Canadian Banks Derivatives Expanded By A Trillion in 2016

Since we reported on the total notional derivatives exposures of the big 5 Canadian banks in Q1 2016, the banks have collectively continued to expand their derivatives portfolios.

The following table summarizes the total exposures of the Big 5 based on the 2016 Q4 report from the Office of the Superintendent of Financial Institutions (OSFI).

Whereas Scotiabank has seen its derivatives books reduced significantly and BMO’s reduced somewhat, the increase in exposure by the other 3 banks way more than offset the shrinkages at Scotiabank and BMO. Particularly of note is TD Bank which increased its notional by a whopping $1.57 trillion (that right, $1,574 billion, 21% increase since Q1).

Collectively, the total derivatives exposure increased by $933 billion to $33.1 trillion, against a total asset base of $4.4 trillion.

BankAssets (billions)Q1 Derivatives notional total (billions)Q4 Derivatives notional total (billions)Change (billions)
Total4,61132,20433,137933
Royal Bank1,21812,42512,594+169
TD Bank1,2127,6309,204+1,574
Scotiabank9185,0493,896-1,153
BMO7334,6874,622-65
CIBC5302,4132,821+408

Notes on Canada’s Bail-in Regime

As we reported early last year, Canada had followed the footsteps of the EU and introduced legislation to implement a bank recapitalization or “bail-in” regime for domestic systemically important banks.

This bail-in regime was not new, as the previous Conservative Government was the first to introduce similar legislation as part of its 2013 Budget. The bail-in regime proposal was further developed in its 2014 consultation paper. The consultation paper outlined a plan to introduce a statutory conversion power that would allow the government to convert long-term eligible liabilities of big banks into common shares. The proposed regime excluded depositors, distinguishing itself from the bail-in approach in Cyprus. Ultimately, no legislation was introduced before the election was called and thus the bail-in regime was not implemented. (link)

The current Liberal Government intends to publish regulations and guidelines setting out a more detailed bail-in regime. How the regime will ultimately work and, particularly, whether retail account holders’ deposits will be part of the assets to be bailed in, remains to be seen.

Bail-in Actions Elsewhere

Also since our last report, a few things, all of which from Europe, have transpired which are worth noting.

  • Austria’s Heta Bank was the first victim since the Eurozone wide bail-in regime took effect in January 2016, bailing in its senior creditors with a 54% haircut. Retail depositors were spared this time. (link)
  • In the wake of the Brexit vote, European bank shares were crushed with breathtaking losses in the range of 20% – 30% in a two-day massacre. (link)
  • The entire Italian banking system which has been saddled with mind-boggling amounts of non-performing loans, was on the verge of complete collapse following the imminent failure of its third largest bank Monte dei Paschi. The EU and the Italian government had a nasty dilemma on their hands: bail out the bank and throw the brand new bail-in regime to the garbage, or bail in the bank’s creditors and depositors and trigger a country-wide (possibly continent-wide) bank run. A back-door bail-in (or bail-in by another cryptic acronym) is being introduced as the Italian government and the EU verbally spar over the legality of such actions. Meanwhile, the Italian banking system, which has long been insolvent by any measure, is being put on life support giving the appearance that the patient is still alive. (link)
  • Deutsche Bank, the poster child of derivatives time bomb with a total notional exposure multiple times the GDP of Germany and the bank singled out by the IMF as the top contributor to systemic risk to the global financial system, has been on a death spiral which saw its share price dip to single digit immediately after the Brexit vote. In addition to shedding assets, Deutsche has gone to the capital markets for the fourth time since 2010, this time trying to raise €8 billion, with a 35% discount to existing shareholders. (link)

Recaps and Reminders

For those who are just recently dialing in and/or are otherwise not familiar with the causes of the global financial crisis of 2008, the reason we keep harping on the topic of derivatives exposures is that derivatives (see the primer on derivatives) were certainly a key if not THE key contributing factor to the 2008 financial meltdown. How governments all over the world ended up incurring trillions of public debt to bail out private banks and how the world plunged into global recession and eight years of economic non-recovery should be quite familiar to most. As articulated in The derivatives time bomb, not only has the problem of bank derivatives exposure not been addressed since the meltdown, it has gotten even bigger and more concentrated.

Now that the bank bail-in regime has either been or will soon be introduced to every banking system in the industrialized world, it is all the more important that depositors understand who owns what when it comes to your bank deposits, what happens when a bank blows up and what safeguards are put in place to ensure these banks don’t blow up.

For the defenders of the status quo practice of allowing toxic derivatives mixed in with bank depositors money in a bank’s assets, the standard argument is the usual “Don’t worry, the numbers involved are notional amounts, the net amounts are tiny and often zero”.

