Balance sheets understate the scale of complexity in the financial system
According to the latest data from the Bank for International Settlements, the Central Bankers’ Central Bank, the total amount of outstanding derivative contracts has declined from a peak of over $700 trillion to about $550 trillion. To put these figures into perspective, the figure has fallen from just under three times the value of all the assets in the world to a little over twice the value of all the assets in the world.
The largest element is interest rate swaps, followed by foreign currencies. Credit default swaps, the derivative instrument at the heart of the 2008 global financial crisis, are now relatively small. If you can accustom yourself to a world in which $15 trillion is a small number. It is only slightly less than US GDP.
Two banks, JP Morgan and Deutsche Bank, each account for about 10% of total global derivatives exposure. Both have more than $50 trillion potentially at risk. The current market capitalisation of JP Morgan is around $200 billion (roughly its book value) and that of Deutsche $25 billion (about one third of its book value). Imagine promising to buy a house for $2000 with assets of $1. From one perspective, Deutsche Bank is leveraged 2000 times.
Before you head for the hills, or the bunker, understand that there is no possibility that these banks could actually lose $50 trillion. The risks associated with these exposures are largely netted out. You have simultaneously agreed to sell the house, though not necessarily at just the same time or price or to the same person – that mismatch is the source of potential profit. But how effectively are these positions netted? Your guess is as good as mine, and probably not much worse than those in charge of these institutions. We are reliant on their risk modelling. But, these models break down in precisely the extreme situations they are designed to protect us against.
You will not find these figures for derivative exposures in the balance sheets of banks. (Though you can, however, extract them if you peruse the hundreds of pages of notes). Nor do such exposures enter directly into capital adequacy calculations
The apparent lack of impact on balance sheet totals is the product of the combination of fair value accounting and the tradition of judging the security of a bank by the size of its credit exposure, rather than its economic exposure. The fair value today of an agreement that has an equal chance of you paying me £100 or me paying you £100 is zero. And, since your promise to pay or receive £100 is marked to market at nil there is no credit risk: you cannot default on a liability to pay nothing. Under US GAAP, you are allowed even to net out exposures to the same counter party in declaring your derivative position: this is not permitted under IFRS, which is why the balance sheets of American banks appear (misleadingly) to be smaller than those of similar European institutions.
The fundamental problem is accounting at ‘fair value’ when that fair value is the average of a wide range of possible outcomes. The mean of a distribution may itself be an impossible occurrence – there are no families with 1.8 children. And netting offsetting positions may also mislead. There is a large difference between being a dollar millionaire and having assets of $100 million and liabilities of $99 million. Accounting practices provide an appearance of precision which may be a poor guide to a world characterised by multiple risks and radical uncertainty. The superficial information we have from balance sheets and capital adequacy calculations understates the scale of complexity and interdependence in the global financial system. Market participants are right to be sceptical, and nervous, about banks.
Citation
http://www.bis.org/publ/otc_hy1511.pdf exposures