The Continuing Risk of Derivatives


Everybody now knows the narrative of the Great Financial Recession of 2008, in particular, the impact that toxic derivatives had in terms of exacerbating the crisis. And the usual defense of those who misdiagnosed the crisis is that the very nature of the so-called “shadow banking system” made it difficult to determine the systemic nature of the crisis and the corresponding extent of the banks’ liabilities.

In fact, that is a lame rationalization, as Jan Kregel notes in this interview. Kregel correctly points out that we’ve seen this show before in Asia during the financial crisis of 1997-98.

The normal scenario for a developing country financial crisis would involve domestic firms borrowing in foreign currency from foreign banks at interest rates that are reset at a short rollover period. Note that it makes little difference if the loans have a short or long maturity, the point is the change in interest costs on cash flows produced by the short reset interval for interest rates. Short reset periods mean that a rise in foreign interest rates is quickly transformed into an increased cash flow commitment for the borrower, instantly reducing margins of safety.

If the change in international interest rate differentials leads to a depreciation of the domestic currency relative to the borrowed foreign currency, then the cushion of safety is further eroded by the increase in the domestic currency value of the cash commitments and the principal to be repaid at maturity. And finally, if the government responds to the weakness of the domestic currency in international markets by raising interest rates, then this clearly will make the situation even worse.

As Kregel points out, all of these conditions pertained in 1997-98, but what gave the crisis particularly formidable force was the used of customized over-the-counter (OTC) derivatives, most of which masked the nature of the true risks being undertaken by the borrower, as well as understating the extent of the credit exposures. In many instances, these derivatives were structured in such a way as to avoid the national prudential regulatory guidelines in the country concerned. In some instances, there was no market involved in these contracts, which may involve the stipulation of standard futures and options contracts outside the organized market on a bilateral basis with individual clients.

However, the majority of OTC activity involves individually tailored, often highly complex, combinations of standard financial instruments, packaged together with derivative contracts designed to meet the particular needs of clients. These contract packages involve very little direct lending by banks to clients, and thus generate little net interest income. However, since they are often executed through special purpose vehicles (such as specialized investment firms that are independently capitalized), they have the advantage under the Basel capital adequacy rules of requiring little or no capital, or of being classified as off-balance-sheet items, because they do not represent a direct risk exposure for the bank. In addition, they generate substantial fee and commission income.

Rather than committing their own capital in these transactions, the banks serve as intermediaries whose services involve not only matching borrowers and lenders, but also acting as market innovators to create investment vehicles that attract lenders and borrowers. Nonetheless, these activities often require banks to accept some of the risks associated with the derivatives created in order to produce packages with the characteristics desired by final borrowers and lenders. But in many instances, the derivatives themselves are so complex and so inadequately “stress-tested” that their destructive effects can only be seen after the fact, which was clearly the case, both in 2008 and the earlier Asian financial crisis.

The other common feature that Kregel notes is that the major objective of active, global financial institutions no longer is the maximization of profits by seeking the lowest cost funds and channeling them to the highest risk-adjusted return. Rather, they are most interested in maximizing the amount of funds intermediated in order to maximize fees and commissions, thereby maximizing the rate of return on bank capital. This means a shift from continuous risk assessment and risk monitoring of funded investment projects that produce recurring flows of interest payments over time, to the identification of riskless “trades” that produce large, single payments with as much of the residual risk as possible carried by the purchasers of the package.

The upshot is that most derivative packages mask the actual risk involved in an investment and increase the difficulty in assessing the final return on funds provided.

Kregel discusses all of these factors in great detail in this video.

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