APPLICATION. Are Financial Derivatives a Worldwide Time Bomb?

In recent years, politicians, the media, and regulators have become very concerned about the dangers of derivatives. Indeed, Warren Buffet has called financial derivatives "financial weapons of mass destruction." This concern is international and has spawned a slew of reports issued by such organizations as the Bank for International Settlements (BIS), the Bank of England, the Group of Thirty, the Office of the U.S. Comptroller of the Currency (OCC), the Commodity Futures Trading Commission (CFTC), and the Government Accounting Office (GAO). Particularly scary are the notional amounts of derivatives contracts—more than $100 trillion worldwide—and the facts that banks, which are subject to bank panics, are major players in the derivatives markets. As a result of these fears, some politicians have called for restrictions on banks' involvement in the derivatives markets. Are financial derivatives a time bomb that could bring down the world financial system?

There are three major concerns about financial derivatives. First is that financial derivatives allow financial institutions to increase their leverage; that is, they can in effect hold an amount of the underlying asset that is many times greater than the amount of money they have had to put up. Increasing their leverage enables them to take huge bets on currency and interest-rate movements, which if they are wrong can bring down the bank, as was the case for Barings in 1995. This concern is valid. As we saw earlier in the chapter, the amount of money placed in margin accounts is only a small fraction of the price of the futures contract, meaning that small movements in the price of a contract can produce losses that are many times the size of the initial amount put in the margin account. Thus, although financial derivatives can be used to hedge risk, they can also be used by financial institutions to take on excessive risk.

The second concern is that financial derivatives are too sophisticated for managers of financial institutions because they are so complicated. Although it is true that some financial derivatives can be so complex that some financial managers are not sophisticated enough to use them, this seems unlikely to apply to the big international financial institutions that are the major players in the derivatives markets. The Barings Bank collapse discussed in Chapter 9, which was due to trading in derivatives, looks like it might have been an exception, but recall that the bank was brought down not by trades in complex derivatives but rather by trades in one of the simplest derivatives, stock index futures. Furthermore, Barings's problem was more a lack of internal controls at the bank than a problem with derivatives per se.

A third concern is that banks have holdings of huge notional amounts of financial derivatives, particularly swaps, that greatly exceed the amount of bank capital, and so these derivatives expose the banks to serious risk of failure. Banks are indeed major players in the financial derivatives markets, particularly the swaps market, where our earlier analysis has shown that they are the natural market-makers because they can act as intermediaries between two counterparties who would not make the swap without their involvement. However, looking at the notional amount of swaps at banks gives a very misleading picture of their risk exposure. Because banks act as intermediaries in the swap markets, they are typically exposed only to credit risk—a default by one of their counterparties. Furthermore, swaps, unlike loans, do not involve payments of the notional amount but rather the much smaller interest payments based on the notional amounts. For example, in the case of a 7% interest rate, the payment is only $70,000 for the $1 million swap. Estimates of the credit exposure from swap contracts indicate that they are on the order of only 1% of the notional value of the contracts and that credit exposure at banks from derivatives is generally less than a quarter of their total credit exposure from loans. Banks' credit exposures from their derivatives activities are thus not out of line with other credit exposures they face. Furthermore, an analysis by the GAO indicates that actual credit losses incurred by banks in their derivatives contracts have been very small, on the order of 0.2% of their gross credit exposure.

The conclusion is that financial derivatives have their dangers for financial institutions, but some of these dangers have been overplayed. The biggest danger occurs in trading activities of financial institutions, and as discussed in Chapter 11, regulators have been paying increased attention to this danger and have issued new disclosure requirements and regulatory guidelines for how derivatives trading should be done. The credit risk exposure posed by derivatives, by contrasts, seems to be manageable with standard methods of dealing with credit risk, both by managers of financial institutions and by their regulators.

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