Four giant banks are thinking of setting up separately capitalized units in order to grab a bigger piece of the booming market for swaps.
Citibank has already received regulatory approval for such a subsidiary, and Continental Bank has an application pending, the banks confirmed Wednesday.
Meanwhile, Chase Manhattan Bank said it was considering such an application, as is the First National Bank of Chicago, according to an industry source.
The four banks share one attribute that hurts their swaps businesses -- low credit ratings. Highly capitalized separate units could attract Triple A ratings, making it easier to attract swap partners.
The $3.8 trillion market for currency and interest rate derivative products is growing rapidly. But participants in the unregulated markets try to avoid counterparties who are at risk of default.
As a result, several securities firms - and now some banks - are asking the rating agencies to give high grades to separately capitalized derivatives units.
Continental Bank's senior debt rating from Moody's Investors Service, for example, is a weak Baa2 while its parent company's rating is a below-investment-grade Ba2.
"We find that many major counterparties who used to deal with us won't do so today, "said Richard L. Huber, vice chairman of Continental. "We have been marginalized, and we're hopeful we can get back in the business."
A Citibank spokeswoman confirmed that regulators had approved the formation of a separate swaps unit. She said tax considerations were the principal motivation. She declined to comment on whether the bank planned to use the unit to attract business.
$200 Million Capitalization?
Continental could inject up to $200 million into the proposed subsidiary, the company said in an application filed during the first quarter.
Reports of that bid as well as one from Citibank appeared in Monday's edition of Swaps Monitor, a New York-based newsletter.
Though Citibank and Continental would be the first banks to set up independent swaps units, Merrill Lynch & Co. and Goldman, Sachs & Co. have already done so.
"It's what everybody who has a franchise and concerns about their own balance sheet is thinking about," said Denise Boutross, executive vice president at DKB Financial Products.
Regulators Seen Acquiescing
Mr. Huber said he could not estimate when Continental would get a response from the Comptroller of the Currency. However, banking lawyers said they do not expect significant problems from regulators.
"It's not a troublesome regulatory issue because, with both national banks and state-regulated banks, it's clearly established that doing swaps business is incidental to banking," said a lawyer who asked for anonymity.
The lawyer, who is working on a related application, added, however, that a derivatives subsidiary is not a cut-and-dried business solution to credit problems.
"People differ as to whether this is a cost-effective way to do business," she said. "It depends on what the rating agency will accept and issues such as whether you pass the risk back to an affiliate or a parent."
In its application, Continental sought to assure the bank regulator that it was not putting its capital at risk. The subsidiary would undertake business only with parties whose ratings are A-minus or better, it said.
It also said that the unit would offset the risk of each swaps contract by entering into a "mirror derivative transaction" with Continental Bank, thus assuring counterparties that the unit would have a perfectly matched "book."
To maintain its legal separation from the bank, the subsidiary would have at least one executive officer and one employee not connected to the parent, according to the application.
It is not clear how much derivatives business - swaps, options on swaps, and forward contracts - the Continental subsidiary could undertake with its capitalization. But rating agency officials have indicated that, if the subsidiary's credit exposure were less than or equal to its capital, it would probably merit a top credit rating, Mr. Huber said.
That could translate into billions of dollars in derivatives business, measured by the notional principal amount underlying the contracts.
At the end of 1991, Continental had $56.4 billion of outstanding swaps, down slightly from the $56.9 billion at the end of 1990. Similarly, Citicorp's swaps agreements outstanding declined to $257 billion at the end of 1991, from $280.1 billion at the end of 1990.
In contrast, the AAA-rated Morgan Guaranty Bank saw its swap book grow to $329.1 billion at the end of 1991, from $267.2 billion at the end of 1990.
The Merrill and Goldman units are seen by market experts as prototypes for the operations banks are considering.
Merrill injected $300 million of equity into its subsidiary, which began doing business late last year. It also pumped in $50 million of preferred equity raised from outside investors. Since the unit's top officers are senior officials of Merrill Lynch, staff additions have been few, said David Milich, a director at Merrill.