The financial-derivatives business is one of banking's few current success stories. By letting banks hedge against adverse interest and currency movements, derivates limit funding-cost risks. By generating fee income, they also increase revenues.

Those dual advantages have led both large and small institutions to participate in the derivatives market. But it is important to determine whether the full potential of these customized transactions is being realized.

Since this market is related to futures and options, financial derivatives are often considered to be "special products." As such, they are seldom considered core products of the average commercial bank. Many large institutions have established separated subsidiaries to conduct the business, while smaller ones generally use derivatives solely for asset-liability management.

Logical Banking Role

Regarding financial derivatives as something esoteric overlooks their full profit-generating potential. As risk-intermediation products, derivatives can be seen as logical extensions of banking's historic financial intermediation role.

By bringing together entities with varying capacities for risk tolerance, financial derivatives become a core banking service that enhances client relationships while increasing customer profitability.

The case for bringing financial derivatives into the mainstream of commercial banking begins with a consideration of the customer's changing requirements.

The narrower margins earned by banks after deregulation resulted from the existence of attractive substitutes for both borrowers and lenders. While strong credits got cheaper funds, investors got higher yields when conducting their financial affairs away from their primary banks.

Push for Free Income

Decreased credit quality of loan portfolios and requests for nontraditional products and services became realities at most banks.

The initial response of banks to these circumstances was to try to eke out profits by cutting margins and costs across the board. These actions, of course, did nothing to bolster credit quality.

And in order to generate fee income, larger banks began to establish specialist units to handle customers' increasingly complex demands. In the case of financial derivatives, these units were often based within the institution's treasury area and did not initially have direct customer contact.

Evolving Involvement

Smaller banks referred such requests to their larger correspondents, thereby losing all revenue potential.

For those banks electing to be full-service providers of derivatives, the evolution was fairly uniform. The initial familiarity with financial derivatives came about as a result of using them to execute specific asset-liability management strategies.

Forward rate agreements, caps, and short-term interest rate swaps were used to protect banks from exposure to adverse interest rate movements on their floating-rate debt.

Eventually, banks began to serve as intermediaries on behalf of selected clients. Sometimes, at the request of investment banks acting as underwriters, banks would stand between the investment bank's customer and their own in order to complete an interest rate swap or other transaction. In these situations, banks guaranteed both sides of the transaction, earning a fee or spread as their compensation.

The initial experience of serving as an intermediary led some banks to maintain warehouses of positions - the better to provide, at a moment's notice, the corresponding side of a transaction once one side was located. Protecting the value of such positions required banks to develop sophisticated hedging capabilities.

Growth of Trading's Role

As fees and spreads shrank, the profitability of derivatives dealing became a function of savvy trading and positioning. Growing experience with futures and options led banks to offer an explosion of new products, with corporations able to get virtually any kind of customized transaction to protect their funding costs and, in some cases, their investment yields.

Spread locks, delayed draw-downs, synthetic equities, asset swaps, and various other kinds of option-related structures became commonplace. Derivatives volume grew, and liquidity increased.

Eventually, the most advanced dealers in the derivatives market began to establish separate organizational entities. In some cases, independent subsidiaries were set up. By treating the function as a stand-alone activity, a focus on product profitability developed.

While major banks were facing this issue, smaller banks increasingly used derivatives as a reliable asset-liability management tool. For the most part, they were comfortable leaving the derivatives function within the treasury area.

Two Classes of Participants

Now, banks that are active in the financial-derivatives market fall within one of two classes. Full-service dealers offer products to customers within a comprehensive financial risk-management service. Occasional participants offer the basic product on a limited basis but primarily use derivatives as part of their overall funds-management strategy.

In order to realize the full profit potential of derivatives activity, both classes of bank must restore the primacy of overall customer relationships. Full-service dealers must integrate derivatives activities within a customer-service orientation in order to let synergistic benefits develop.

Project finance, private placements, financial restructuring, and portfolio management are all functions that can benefit from a close coordination with financial derivatives. They are also services that are not central to investment banking competitors, allowing commercial banks to enjoy a competitive advantage.

Occasional participants must heighten the profile of their derivatives activity in order to offer product benefits to emerging companies. Such companies are a natural starting point for building a profitable, customer-driven derivatives function.

Need for Market Research

In order to maintain the proper focus, it is important for banks to do targeted market research on their customers. The objective should be to learn customers' primary needs.

A detailed description of customer requirements and level of satisfaction will suggest where the institution has a profitable niche and will help to measure penetration. A frank exchange of views on how activities can be more responsive to customer needs can reveal ways to improve product delivery.

Research should also include interviews with dealers, brokers, and exchanges to determine the level of current and anticipated liquidity for all financial-derivative products that the bank will be offering. This can ease the preparation of time and cost budgets for new or modified resources. It can also reveal the feasibility of planned initiatives.

Having completed external research, banks should turn their attention to some internal matters.

Looking at Product Offerings

A detailed review of existing or planned infrastructure must be done in the context of specific product offerings. Accounting, legal, and regulatory issues should be considered and verified. License requirements for individuals, regulatory approvals for the dealing entity, and organizational rules must be known in advance.

This allows a fully supportive organization to be developed, with employees secure in their roles. This approach prevents misinformed investments that may lead to unanticipated losses.

With the external research and review activities completed, installation of the function can proceed.

In moving forward, a number of choices must be made. One of these affects position management. A derivatives participant can be predominantly a trader or positioner.

How to Market Products?

If trading skills are paramount, a different kind of product specialist will be required than if a positioning orientation is taken. Of course, it is possible to have both sets of skills within a single entity. Roles and responsibilities of the two disciplines must be clearly delineated. Management and mediation of competing requirements will be required.

Another important consideration will be to determine how to market the products.

For a comprehensive dealer, integration of the function with the priorities of account officers must be assured from the outset in order to deliver a consistent message to the customer. An institution desiring to serve a market niche must be sure that potential customers know the value of dealing with a specialist.

Success will largely be determined by the degree to which cross-product

synergies are realized to the customer's advantage. Bringing together all product specialists regularly to discuss penetration with specific customers will reveal where these linkages exist.

It is also important not to relegate weaker credits to a secondary status in this process. Giving the customer multiple-product servicing reduces the customer's risks, consequently reducing the bank's exposure.

Once the activity has been successfully launched or revamped, it is critical that adequate monitoring be done. The importance of daily readings of position costs, trading profits, and credit usage is apparent.

There is also a need to measure the comprehensive value of the function.

Return on investment should be measured periodically in order to ensure that the function is on track toward its objectives. The value of capital benefits should also be calculated. Fee and trading income are treated differently than interest margin revenues for capital-adequacy determination.

Accordingly, profit measurement should allow for the fact that a given dollar of fee income benefits your bank more than a dollar of interest income.

A strong reputation as a financial-derivatives provider can be expected to generate new business from existing customers. Referrals from these sources may lead to relationships with new customers. Measuring this aspect of the derivatives business offers a further indication of its value to the bank.

Taking a customer-oriented approach to the derivatives business does not diminish the ability to use these products for asset-liability management. By coordinating treasury activities with customer requirements, senior management may be able to cut the cost of hedging transactions executed on behalf of the bank. These two requirements may offset each other.

Financial derivatives are an attractive means by which to develop business while protecting the bank's capital base.

By responding to customer demands for noncredit services, the derivatives function builds a foundation on which the bank can grow. Professional response to customer requests for sophisticated intermediation services will let banks compete successfully.

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