DERIVATIVES STUDY CENTER 1660 L Street, NW, Suite 1200 Washington, D.C.   20036







"New Derivatives Data

Shows Increased Credit Risk"


Randall Dodd


Financial Policy Forum


September 17, 2003



This is a brief update on the U.S. Treasury Department's Office of Comptroller of the Currency's recently released data on the derivatives activity of U.S. banks and bank holding companies for the second quarter of 2003 (a copy of this update in PDF format is attached below). The news, in short, is that the numbers for the volume of activity and the amount of exposure are large and growing rapidly. Most of the data is in user-friendly formats at our website:


The new data supports two fundamental points about derivatives markets. One is the adage, "it was a bad year for volatility, but it was a great year for volume." This refers not just to day-to-day or intraday volatility, but especially to large price movements. The second quarter of 2003 witnessed an upswing in U.S. equity prices, record low long-term dollar interest rates and a substantial change in the U.S. dollar-Euro exchange rate. The third quarter of 2003 will likely show more gains in volume as a result of the sharp rise in long-term dollar interest rates.


Another fundamental point is that market risk can become credit risk, as evidenced by the new data which shows large increases in credit exposure for U.S. banks that act as dealers or market makers in OTC derivatives markets.


Consider the overall numbers on the volume of activity. Total derivatives holdings of U.S. banks reached $65.8 trillion (or $65,800,000,000,000) up 31.4% from a year ago. Of this total, 96% is held by the largest 7 banks J.P. Morgan Chase ($33.7 trillion), Bank of America ($13.8 trillion), Citibank ($11 trillion), Wachovia, Bank One, HSBC, and Wells Fargo.


Most of the outstanding amounts (96%) and growth is for "trading purposes" rather than hedging balance sheet exposures (which explains 4% of holdings).


The credit losses by banks on their derivatives trading business that is default-type losses due to performance failure or bankruptcy have now totaled $686 million in the two years (eight quarters) since Enron began to collapse in October of 2001.[1] The good news is that such losses have slowed to $55.2 million in the first half of this year after losses of $237 million in 2002 and $395 million in 2001.


Although the amount of credit losses has declined, credit exposure that is the risk of such future credit losses has increased substantially. Since the end of 2002, credit exposure at the top banks has risen sharply. Measured as a percentage of risk-based capital (the sum of Tiers I, II and III of capital), the average for the top 10 banks has risen form 198% to 240% of capital. The situation is of greater concern when looking at particular banks. The ratio of credit exposure to risk-based capital for J.P. Morgan Chase rose from 655% to 797%; Bank of America from 205% to 261%; Citibank from 201% to 239% and HSBC from 127% to 200%.


This rise in credit exposure explains part of the remarkable 26.3% increase in the volume of credit derivatives in the first six months of this year. J.P. Morgan Chase alone held $460 billion (notional value) in credit derivatives.


The bank J.P. Morgan Chase (JPM) is in a class by itself. Looked at in more detail, using the Call Report available from the Federal Financial Institutions Examination Council (see our website under Derivatives Data for instructions), JPM had an credit exposure of $750 billion due to the positive gross value of outstanding derivatives and $246.9 billion measured as credit equivalent exposure.


In sum, derivatives markets show strong growth in volume and a substantial increase in concern for credit exposure. The data does not support the claim made by some critics of financial market regulation that the Sarbanes-Oxley Act was discouraging the use of derivatives to manage risk. The purpose of highlighting this new data is not to alarm but to raise awareness and understanding of risk. Derivatives markets and especially these financial institutions that act as derivatives dealers (which are undoubtedly in the too-big-to-fail class of firms) pose a public interest concern because serious trouble at any one of these firms would have a material impact on other financial institutions and the overall economy.


[1] Enron did not declare bankruptcy until December 2001, but it was in serious trouble by the time it announced revisions to earning on October 16, 2001.