The notional amount of derivatives held by commercial banks hit a record in the second quarter, rising 8% to $28 trillion, according to a government report released Wednesday.
In the last five years the notional amount of derivatives held by banks has increased more than 250%, the Office of the Comptroller of the Currency said.
Whether this fevered pace will continue depends, in part, on how volatile the equities, interest rate, and exchange rate markets remain.
"The growth, we know from our exam work, is being driven by customer transactions" not banks themselves, said Mike Brosnan, deputy comptroller for risk evaluation. "Customers are more inclined to do a lot in uncertain markets."
Cashing in on the volatility, banks made $2.56 billion trading derivatives in the second quarter, just $147 million off the record set in the first quarter and far more than the $1.96 billion in revenues reported a year earlier.
But several large banks have announced trading losses recently, and Mr. Brosnan predicted profits may decline in the third quarter.
"There are still two weeks to go," he said, "but should the market continue to gyrate or various economies contract, it would not be unreasonable to see further credit writedowns and perhaps trading losses at some banks."
Still, in the second quarter, credit losses from derivatives reversed a five-quarter trend by falling 31%, to $94 million. However, losses were still way above a year earlier when derivatives cost banks just $2.2 million.
Mr. Brosnan cautioned against reading too much into these loss figures.
"They are always lagging indicators for us," he said. "You're going to see more losses down the road just as a result of the business maturing process.
"We're going to spend a lot of time making sure we know who the customers are, why the bank picked them, and" how banks are assesses the probability of repayment.
Eight holding companies, led by Chase Manhattan Corp. and J.P. Morgan & Co., account for 95% of the total notional amount of derivatives in the banking system.
Of the top eight, only First Chicago NBD and NationsBank increased trading revenues as a percentage of gross revenue in the second quarter. But J.P. Morgan continued to dwarf all its competitors, earning 22.7% of its total revenues from trading activities, or more than triple the average earned by the top eight banks.
Chase Manhattan Bank was the only one of the top eight banks to increase its credit exposure relative to risk-based capital. At June 30, Chase's credit exposure from derivatives contracts was 334.3% of its capital, up from 325.7% on March 31. Again Morgan led the top eight at 727.6%, down from 810.2%.
Though still a small slice of the overall market, use of credit derivatives soared 42% in the second quarter, to $129 billion. An alternative to syndication, a credit derivative allows a bank to keep a large loan and still hedge its losses.
"The good news is that it gives bankers another tool to manage their credit risk," Mr. Brosnan said. "On the other hand, we worry about whether people know what they are getting into."