WASHINGTON -- Derivatives market participants may have experienced recent losses partly because the sophisticated models they use to gauge derivatives risks failed to accurately predict interest rate swings, a Federal Reserve Board governor said yesterday.
"Some of the models failed to provide the guide to [a] safe harbor because they assumed narrower swings in interest rates than actually took place," John P. LaWare told those attending the American Bankers Assocation's annual regulatory compliance conference here.
Derivatives market participants use mathematical models to understand derivatives and the risks they pose. The models simulate the behavior of markets and financial instruments during periods of volatility, which are usually triggered by wide savings in interest rates.
LaWarehs remarks that some of the models may not have performed as expected during the most recent period of market volatility come as derivatives players are pleading with banking and securities regulators for approval to use such models to determine market risks and help establish appropriate capital requirements for their derivatives activities.
LaWare's overriding message to the bankers, however, was that derivatives are not new and do not pose undue risks in the hands of experinced market participants. Supervision rather than legislation providing new regulatory authority is all that is needed to police the derivatives markets, he said.
"Legislation would inevitably try to set standards or parameters for the industry which ignore individuals differences among institutions," LaWare said.
"I am convinced that with full disclosure by banks of their derivatives activities and exposure, trained examiners will be able to assess the risk inherent in the activity and then make an informed judgment whether the risk management process in the bank is adequate to protect against a disastrous loss that would threaten depositors and shareholders," he said.
The recent concerns about derivatives, LaWare said, have been fueled by "an overheated environment created by recent market volatility, one or two sizable accidents, and media treatment which has created an aura of mystert and danger."
LaWare said he has "not shed any tears" over the recent derivatives losses of such market players as the Granite Funds or Proctor & Gamble because these are sophisticated investors who should have known what they were doing.
"My protective instincts are not stirred by the plaintive cries of 'foul' from a giant manufacturer which walked eagerly into a highly speculative transaction with a huge bet and stayed with it while the market piled on losses," LaWare said.
"There is no evidence that gullible widows and orphans are playing the derivatives market unless they are very rich ... and, in that case, who cares," he said.
LaWare compared derivatives to Indianapolis 500 race cars that are not in and of themselves dangerous when handled by experienced drivers.
There are other, more traditional, banking activities that are more risky than derivatives, LaWare told the bankers.
"Some argue that proprietary trading in derivatives instruments is extraordinarily risky and, therefore, inappropriate for banks with insured deposits," he said. "But making term loans to businesses is probably the riskiest business of banks and we don't give that a second thought."
That remark appeared to be a veiled criticism of comptroller of the currency Eugene Ludwig, who last April announced that his office is considering restricting national banks from engaging in proprietary trading of complex and exotic derivatives.