At face value the argument is not incorrect, and, under normal circumstances, derivatives are designed to transact and transpire as intended. Problem is, when a banking crisis flares up, the circumstances are anything but normal. In the world of derivatives where participants are exposed to long, convoluted chains of counter-parties, one’s notional exposure immediately becomes one’s net exposure when one counter-party along the entire chain fails, as amply demonstrated in 2008. Rather than regurgitating the entire failure mechanism here, readers are encouraged to check out the full explanation here.

In terms of what it means to you as a depositor, here’s a recap:

  • When you deposit money in the bank, your money becomes the asset of the bank. You become an unsecured creditor of said bank.
  • When a bank fails and their liabilities need to be settled and creditors paid, it is done according to creditor seniority. As a depositor (unsecured creditor), you are the bottom of the pile. To add insult to injury, derivative bets between financial institutions are considered super senior and they all get settled first. That’s right. Read this one more time: those institutions which are derivatives counter-party to the failed bank get to pick at the carcass first.
  • The bail-in regime would ensure that shareholders of a failed bank get wiped out first (right thing to do), bondholders get a haircut and depositors’ money gets bailed in. The if, how-much and exact order of ‘sacrifice in order to save the bank’ for each group of creditors involved would vary depending on the circumstances at the time.
  • If you think CDIC/FDIC and other deposit insurance schemes would be your savior, think again. The amounts in these insurance systems amount to a few drops in the bucket when something big blows up. As made abundantly clear in the 2008 fiasco, the entire FDIC would have vaporized in a matter of days if the government did not step in to bail out the banks. Remember, ALL of the big banks, including non-banks such as Goldman Sachs which got turned into a ‘bank’ in order to get bail-out money, would have failed in 2008.
  • Even if the bail-in regime which eventually passes legislature would explicitly exclude depositors, there is no guarantee that the bail-in process will be followed exactly as prescribed. The reason is simply this. If and when a next global banking crisis erupts, say, due to these interlocking derivatives, the losses suffered by the too-big-to-fail banks are going to be so staggering that depository insurances like CDID/FDIC will be vaporized in a matter of days and the banks will still be short after all creditors are bailed in. What does a government do at that point? It can either bail out the banks using taxpayers’ money and/or bail-in other depositors who have so far been spared. We will be in uncharted territory, and the government will be making it up as they go. Whose money will be used and how much will be a combination of which ruling party is running the government at the time and which segment of its political base it would try to avoid antagonizing the least. Governments have unlimited power to make up their own rules in times of crises as readily demonstrated in 2008.
  • If you think bank failures won’t happen in Canada because it did not in 2008, think again. Just because it did not last time does not mean that it won’t next time. Besides, us common folks won’t find out what was done behind the scene between the government and the banks at the height of the last crisis until details get declassified decades down the road. By the way, the people in Cyprus did not think a bail-in would happen to them either. Nor did the Italians. Or Austrians.
  • The most fundamental requirement for a functioning fractional reserve banking system is the confidence that depositors feel their money is safe in the banks. The minute that confidence disappears, depositors would pull their money out and a bank-run would ensue. For that simple reason, no bank or banking regulator would ever warn the public that a bank might be in danger of failing. In other words, take it as a given that you as a depositor would be the last one to find out.

With bail-in legislation introduced and depositors now explicitly on the hook in the name of saving a failing bank, what extra measures are being put in place to reduce the risk of banks blowing up? What argument is left for not separating commercial banking activities where depositors’ money resides and is protected by deposit insurance and investment banking where the banks are engaged in high risk derivatives and other casino activities?

Bank bail-in

This article is part of the Bank bail-in in-depth topic. Get a crash course and read the latest developments on this topic.

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9 thoughts on “Canadian Banks Derivatives Expanded By A Trillion in 2016

  1. Chris Hoff

    I read a few years back the total worldwide derivatives exposure was 2 Quadrillion dollars, as in 2000 Trillion. If that house of cards folds up, there’s going to be some very serious debt write downs.

    • Editor Post author

      The total notional amount is definitely some incomprehensively huge number. It would have taken down the entire global banking system if the governments did not step in and bail out the banks in 2008. The problem has not gone away, and, if anything, has gotten worse since then.

  2. Mike

    Thank you for the update. What is your opinion regarding smaller banks and credit unions? How much derivative risk is associated with them? Are they less likely to get bailed-in?

    Also, it may seem off topic, but are the savings under the brokerage firms associated with the big banks (e.g. TD Waterhouse) also at risk for bail-in as well?

    • Editor Post author

      I am not sure about smaller banks, but credit unions, by their mandates, are restricted from lending beyond their domestic regions. Unless someone finds a loophole to do otherwise, they are not involved in investment and shadow banking. As such, I do not believe they have derivatives directly in their balance sheets. The risks with credit unions would be their portfolio risks. If there is a severe downturn in the local economy or if the housing bubble blows sky high, their mortgage portfolios could suffer severe losses and potentially make some credit unions insolvent. Keep in mind if the housing bubble blows up, it would impact just about all credit unions and banks, as in the case in the States in 2008.

