Banks' revenue from derivatives tumbled 18% in the second quarter, even as business volume increased, the Office of the Comptroller of the Currency reported Monday.
Observers said the results reflected a stabilization of financial markets, which reduced the need for derivatives-based hedging, and an increase in competition among banks.
The notional value of banks' derivatives-the key measure of volume-rose 6.4%, to $23.3 trillion, the OCC said. But revenues fell to about $2 billion from a record $2.42 billion in the first quarter.
Michael L. Brosnan, the director of the OCC's treasury and market risk division, said it would have been difficult for banks to sustain the unusually high earnings achieved from January through March.
"When markets are more volatile, people are more inclined to hedge with derivatives," Mr. Brosnan said. "Banks made money during the first quarter because of that."
During the first quarter, interest rate and foreign exchange rate swings encouraged more investors to hedge against the risks those changes posed to their portfolios, he said. The second quarter was more stable, Mr. Brosnan noted.
"This last quarter wasn't a down quarter, it was a normal quarter," he added.
A major chunk of the second-quarter decline was attributable to a drop in earnings from instruments used to hedge against changes in interest rates. Industry revenue from these contracts declined 30% to $939 million. Commodity and equity hedges contributed $116 million to commercial banks' bottom line, a 66% decline from the first quarter.
Experts said the drop in revenue also reflects a larger number of savvy derivatives dealers chasing a limited amount of deals.
"There are simply more smart players, so the profit is harder and harder to make," said Heinz Binggeli, president of Global Investment and Risk Advisors, a risk management firm in Long Island, N.Y. He added that if derivatives volume and revenues continue to diverge, some dealers will be forced out of the market.
"If this is a one-quarter thing, then there is no problem, especially since the first quarter was a record," Mr. Binggeli added. "But if volume continues to grow while profits don't, there ultimately has to be some shakeout."
In fact, the number of commercial banks holding derivatives declined in six of the last seven quarters. In the second quarter, the number of banks in the business fell 40 to 463. However, the Comptroller's Office cited industry consolidation as the main reason.
"In many cases, banks with several charters are converting down to one charter," Mr. Brosnan said. "We are starting to get a truer picture of how few institutions use these instruments."
The volume of credit derivatives-used to reduce exposure to loan concentration risk-also rose significantly during the second quarter. The notional amount of these relatively new instruments climbed 34% to $25.6 billion; Morgan Guaranty Trust Co. of New York accounted for 75% of that total, the OCC said.
"This is a very hot area because never before have financial institutions had an instrument that can reduce or eliminate credit risk," said Andrew S. Lese, a principal at Ernst & Young's risk management and regulatory practice.