Derivatives A Fair and Balanced Look

1. DerivativesA Fair and Balanced Look Kurt Wilhelm Director, Financial Markets Group Office of the Comptroller of the Currency October 17, 2013

2. Agenda • Assess the criticisms of derivatives • Are they legitimate? • Provide a better understanding of the risks and policy actions to address concerns • Quick update on significant, unfinished, Dodd-Frank Act rules

3. Criticisms of Derivatives • A laundry list of allegations • Huge volume of notionals indicates a future financial crisis is inevitable • Complexity/opacity of some products creates risks that can’t be managed • Derivatives, and proprietary trading, caused the financial crisis • Required the bail-out of AIG Financial Products • Permits increased leverage in the system • Creates concentrated counterparty credit exposures that are not well understood • Increased reputation risk for banks due to “inappropriate” transactions • Fair value accounting encourages LT, illiquid transactions to book large up-front P&L • Since most trading is dealer-to-dealer, it’s a casino • Credit derivatives may not be effective hedges • Regulators don’t understand derivatives risks, so there’s no control over them • Caused best and brightest STEM students to work in finance, not other potentially more socially productive/useful endeavors

4. Notionals • Notionals are huge; > $600 trillion globally and $235 trillion in US insured commercial banks • But, notionals do not reflect risk • Counterparties rarely exchange notional amounts; they simply are the basis from which payments are determined • Critical contrast vs. loans and bonds • It is the gain or loss on derivatives that gets reflected on the balance sheet (BS) • Bond analogy: with bonds, the amortized cost or fair value is on the BS • Derivative analogy: only the appreciation (asset) or depreciation (liability) is on the BS

5. Growth in Notional Derivatives Compound Average Growth Rate 1996 to 2011 Peak ~ 18% Regulators are generally concerned about any market with such rapid growth. Key question here is whether the notionals are indicative of risks. Derivative Notionals by Type of UserInsured U.S. Commercial Banks and Savings Associations

6. Notionals (Cont’d) • Some fanciful claims • “Derivatives are financial weapons of mass destruction.” Berkshire Hathaway Annual Report 2002 • “Losses of only a few percent of face value therefore would be enough to wipe out even the best capitalized derivatives traders.” Time.com, Why Derivatives May Be the Biggest Risk for the Global Economy, March 27, 2013. • NYT claimed MF Global felled by leverage and bad derivative bets on debt-weakened Europe . Morgenson, Gretchen, Sad Proof of Europe’s Fallout, New York Times, November 5, 2011. • But, MF Global’s risk was in sovereign bonds, not derivatives. • “If we continue as now and ignore them [warning signs] again, the great white shark of global financial meltdown will gobble up the meager economic recovery and make 2008 look like a hiccup. We can’t say when this will happen. We can’t say which bank or which particular instrument will trigger the debacle. What we can say with virtual certainty is that if we continue as now is that it will happen. Because the scale of the trading is larger, and because the depleted government treasures are not well placed for another huge bailout, the impact will be worse than 2008.” Forbes, Big Banks and Derivatives: Why Another financial Crisis Is Inevitable, Jan. 8, 2013.

7. Notionals: Upon Further Review • Since counterparties do not exchange notionals, the real systemic issue is the credit risk from the transactions, as the Time quote awkwardly notes • Notionals do determine receivables/payables, so you should first look at the scale of receivables/payables relative to notionals • We call these gross positive and negative fair values • But, we also must consider “netting,” which allows entities to report a single net amount, rather than gross receivables and gross payables • But, note that US GAAP here is a major difference compared to IFRS • Then, we need to consider collateral • So, how much risk is left after netting and collateral? What do the charge-off rates for derivatives look like relative to C&I loans?

8. GPFV as a % of Notionals Equity and commodity derivatives have the highest exposures as a % of notionals. They are very small segments of the derivatives market. Interest rate contracts dominate the market. “Gross” credit exposure on these contracts is 1.5% of notionals.

9. Drilling Down to Unsecured Credit Exposure We’ve used a log scale here so that you can see all the bars. Without this scale, it looks very different!

