In April 2012, I calculated the size of banks’ derivatives positions relative to their capital to show how small an upset it would take in the derivatives market to wipe out banks’ Tier 1 capital.
The results were pretty alarming. It would take only a 0.18% decline in the value of their collective $240 trillion derivatives portfolio to wipe out their Tier 1 capital.
S&P’s announcement this evening that it had placed big US banks on Ratings Downgrade Watch got me to thinking. Have banks improved their financial stability, or are they still positioned on the eve of destruction?
First, it should be noted that it isn’t that easy to find Tier 1 capital anymore. The OCC now reports Total Risk-Based Capital, which includes Tier 2 items such as subordinated debt, asset revaluation reserves, undisclosed reserves and hybrid (debt/equity) capital instruments.
The upshot is that Total Risk-Based Capital is bigger than Tier 1 alone (from 5-18% bigger.) Regardless of whether or not the padding is warranted, we’ll ignore it for comparison purposes.
The 2015Q2 results can be seen in the chart below. Things have improved, but only slightly.JP Morgan and Bank of America significantly decreased the size of their reported (nominal) derivatives portfolios. And, each has roughly doubled their Wipeout Ratio.
Citibank and Goldman Sachs, on the other hand, barely decreased the size of their derivatives portfolios. And, their Tier 1 Capital increased only slightly. So, their Wipeout Ratios improved marginally.
The fact remains that, seven years after the financial crisis, the four largest banks are still extremely vulnerable to a fluctuation in the value of their derivatives. Theoretically, a 1/4 of 1% decline in the value of their derivatives would wipe out their capital.
Fortunately for them and their shareholders, the regulators don’t require them to mark derivatives to market anymore. They’re also able to net out (supposedly) offsetting positions without providing much, if any, proof that such offsetting is appropriate. From JP Morgan’s financial statements:
U.S. GAAP permits entities to present derivative receivables and derivative payables with the same counterparty and the related cash collateral receivables and payables on a net basis on the balance sheet when a legally enforceable master netting agreement exists.
In other words, if you have an agreement with the next Bear Stearns, AIG or Lehman wherein you promise to make each other whole when TSHTF, there’s no need to burden us with all the details. It’s enough to say that there’s no net exposure.
If any of these deceptions helps you sleep at night, God bless. The banks will gladly hold even more of your money and pay you next to nothing. Or, maybe they’ll start charging you for the privilege, as in parts of the eurozone.
Bottom line, S&P is probably making a big deal out of nothing. Though global derivatives still exceed $1 quadrillion (that’s 1,000 trillion or $1,000,000,000,000,000) and the capital of the biggest, strongest banks in the world are 0.25% away from being wiped out, there’s really nothing to worry about.*
* until there is
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