Bail-in At Your Local Bank – Part 2: The Derivatives Time Bomb

Series: Bail-in At Your Local Bank

With no fanfare and little to no media coverage, your government has just put in place a mechanism to use your deposit money to bail-in a failing bank, like what happened in Cyprus a short time ago.

The derivatives market, the trigger of the 2008 global financial crisis, has since gotten even bigger and more concentrated into fewer hands. A mutually assured destruction awaits the global economy next time it goes off again.

Herded along by the Financial Stability Board, governments of leading economies endorsed a framework during the past G20 Summit whereby depositors’ money will be used to rescue a failing bank when the global derivatives casino blows up again next time.

G20 governments are quietly slipping bail-in provisions into law to make sure that next time a too big to fail bank blows up again by derivatives it will be rescued using depositors’ money, in the name of protecting the taxpayers.

Financial derivatives are financial contracts in which the promised payoffs are derived from the performance of another underlying entity. The underlying entity can be an equity (such as an individual stock or a stock index), interest rate, credit or c …

In Part 1 we described how the concept of bailing in depositors’ money to rescue a failing bank was unceremoniously agreed upon by the leaders at the last G20 summit in Brisbane. We also argued the successful trial run (successful, as in no subsequent riots, no politicians hauled out and shot by angry mobs, no contagion of bank-runs in other euro zone countries in the aftermath) of said concept in Cyprus in 2013 has emboldened the establishment to conclude that Cyprus will serve as a template for the handling of failing banks in the future.

The fact that ordinary depositors became unsecured creditors and got pushed to the very end of the creditor line in order to save the creditor banks which are stupid enough to lend money to the failing bank, in and of itself, should be a cause for outrage.

The other provision enshrined at the G20, namely – derivative obligations by banks to each other are placed at the top of the heap and ahead of any other creditors – would ensure that a large number of mega banks will be affected and every depositor large or small will be part of the mutually assured destruction when this derivative time bomb blows, thanks to the fact that the opaque, unregulated derivative market is so large, so interconnected and so out of control.

Sound fear monger-ish?

To call this a derivatives time bomb actually does injustice to the term time bomb, because this ‘bomb’ had already gone off once, during the subprime mortgage crisis. To get a refresher on what derivatives are and how they almost brought down the entire banking system, check out this primer on derivatives.

One would think that after a near death experience, the only logical and sensible actions governments and central banks of advanced economies should take would be at least a subset of the following:

  • Regulate, cap and reduce the size of derivatives and the shadow banking system.
  • Re-institute the Glass-Steagall Act (wiki) or something similar, separating the risky investment banking from commercial banking where the safeguard of depositors’ money should be the highest priority.

Nope, not a chance. In a world where regulatory capture is complete, the opposite actually happened. The world’s total notional value of derivatives contracts was around $500 trillion prior to the financial crisis in 2007, a number which has since gone up to a staggering $710 trillion according to the BIS.

A recent survey of this derivatives minefield looks something like this:

Five banks in the US account for over 90% of all US outstanding derivative exposure – the same usual suspects of too-big-to-fail (TBTF) banks which all blew up and had to be subsequently bailed out in 2008. Each one carries more than $40 trillion in derivative exposure.

Context references: Total US national debt outstanding: approx $17.7 trillion, GDP of entire world: approx $75 trillion

JP Morgan Chase (derivative exposure / assets): $68 / $2.5 trillion
Citibank: $63 / $1.9 trillion
Goldman Sachs: $58 / <1 trillion
Bank of America: $55 / 2.1 trillion
Morgan Stanley: $44 / <1 trillion
Total exposure of US banks: $303 trillion

 Derivatives exposures of top US banksNotional amount of derivative contracts held by US banks

 

And the bank with the biggest derivative exposure of all is, drum roll……,

Deutsche Bank, with a grand total exposure of $75 trillion, an amount 100 times greater than its deposits and 5x greater than the GDP of Europe…..

North of the US border where they had apparently, at least on the surface but who knows what happened behind the scene, dodged the last bullet, the supposedly safe Canadian banks have also been busy building up their derivative portfolios.

Per this Canadian Credit Health Update (data to 2013 Q4):

Canadian banks have $21 trillion of notional derivatives, up +11.5% in one year.
Royal Bank of Canada reached a milestone: more than $8 trillion notional derivatives.
Over-the-counter derivatives (OTC, the riskiest category) growing even faster, up +16.4% in one year

Royal Bank (total notional / OTC notional): $8 trillion / $7.8 trillion
TD Bank: $4.3 / $4.0 trillion
BMO: $3.5 / $3.3 trillion
Scotiabank: $3.1 / $2.8 trillion
CIBC: $1.9 / $1.8 trillion
National: $0.5 / $0.5 trillion

 

I know some of you would cry foul, contending that the argument is not fair because these huge numbers are only notional values which net out to more or less zero. In a perfect world where liquidity is ample and all moving parts within a complex system are functioning as expected, that is certainly true. When the world gets less perfect, as what happens when some financial entity blows up somewhere, liquidity seizes up, or, gasp, one or more counterparties within the derivative chain becomes insolvent, this interlocking web would virtually guarantee that cascading failures would ensue. (check out this primer for an explanation of the difference between notional and net)

So they are right: notional exposures are not net exposures – until the chain breaks. When that happens, one’s notional exposure is his net exposure.

If the derivatives market has grown to such a menacing size and had already blown up once, why is it not reigned in but growing like cancer instead?

In short, it’s money and greed. The opaque and largely unregulated derivatives market exists primarily in the shadow banking system and generates massive and lucrative profits for the banks. This is a place where banks can legally and illegally feast on the wide margins between the bids and asks on these thinly traded instruments, front-run their clients, and, in the worst case of conflict of interest, initiate positions on clients’ behalf and then have their in-house proprietary desks (or prop desks, trading for the company’s own accounts) trade against these positions. If caught, as happened multiple times to all of these TBTF banks, they simply settle with the government with infinitesimally tiny penalties, paid for by shareholders and not executives and with no admission of guilt. Small costs of doing business.

Legally and moral ethics notwithstanding, there is little wrong with an enterprise trying to maximize its profits and returns on investment. After all, there is always the risk-vs-return continuum where individuals and businesses alike constantly try to determine their respective optimal balances.

The problem with this picture with the banks is that in their search for outsized profits in the world’s biggest casino that is the derivatives market, your money is intermixed with the banks’ risk capital. They (their executives) reap in mega profits as long as the market does not blow up. If the market blows up, the mutually assured destruction will assure that the governments and the public will bail them out.

So under the Zero Interest Rate Policy (ZIRP) orchestrated by the central banks controlled by these banks and administered by regulators captured by the same banks, you get this perversion:

  • The banks take on unmitigated risks and reap maximum profits, backstopped by the taxpayers.
  • Instead of risk free returns, depositors get “return free risks” by having their money in the bank.

Part 3 will examine the probable mechanism of how the newly enshrined bail-in concept will likely work by pulling in bank depositors’ money when, the derivatives market blows sky high.

 

Bail-in At Your Local Bank series guide

 

References:

 

Bank bail-in

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