10. Drilling Down to Unsecured Credit Exposure Notionals do not measure risk; the actual unsecured credit risk of derivatives is $33 billion. That is a big number, but it’s only 1.4 basis points on notionals. Gross receivables are 1.6% of notionals; NCCE is 9% of gross receivables, …

11. Derivatives vs. C&I Charge Offs *Not annualized

12. Notionals: the Verdict • Claims of impending doom due to large notionals don’t seem credible • Starting with $235T in notionals: • Gross fair values are 1.6%, or $3.7T • Legally enforceable netting agreements allow banks to reduce that exposure by 91%, down to $339B in net current credit exposure (NCCE) • Banks hold collateral of $306B, leaving $33B in unsecured exposure • This is 0.014% (1.4 basis points) of notionals!

13. Complexity/Opacity • When Berkshire Hathaway (BH) bought Gen Re, Warren Buffet was concerned about very long term, illiquid derivatives contracts, leading to his famous comment • From a supervisory perspective, major concern about complexity is whether the receivables/payables on the balance sheet are accurate • Focus is on Level 3 (L3) exposures • During the crisis, L3 exposures were indeed very large, but they have come down sharply as market conditions improved • Assessment: the contracts that gave rise to BH’s concern are not material in the US banking system, but L3 exposures are inherently problematic and thus will always be a concern • Interest rate contracts are the dominant derivative exposure • Swaps are the most common product • Maturities of derivatives are concentrated heavily in maturities < 5 years

14. Distribution of Notionals 2Q ‘13

15. Top 4 Banks Level 3 Assets to Equity Volume of “mark to model/myth” exposures have fallen sharply since the peak of the financial crisis.

16. Role of Derivatives in the Financial Crisis • Derivatives did not cause the crisis, but credit derivatives in particular did help to make it worse • “Demand from investors for high-yielding ABS CDO tranches drove growth in the US subprime mortgage market to such an extent that dealer firms transferred more subprime risk to investors than was originated in 2005-06.” Joint Forum Report on Credit Risk Transfer, April 2008 • Ability to synthetically create credit exposures via derivatives made this possible; the same poor quality RMBS were referenced many times over in CDO structures • AIG Financial Products had a large open risk position in protection sold contracts on ABS CDOs, which led to its rescue • What is less known, however, is that its securities lending activities were equally (and perhaps more) responsible for its rescue • “Before the financial crisis, its loans were mostly open and its pool of cash collateral was invested in particularly long-term and illiquid assets. This investment strategy yielded high returns before the crisis; however, it contributed to AIG’s liquidity squeeze during the crisis. The firm experienced something similar to a run as borrowers of its securities sought to return them as part of the general market deleveraging that took place. The need to liquidate some illiquid assets to accommodate this return of securities contributed to a sizable share of AIG’s losses. Maiden Lane II LLC was created to alleviate capital and liquidity pressures on AIG associated with the securities lending portfolios of several regulated US insurance subsidiaries of AIG. “ Repo and Securities Lending; a FRB NY paper,

17. Did Bank Prop Trading Cause the Crisis? • Not according to Paul Volcker • “There is no question that proprietary trading was a contributor to the crisis in commercial banking, and particularly outside commercial banks did contribute, but a lot of other things contributed - and proprietary trading, particularly proprietary trading in commercial banks, was there, but not central.” Transcript from Paul Volcker, On Essential Elements of Financial Reform, Peterson Institute for International Economics, March 30, 2010 • Were ABS CDO positions that caused major losses prop trades, or traditional investment portfolio positions?

18. Do Derivatives Permit Increased Leverage • Yes, since the notional amounts aren’t exchanged • Current practice has most counterparties pledging variation margin to secure any current payables, but not initial margin to secure potential exposure • Indeed, one can argue that equity swaps exist as a means of permitting more leverage in stocks than permitted by Reg T/U • But, it is important to note that similar leverage can exist in the cash markets via repo financing • Policy actions: swap margin rules will require initial (IM) and (more widespread) variation margin (VM) to secure potential exposures on derivatives, limiting leverage

19. Counterparty Credit Exposures • Charge-off rates on derivatives are much lower than for C&I lending • Criticism during the crisis was that risk posed by AIG was not well understood; this was definitely true • As a Aaa/AAA counterparty, AIG did not post variation margin • When it was downgraded and had to begin posting, it could not meet the margin call • Ironically, it was the highest rated (monoline) counterparties that proved most problematic during the crisis • GSEs, MBIA, AMBAC, AIG • Credit exposures between the major dealers are completely secured by VM • Credit exposures banks have from hedge funds are completely secured by VM and potential exposure is secured by IM, explaining why charge-offs are so low • Credit exposures from corporates are seldom secured; exposures from sovereigns are not secured • Policy actions: Dodd-Frank requires standardized trades to be cleared by central counterparties (CCPs) • Will substantially reduce bilateral credit exposures, but create concentrated exposure at the CCPs

