Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Are Derivatives Too Risky for Banks?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Are Derivatives Too Risky for Banks?

Article excerpt

Bank participation in the market for derivatives has been growing rapidly in recent years. Derivatives such as swaps, futures, and options now form a significant share of total assets at some of the nation's largest banks. Moreover, participation in these markets accounts for a growing share of bank revenues.

Some observers worry that derivatives may be too risky for banks, because derivatives are relatively new and complex assets. In a 1992 speech to the New York Bankers Association, E. Gerald Corrigan, then-president of the Federal Reserve Bank of New York, warned that the growth and complexity of derivatives activities "should give us all cause for concern." And in April of this year, prominent investor Warren Buffet worried that derivatives might one day trigger a catastrophic "chain reaction" in world financial markets.

In light of these concerns, it is relevant to ask whether banks should be prohibited from participating in derivatives markets. Laws and regulations already restrict many bank activities to protect depositors and ensure the integrity and stability of the payments system. For example, most investment banking activities are barred by the Glass-Steagall Act, and banks are prohibited fiom buying corporate stocks for their own accounts because stocks are considered too risky. Some observers believe that derivatives, like corporate stocks, may be too risky for banks to deal in or to hold.

This article examines whether derivatives are too risky for banks at the current stage of market development. The first section defines derivatives and explains their uses. The next section examines the role of banks in the derivatives market, traces the growth of bank participation in the market, and considers the reasons for this increased participation. The third section describes the risks derivatives pose to banks and discusses how banks are managing these risks. The fourth section explains how regulators monitor banks' derivatives activities. The article concludes with the view that banks can safely manage and regulators can effectively supervise bank participation in derivatives markets.

DERIVATIVES DEFINED

Derivatives are financial contracts whose values are derived from the values of other underlying assets, such as foreign exchange, bonds, equities, or commodities. Because their values are related to these underlying assets and because they have certain other characteristics, derivatives are useful for hedging, speculating, arbitraging price differences, and adjusting portfolios at low cost.

WHAT ARE DERIVATIVES?

A derivative is a financial contract whose value depends on the value of an underlying asset or index of asset values.(1)

For example, an interest rate futures contract is a derivative that commits the parties to exchange a debt security, say a Treasury bond, at a future date for a predetermined price. The value of the futures contract depends on the value of the Treasury bond that underlies it. If the Treasury bond price rises, the value of the futures contract also rises because the buyer of the futures contract is now entitled to receive a more valuable asset.

The enormous and rapidly growing variety of derivatives can be bewildering even to experienced financial marketparticipants. But all derivatives can be classified according to three features: the type of contract, the type of asset underlying the security, and whether the derivative is traded on an exchange or in the over-the-counter (OTC) market.

Banks trade mainly in the following three types of derivatives contracts. Forward and futures contracts are agreements between two parties to exchange a quantity of assets at a future date at a predetermined price.(2) The Treasury bond futures contract mentioned above is an example of this type of contract.

Options contracts confer the right, but not the obligation, to buy or sell an asset at a predetermined price on or before a fixed expiration date. …

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