Wheat First analyst is bullish on fuller disclosure of derivatives.

Even as Congress and regulators probe banks' derivatives use, Merrill Ross is seeking answers of her own.

A senior analyst at Richmond, Va.-based Wheat First, Butcher, Singer Inc., Ms. Ross would like to see better disclosure by banks of their off-balance-sheet risks.

Like many, she finds little benefit from knowing the notional value of the derivatives book, because that says little about the instruments being used. Rather, she believes banks should discuss the cost of this growing risk management tool and disclose their strategy.

Ms. Ross also says that would soothe the nerves of investors, who have beaten down the value of some bank stocks over derivatives worries.

In a recent interview, Ms. Ross, who follows companies from Charlotte-based Nations-Bank to super community banks in the Middle Atlantic region, offered her observations about how well investors are being informed and what they want to know.

Q.: When you sit down with management, what do you want to know about the derivatives book?

ROSS: I try and understand from the banks to what extent their hedging positions are perceived as a profit center.

The banks are clearly in the business of taking interest rate risks, but in their hedging position they could potentially be expressing a stronger view of interest rates that would put the institution in a significant profit or loss position.

This is something that you can't really answer with numbers, but it's a nice, responsible thing to ask.

Q.: That's perhaps the most critical question, isn't it -- because every bank is going to have a different view. Do you have any principles that you use yourself for determining when a bank has crossed that line?

ROSS: No. That's because I can't quantify it, and I can't yet get my arms around it. But it is a gray area, and that worries me. Because gray areas just invite regulatory risk, and the risk the regulators will take away some of these tools that are fundamentally useful things.

Q.: So then what is important to focus on?

ROSS: If we are going to quantify with disclosure, it would be nice to focus on what portion of current earnings is allocated to protecting positions.

At least in theory, when you enter into a contract to swap some kind of fixed rate for floating rate, you have paid a premium for that. If the deal doesn't work out, you've lost your premium.

So the potential risk is not a loss of principal, but of interest income -- and the protection you thought you were buying turned out to be ineffective or less effective than you thought.

Q.: Can that "current income" cost be mitigated?

ROSS: I think there are ways you can minimize that.

You can use only exchange-traded derivatives, but maybe that doesn't get you to where you want to be.

Another issue is to exchange collateral in those cases where credit is at risk. It's really common in this industry to not exchange collateral. But it would really benefit banks to use third parties to hold something in trust through the terms of the contract to make sure the other person stays honest.

Q.: But wouldn't that add to the cost of the transaction.

ROSS: It sure would, but at what cost safety? In that sense, if they were going to increase their safety, then the capital requirements should be significantly lower. In other words, the regulators should use the capital requirements for some of these things to fine-tune safe and sound business practice.

I don't know that I trust regulators to do it right. They have an unerring tendency to take the most deviant path to enlightenment in many issues.

Q.: Why is it important in your view to discuss how much current income is being spent?

ROSS: Because it has the potential to become a sizable amount of current income. For example, when we talked about it at First Union Corp., they said they spent $27 million in premium to put their current position on the book.

That's not a terriblyu damaging number to First Union, but to what extent could it be to some of the regional banks? I started to get a little concerned about that.

Clearly, if you are trying to run a matched book, it could be a very expensive proposition. Probably it's a money loser, because investment banks in the middle want their money, too.

Even though, theoretically, a matched book doesn't lose you money, you lose money on the (cost of) transactions. If you can get an idea of what that number is, you sort of get an idea of the risk.

Q.: What else?

ROSS: Another piece of relevant disclosure came from Crestar. They could tell us how much it would cost to replace their $2 billion in notional amount in off-balance-sheet protections with on-balance-sheet instruments, like how much it would cost to replace it with Treasuries. And they could tell us that number as a percent of capital.

Q.: What would the market's reaction be if banks started to uniformly make that disclosure?

ROSS: I don't think it would be negative at all. I think people would be surprised at how low it is as a percent of revenues, and they would take a lot of comfort from it. They think the potential for derivatives to blow up is just amazing. They really don't know exactly what they mean by blow up. I think there just needs to be a lot more light shed on it.

Q.: What are banks disclosing now that you find useful?

ROSS: I thought First Union's disclosure was very interesting. It described why they entered each type of contract and what uses they might have for it. They told us about their collateral risk. Their total credit risk was $313 million, and they held collateral for $285 million.

But I have no idea if that's a standard amount, but it gives us something to start drawing up the (disclosure) rules from.

Q.: You hit on a relevant point, and that is that not everyone does the same thing.

ROSS: That's right -- and until it's regulated, they won't. Until we have meaningful comparisons, they are totally useless -- except and they deserve some credit.

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