      Assets in brokerage firms are protected by the Canadian Investor Protection Fund which is industry run. It covers 1 million for all combined general accounts (cash accounts, margin accounts, TSFA), 1 million for all registered retirement accounts (RRSP, RRIF, etc.), and 1 million for RESP. I am not sure how much the CIPF pool has in terms of assets to cover potential claims. I am confident that the coverage ratio is lower than that of the CDIC which is pretty low.

      All client assets in a brokerage firm get mixed up with the investment bank’s assets. From that point of view there is no difference from a one’s savings account. The one difference is the insurance pools which protect their respective accounts.

      Hope this helps.

      • Mike

        Thanks again for the reply.

        I think that the whole derivative market (notably credit default swap, or CDS) will inevitably lead into a huge crisis, the one possibly even bigger than one in 2008, as the big banks all around the world are accumulating ever increasing amounts in their balance sheets, and the people and the governments around the world have to wake up to the absurdity in the risks that the bankers are able to take for some profit. These are financial instruments designed to fail because they are designed to circumvent the regulatory capital requirement.

        CDS as I understand it basically insures the interest and principle of an investment made by a creditor, such as mortgage backed security. It relies on the speculative assessment of the security issuer’s creditworthiness, that the credit rating of the issuer should be higher and that the interest on the security should thus be lower. The CDS issuer, in turn, sells CDS to the creditor to guarantee the principle and the interest payment; the CDS issuer profits by taking the spread between the interest that security issuer pays and the interest that the CDS purchaser receives. It is entirely absurd that this kind of financial instrument should even exist! If the CDS issuer thinks that the creditworthiness of the security issuer is underrated, then he should buy the security from the creditor (at a higher premium) to earn the full interest, so that the CDS issuer can take a full advantage of the risk-premium associated with the security, instead of selling a financial product riddled with a counter-party risk. By taking only a fraction of the risk-premium, the CDS issue won’t be able to fully offset the loss from a potential default. The only reason why I think the CDS market exists is because the issuing institutions can circumvent the regulatory capital requirement that they have to meet if they had to purchase the security. By not having to report their true notional exposure to the derivatives, and merely reporting their net exposure in the event of default, they don’t have to expand their capital requirement as much.

        Essentially, what I’m trying to say is that the bankers are ripping huge returns on the risky bets while economy is stable, because they can sell a staggering number of CDS’s without having to significantly expand their regulatory capital. However, because the returns on CDS cannot fully offset the losses from default, CDS will inevitably lead to a varying degree of counter party risks during economic downturn, when the rates of default are expected to rise. The government, taxpayers, and depositors have allowed the bankers to rely on bail-out and bail-in schemes to offset the losses during an economic downturn, instead.

        • Editor Post author

          Hi Mike,

          Thanks for the insight. In a way CDS is little different from insurance, and its intended purpose is to insure a creditor against the debtor defaulting. For example, A buys a high yield bond taking on more risks but earning a higher interest, and buys a CDS to protect against the bond defaulting. The issuer of the CDS bets that the bond won’t default during the term of the CDS. The issuer also buys insurance, fully or partially, from another issuer in case he makes a wrong bet. In that regard it is pretty similar to the insurance industry.

          The problem with CDS is at least twofold. First, unlike insurance, anyone can participate (bet) – for or against the underlying security. It is like you buy fire insurance on your house, which is totally legit, but your neighbor John and some other guy Sam can also place the same bet on your same house (for example, Sam bets that your house won’t catch fire and John bets it will). In this case, the transaction between John and Sam is purely speculative and serves no economic purpose. Worse yet, you should get alarmed if you see John walking around your backyard with a liquid container.

          Second, the issuing and re-issuing of CDS create a complex and tangled chain of counterparty risks. If one fails, the entire chain collapses, as witnessed in 2008.

          You nailed it in the head that CDS resides in the shadow banking system beyond the control of the banking regulators. The right thing to do is to separate the activities of investment banking from repository banking, in the process safeguarding the depositors’ funds should the bank makes a wrong bet.

      • bobi

        Re credit unions, I once asked about this and was told that in Ontario, credit unions are required to have strategies in place to protect themselves against interest rate fluctuations. I took this to mean that they purchase some sort of insurance/ derivative for this purpose. As far as depositors are concerned, their deposits are insured by the province instead of by the feds. Given Ontario’s indebtedness, that seems like cold comfort!!

        • Editor Post author

          Thanks for the insight. You are right, credit union deposits are guaranteed by the respective provincial governments. In the case of BC, the full amount of deposit is guaranteed. As in CDIC, the guarantee is as good as the size of the pool of money available to cover losses. Credit Unions are limited in where they can invest and, in that regard, does not have the same risks as the money center investment banks as far as derivatives are concerned. That said, they are heavily involved in housing mortgages. With the housing bubble as big as it is in Canada, it is still cold comfort.

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