Trading swaps and options may not be so risky after all.
That's the view of Standard & Poor's Corp., which thinks derivatives trading may be among the least risky of bank activities.
Half the Capital Requirement
In fact, S&P analyst Tanya Azarchs,. in a report being released today, says the derivatives business requires about half the capital needed for lending.
For example, to qualify for an A rating, a bank's equity capital typically equals at least 5% of assets. A swap or option needs only about a 2% capital cushion, Standard & Poor's said.
"We don't think having a large derivatives business is inconsistent with being a highly rated bank," Ms. Azarchs said in an interview.
That view is more sanguine than the opinion of some regulators - notably E. Gerald Corrigan, president of the Federal Reserve Bank of New York - who fear that banks' swap exposures are a ticking time bomb.
Regulators have been concerned that large potential losses may be lurking behind the swaps market's explosive growth - a 13.6% compound annual rate since 1983.
The industry is facing new regulations from a variety of U.S. and international authorities. The Bank for International Settlements, made up of regulators from throughout the industrialized world, advocates greater international scrutiny of the derivatives markets.
But the Standard & Poor's report is likely to bolster industry arguments that regulators are overreacting.
"Swaps are a bright spot in the banking business," said Mark Brickell, former chairman of the International Swap Dealers Association. "It's always useful to have more evidence of this from an independent source."
Interest rate or currency swaps involve a company's agreeing to exchange its payment obligations for an obligation that better suits its balance sheet - such as exchanging a floating-rate payment for a fixed rate or exchanging a German mark payment stream for payments denominated in dollars.
The eight most active banks in the business held derivatives at June 30 with a gross market value of $128.7 billion, according to Standard & Poor's.
S&P said the eight banks could expect a default rate equal to 0.8% of the adjusted market value of their swaps over the life of those portfolios, which have average maturities of less than two years.
Losses to date have been less than this, Ms. Azarchs said. "We recognize that actual losses in the derivatives businesses have been low," she said. They have begun to accelerate."
Bankers Trust New York Corp. and J.P. Morgan & Co. have the highest-risk portfolios, S&P said, because they are more heavily involved in commodities and equities swaps.
Also, the two banking companies have a higher than average share of swaps with maturities exceeding one year, said S&P. However, Bankers Trust, with a AA senior debt rating and J.P. Morgan, rated AAA, are also the most highly rated banks.The Big PlayersDerivatives exposure ofmajor banks Market Face value value ($ billions)Citicorp $1.4 tril. $23.5Chemical 1.3 tril. 19.4J.P. Morgan 1.0 tril. 20Bankers Trust 958 bil. 21.6Chase 837 bil. 16.7BankAmerica 795 bil. 18.4Source: Standard & Poor's Corp.