20. Reputation Risk • Complexity and customization of derivatives has permitted large dealers to extract “excess rents” from market participants • Also happens in cash markets • Reputation risk cuts both ways • Dealer banks have occasionally created derivatives products that were inappropriate for certain clients • Some prior transactions permitted counterparty clients to hide debt on their balance sheets • But, some sophisticated clients have used reputation risk leverage to persuade banks to forgive legitimate financial obligations • Policy actions: bank supervisors require banks to have reputation risk policies, and get approval for transactions (particularly structured finance) that involve elevated risk

21. Fair Value Accounting • Commercial banking generally uses historical cost accounting; income accrues over time • Focus is on spread between asset yields and liability costs • Trading activities, however, use fair value accounting • Permits banks to front-load income by taking the present value (PV) of a long-dated income stream • Example: Bank does a 30 year interest rate swap with a client; records day 1 P&L equal to the PV of its positive spread based upon mid-market price less adjustments • Encourages long-term, illiquid transactions to maximize current period profits (and bonus) • This criticism of derivatives is definitely valid • Policy response is to have compensation aligned with risk

22. Derivatives Trading: is it a Casino? • The lion’s share of transactions in derivatives are between dealers, leading to an obvious question: are banks using insured deposits to take big “casino” bets? • The facts • Gross receivables and payables on derivatives are closely matched, suggesting banks do not “gamble” with derivatives • Dealers trade with each other to dynamically hedge their risk positions • Especially true for options; it is unlikely a bank can have client trades that will provide the specific hedge the bank needs for risk management • Aside from 2008, bank trading revenues have been fairly stable over time • Inter-dealer trades dominate the cash securities markets too • Dealers have to constantly buy and sell to test market liquidity • Active traders prefer liquid markets; derivatives markets are generally not liquid enough to provide comfort for large risk positions • See JPM CIO

23. Gross Fair Values

24. Total Insured Commercial Bank Trading Revenues

25. Are Credit Derivatives Effective Hedges? • Banks have used credit default swaps (CDS) very effectively to hedge corporate credit exposures • The CDS market, however, has morphed into a product to hedge/speculate on sovereign credit exposures • The top 9 gross notional exposures in the CDS market are all sovereigns (Italy, Spain, France, Brazil, Turkey, Germany, Russia, Mexico, Korea) • Some concerns that political considerations will preclude “credit events” on sovereign defaults and thus not provide desired protection • For a short period of time, this was the case with Greece

26. Can Regulators Supervise Derivatives Risks? • The OTC Derivatives Supervisors Group (ODSG) initiated early stage derivatives market improvements using collaborative efforts among global derivatives market participants • Initially focused on cleaning up unconfirmed credit derivatives trades • Extracted progress on infrastructure improvements through industry commitment letters and data collection • Expanded to other asset classes and to market infrastructure more broadly • Outcomes: improved rate of electronic confirmations, processing time-period, established trade repositories and central counterparties • Set the stage for the G-20 Derivatives initiatives • All standardised OTC derivatives should be traded on exchanges or electronic platforms, where appropriate. • All standardised OTC derivatives should be cleared through central counterparties (CCPs). • OTC derivatives contracts should be reported to trade repositories. • Non-centrally cleared derivatives contracts should be subject to higher capital requirements, and margin requirements on non-centrally cleared derivatives.

27. Progress in Infrastructure

28. Update on Dodd-Frank Act Implementation • Swap margin rules • BCBS-IOSCO formulated Working Group on Margin Requirements (WGMR) to set an international standard • Goals are to reduce systemic risk and promote central clearing • WGMR issuances: Final Margining Framework for non-centrally cleared derivatives (BCBS/IOSCO 261, September, 2013) • Initial margin and variation margin required • Two way margining – post and collect • U.S. Prudential regulators are now re-engaged in the domestic rulemaking process; will update the 2011 proposal to conform to WGMR • Volcker Rule • Securitization