Derivatives activity by U.S. banks: impact on risk and profitability.

The stability and integrity of the U.S. banking system is crucially important to a sound and healthy U.S. and world economy. The financial crisis in the third and fourth quarter of 2008 has reinforced this critical role of financial institutions. Many market participants suggest the catalyst for these events can be traced back to sub-prime mortgage lending practices. These risky lending decisions, and subsequent defaults, began a cascading effect for both small and large intermediaries. The declines in market values and financial viability for Lehman Brothers, Merrill Lynch and AIG serve as examples of this downward spiral. However, increased leverage and risk exposure is not unique to the most recent economic period. In the 1990s, the increased use of derivatives by the banking industry and a spate of derivative disasters (bankruptcy of Orange County, collapse of Barings PLC, Bankers Trust and Procter and Gamble, derivative related losses at Mettallgesellschaft AG and NatWest Markets, to name a few) drew the attention of the regulators and investors (see Kuprianov (1995) for a discussion of derivative debacles).
Bank derivative usage increased from $32.5 trillion (notional value) in the first quarter 1999 to $122.5 trillion in the fourth quarter of 2006 (see Tables 1 and 2). This represents an annual compounded growth of over 18%. This is a much higher than the growth rate of total assets for these banks. In recent years, total assets are only 5-6% of the total notional value of the derivative contracts. Of these contracts, majority of the derivative positions today represent interest rate contracts (over 85%; OCC bank derivatives report, see Table 3). Further, the majority of the derivative contracts are traded in the OTC market leading to a higher credit risk. On average, 90% of the contracts are OTC traded and only 10% are exchange traded (Table 3). Given this significant growth in the use of derivatives by banks, a reason for concern by regulators is the lack of knowledge concerning the impact of these activities on the risk and profitability of the banking industry.