Derivatives - Banks' Achilles Heel

May, 22, 2020

The Bail-in

In a period of radical transformation, many of our basic assumptions are being challenged, including the safety of our bank deposits. Our primary concern is the scale of derivatives outstanding at this time, which poses a threat to the safety of depositors’ assets. Following the losses during the financial crisis of the 1930s, it was illegal for banks to be party to derivatives contracts from 1936 to 1982.

As you may know, a derivative is a contract between two parties that requires the exchange of money to settle the difference in price of another security at the end of the contract period. A simple example is a currency forward, which locks in a currency price for a future date. But there are many more complex derivatives, some with maturities of 20 to 50 years. Derivatives pose two risks. First, the failure of a counterparty can increase derivative losses. Second, a 2010 law gave settlements of derivatives payment priority over the claims of depositors to bank assets.

It is important to note that the notional value of global derivatives grew from $9 trillion in 1990 to $95 trillion in 2000 and $640 trillion in mid-2019. The derivative exposure for the top 10 US banks is shown in the table below. About 82% of derivatives are related to interest rates. Interest rate derivatives are not normally a concern, but the artificial suppression of interest rates in Europe and Japan, and the potential risk that Greece and/or Italy may need to leave the EU in order to protect their economies heightens the financial risk. It is not surprising that the settlements value on European interest rate contracts is 12.6%, while US interest rate contracts have a 2.2% settlements value.

U.S. Banks Derivatives

What is the risk? It is the risk that US banks will not have sufficient equity and loan loss reserves to cover potential derivative losses. Banks are required to maintain collateral for deposits in excess of $250,000. Deposits under $250,000 are expected to be covered by the FDIC insurance program, which has reserves of $107 billion. Banks have equity of $2 trillion and loan loss reserves of $6.2 trillion, which represents about 2% of assets to serve as a buffer against losses. These numbers are relatively small compared to 80 Hayden Avenue, Suite 110, Lexington, MA 02421 O: 781-890-5225 F: 781-890-5279 E:

US banks’ majority share of the $12.1 trillion derivative settlements value, which was computed before the global economic shutdown. Historically, central banks followed “bailout” policies, which nationalized the losses. However, the global central banks adopted “bail-in” policies, in 2014, because bailouts had outgrown their resources. Bail-ins put the individual depositor at risk. Bail-ins have already been used in Cypress and Spain to liquidate banks using investor/customer deposit funds.

Depositors were in a better position before the passage of the Graham Dodd Act of 2010, which gave super priority to the payment of derivatives over all other claims. A 2013 Congressional investigation revealed that JPMorgan and Bank of America, two of the largest derivative holders, were commingling 99% and 71%, respectively, of their derivatives in their depository arms, rather than in the unregulated and more vulnerable derivatives area.

Given the risks posed by 10 largest US commercial banks, we suggest that investors reconsider having significant deposits in banks with large derivative positions. There is a risk of significant counterparty failures, particularly in the European banks, at a time when the central banks have all adopted “bail-in” policies because the “bailout” policies exceed their abilities. Warren Buffett called derivatives “Financial weapons of mass destruction.” We all hope he is wrong, but we can all move to protect ourselves if we understand the risks. As always, we welcome your thoughts and questions. In the meantime, we wish you a wonderful Memorial Day weekend.

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