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Once Again, Banks Are Leaving Investors In The Dark

Finance: Commentary


Banks have a checkered history when it comes to new ventures. From less-developed-country loans in the 1970s to commercial real estate and leveraged-buyout loans in the late 1980s, banks have chased one another into seemingly profitable new areas only to find themselves often hit with big losses.

Today, one hot activity for many banks is trading in derivatives. Derivatives are contracts that are linked to such things as interest rates, foreign-exchange rates, commodity prices, and market indexes, whose values vary over time. Often, companies swap streams of payments with one another to modify their exposure to these variables. These days, many financial and industrial companies use derivatives routinely, which is giving lots of new business to banks that sell derivatives contracts. Some individual major banks have derivatives tied to several hundred billion dollars in


That may seem fine. But unfortunately, under today's accounting and disclosure rules, it's almost impossible for outsiders to get anything but the sketchiest picture of a given bank's derivative activities. One example: Citicorp's 1992 annual report. Citi actually provides more details on its derivatives than many banks do. But almost the only statistics it publishes are the aggregate amount of the principal underlying its derivatives and the associated "credit risk," or the amount the bank would have to pay to replace its derivatives contracts if they were suddenly terminated. That's hardly enough to allow the average investor or corporate financial officer to get a handle on Citi's derivatives business.

NEED TO KNOW. Why should banks tell more? Plenty of reasons. One is potentially huge risks. Derivatives markets have occasionally been shaken by sudden rate shifts. For example, Showa Shell, a Royal Dutch/Shell Group affiliate, earlier this year declared an unrealized loss of more than $1 billion from a currency hedge. Joe Kolman, editor of newsletter Derivatives Strategy & Tactics, says the extent of the loss "was not known even to the people at Showa." Citi, Bankers Trust New York, and J.P. Morgan found themselves with a credit risk approaching $114 million from swaps contracts when Mutual Benefit Life Insurance Co., a New Jersey insurer, failed in 1991.

The International Swaps & Derivatives Assn., the trade group for derivatives dealers, says defaults on swaps represent less than 0.5% of the market value of all contracts outstanding. But investors are still in the dark about credit standards used by individual banks and the degree to which they might suffer from rapid changes in market rates. Using an extreme example, David S. Berry, director of research at Keefe, Bruyette & Woods Inc., says: "My sense is, there are some pretty plain-vanilla things people do, but long-term amortizing swaps linking oil prices to gold are different."

The portfolios of some banks are large. Citibank's credit exposure is now at least 86% of its equity, Morgan's is 141%, and Bankers Trust's is 213%.

Some useful changes are afoot. The Group of Thirty, whose members are bankers and finance experts, is recommending more numerical information and substantially more discussion of banks' approach to managing their derivatives businesses. The Financial Accounting Standards Board has boosted requirements on accounting for derivatives, and the International Accounting Standards Committee, a group of accounting professionals, is also developing recommendations for more comprehensive accounting standards. Legislators are looking at derivatives, too: The House Banking Committee held hearings on derivatives during the week of Oct. 25.

QUALITY COUNTS. Still, more needs to happen--now. While the G-30's recommendations are a good start, banks are under no obligation to follow them. For investors to become comfortable with the industry's use of derivatives, regulators should require bank financial statements to detail the credit quality of their derivatives. Citi provides details on region and size of loans for its commercial real estate loan portfolio; banks' derivatives portfolios should be described in the same detail.

Bank reports should also explain how they use derivatives to guard against changes in market rates as well as what degree of rate swings they can tolerate. And dealers should discuss how they manage their derivatives business--what internal controls they use and what steps they take to insure that top management really understands what's going on.

Banks became a lot more forthcoming about their real estate loans after they got into trouble. Why wait? They should come clean about their derivatives operations before big troubles start. Maybe more disclosure would stop problems from developing in the first place.Kelley Holland

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