, President of the American Bankers Association. This PDF file contains the letter. Note the bold type in the third paragraph.

  ABA-Letter-to-Fed-Officials-Sept-22-2008.pdf (469.8 KiB, 1,252 hits)

If 25% of the amount of cash collateral estimated above (nearly $150 billion) were to support loans to small business, based upon the ratio of $7.6 of lending to every $1 of bank capital, that amount of bank credit to job-creating businesses would total $1.1 trillion. Derivatives can be useful, but they shouldn’t be backed by taxpayers. They are used primarily by sophisticated players who should know their counterparties. Derivatives also shift cash resources in the economy from the banks that lend to job-creating businesses to the biggest banks — the ones which created the financial superhighway of risk where they collect the tolls.

By the way, a key reason why Mr. Romney didn’t support breaking up the biggest banks was money. The Center for Responsive Politics/OpenSecrets reported the sum for Mr. Romney’s largest donor institutions (PACs and individuals associated with the institution), based upon Federal Election Commission data. Here is their top 20 list, in order of size, down to the last bank. Goldman Sachs at #1 donating $1,033,204. Bank of America $1,013,402. Morgan Stanley $911,305. JPMorgan Chase $834,096. Wells Fargo $677,076. Credit Suisse $643,120. Deloitte LLP $614,874. Kirkland & Ellis, $520,541. Citigroup $511,199. PricewaterhouseCoopers $459,400. UBS $453,540. Barclay’s #12 at $446,000. Two Swiss and one U.K. bank are large donors to our presidential elections. Globalization?

Here’s why Mr. Volcker’s expert advice to break up the biggest banks to reduce systemic risk was so thoroughly ignored by first-term President Obama and the Congressmen who pushed through Dodd-Frank: money. The Center for Responsive Politics/Open Secrets also published Presidential Candidate Obama’s top 20 donors in his first run. Goldman Sachs was his #2 donor giving $1,013,091. JPMorgan Chase was his sixth-largest donor at $808,799, followed by Citigroup at $736,771. Swiss bank UBS was his 15th-largest donor at $532,674. Morgan Stanley was 19th at $512,232. That was in the 2008 election. In his 2012 re-election, President Obama didn’t have a single big bank among his twenty largest donor institutions. Guess they didn’t like Dodd-Frank.

If President Obama nominates the biggest banks’ favorite candidate for the next Federal Reserve Chairman, maybe it says that their influence is much more important to both parties who want to win the White House in 2016 — much more important than jobs, despite the political rhetoric.