In this era, banks must offer risk management to clients.

Bankers ignore the $7 trillion U.S. derivatives market at their peril.

Bank customers, bolstered by recent accounts of successful class-action lawsuits against corporate hedging practices, are not just requesting effective risk management expertise. They are demanding it.

Banks that don't respond are ignoring one of their most critical fiduciary responsibilities - to protect clients' assets as well as their own - and are setting themselves up as possible targets for litigation.

The recent adoption of Financial Accounting Standards Board rule 115, which will force banks to mark their bond portfolios to market values, coupled with the other economic issues facing banks, exacerbate this situation.

Competition Heats Up

Industrial giants like AT&T, General Motors, and General Electric, along with a bevy of financial service companies, now offer credit cards, consumer loans, mortgages, and other services. They are taking away the banking industry's bread and butter.

With more and more bank customers looking to other institutions to help them manage risk, banks are seeing a steady erosion in their basic business. One can almost feel the vise tightening on the bottom line.

Avoiding Past Mistakes

Banks can dodge this triple threat simply by avoiding mistakes of the past. That means acting sooner rather than later to become expert in risk management techniques, so that clients' needs can be fulfilled and the effects of FAS 115 effectively mitigated.

Hedging - the most effective risk management tool available to reduce financial portfolio risk - is already very much in demand by both individual and corporate customers.

Smaller investors are realizing that derivatives can be tailored to suit their needs, while increasing numbers of corporate clients are already using the derivatives market to manage all types of risks, including those associated with currency, commodities, interest rates, and equities.

Because risk management expertise has not effectively been developed within the banking industry, many customers are unnecessarily exposed or, or worse yet, attempting to do the job themselves. Moreover, the bank's own portfolio is at equal risk.

Hands-On Approach

Bank presidents who want to realize the full potential of hedging must do more than delegate responsibility to the asset-liability management committee.

This matter is too important to delegate.

In order to comprehend the rapid changes that are now taking place, they and their boards of directors must achieve a full understanding of risk management and implications of being left behind.

An inadequate understanding of hedging techniques will almost always make senior bank officers and board members timid in adopting the broad risk management policies needed to protect profitability.

If not fully understood, hedging, like any other new concept, can breed fear.

And fear can paralyze even the most aggressive chief executive officer, particularly the consequences of not implementing policies, procedures, and capabilities to apply these techniques to customer and bank assets.

Accounting Changes

The primary issue facing banks today is the change in accounting for "trading securities" and "available-for-sale securities," which under FAS 115 includes any securities that do not meet the strict requirements of the "held-to-maturity securities" portfolio.

Unrealized holding gains and losses for "trading securities" are included in earnings.

But unrealized holding gains and losses for "available-for-sale securities" (including those classified as current assets) are excluded from earnings and reported as a set amount in a separate component of shareholders' equity on the balance sheet.

It's this last provision that poses the greatest challenge to bankers because the market valuation of the bond portfolio is particularly sensitive to interest rate changes.

Even a small increase in long-term interest rates at the end of a reporting period will mean marking down the value of long-term bonds held in the "available-for-sale securities" and "trading securities" categories.

Under FAS 115, that markdown will result in a reduction to the capital account from an unrealized loss in the "available-for-sale securities" account, or directly to income if held in the "trading securities" account.

Market Whims Feared

Bankers are not happy about subjecting the valuation of vital bank capital and income to the volatility of the marketplace, something over which they feel that have no control.

So, as predicted by those who closely follow bank accounting issues, many banks are responding by dramatically shortening their portfolios in the hope of avoiding volatility. As long-term bonds mature, the proceeds are being invested in less volatile, shorter-term instruments.

Stopping short of tagging this practice as a short-sighted way to control portfolio risk, there is little question that it's an expensive practice. Shortening bond maturities may reduce the risk of volatility, but it does so at a very steep price.

No doubt, the sizable returns (spreads) banks have been realizing by investing low-cost deposits in high-yielding long-term bonds will shrink dramatically when invested in shorter-term instruments.

Banks don't need to give up the impressive yields on their bond portfolios. They can still purchase long-term bonds and maintain interest rate spreads, but they need to hedge the risk of rising interest rates against their long position. As bond values decrease, hedging values will offset any losses.

In the Vanguard

Many forward-looking bankers realize that they have the distribution networks, client bases, and balance sheets to support over-the-counter derivative trading, putting them in an enviable position to provide superior customer service and maintain healthy financial positions.

The problem of how to obtain the hedging expertise they needed was addressed differently by each of five banks.

Some purchased hedging expertise outright, such as NationsBank Corp., the country's fourth-largest banking company, which recently purchased CRT, one of the largest options market-making and trading firms.

Others like Bankers Trust New York Corp., chose the do-it-yourself approach, building expertise internally to serve their own needs as well as the hedging requirement of their customers.

Three others - Swiss Bank, Chase Manhattan, and Matsui - either formed strategic alliances or purchased derivative arbitrage firms in order to obtain instant hedging expertise.

Fiduciary Responsibility

Protecting the bank and its clients from undue financial risks is a fiduciary responsibility too critical to ignore. Bankers, who, like the rest of us, tend to stick with what they know, are comfortable with their ability to control the credit risks associated with lending.

They also understand how to use asset-liability tools to control the interest rate risks in funding their loan portfolio.

With hedging, bankers can effectively control other financial risks - currency risk, in all its dimensions, and interest rate and security price risk in the investment portfolio - while fulfilling their clients' needs for total risk management services.

But it won't happen by accident. It will take enlightened action, and the time to act is now.

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER