Current Legal Issues Affecting Central Banks, Volume V


Robert Effros
Published Date:
May 1998
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Financial Derivatives

The chapters on the topic of banks in distress provide ample evidence that the use of financial derivatives by banks raises important and difficult questions of prudential supervision. The collapse of Barings shows that leveraged derivatives trading, in combination with lax risk-management practices and inadequate prudential supervision, can bring down a financial institution.

Some chapters provide extensive information about the new methods and procedures for risk management by banks that were recently developed by bank regulators, including in particular the new “supervision by risk” system of the Office of the Comptroller of the Currency in the United States. Nevertheless, questions remain concerning the effectiveness of these new prudential systems in controlling risks and protecting banks from ruin, especially in extreme market conditions. The following comments address some of these questions in respect of leveraged derivatives trading by banks.

The term “leveraged derivatives trading” implies that it concerns banking activities that are speculative in nature, producing unhedged positions that are “leveraged.” It should be assumed that leveraged derivatives trading occurs for a bank’s own account and not for the account of its customers; in the latter case, the bank would not be exposed to risks deserving special attention.

These features of leveraged trading activities, namely, their speculative character and the fact that they are leveraged, cause these activities to pose risks for banks that differ from those posed by more traditional banking activities. Consequently, the risk-management methods and procedures that suffice for traditional banking activities are inadequate for leveraged derivatives trading. An example may illustrate this observation.

Traditional banking activities, such as taking deposits and making loans, expose banks to interest rate risk, namely, that the rate of interest payable on their deposit liabilities may exceed the rate of interest receivable on their loan assets. It follows that such traditional banking activities are particularly profitable in a stable interest rate environment.

Speculative trading, however, requires an interest rate environment that is volatile. For trading, interest rate volatility is not a risk but a necessity. Trading—successful trading that is—requires the ability to predict accurately the direction of short-term movements in asset prices. For the trader, the “risk” that actual price movements are contrary to his market predictions is not really a risk but rather a probability, an event that is expected by the trader to occur from time to time. In fact, many traders successfully use trading systems whose accuracy in predicting price directions is not much better than 50 percent. The profitability of these systems does not depend entirely on the traders’ ability to make accurate market predictions but also and especially on their employing rigorous rules for the preservation of capital by limiting position size, cutting losses short while letting profits run, and adding to profitable positions. Although leveraged derivatives trading requires management of risk exposure in terms of value-at-risk, it equally requires sound trading techniques to generate profits and to avoid catastrophic losses. In this respect, the misfortune of Barings is instructive: the single most important reason for the Barings collapse was its failure to liquidate losing positions, requiring it to pay additional margin. Barings thereby violated the old futures traders’ rule never to meet a margin call.1 It is not clear that this major risk, namely, that traders do not adhere to proper trading strategies, is adequately reflected in the nine categories of risks that form part of the new U.S. system of bank supervision by risk.2

The term “leveraged” in leveraged derivatives trading implies that the value of the investment made to trade the derivatives is significantly less than the value of the assets underlying the derivatives traded. The following example may serve as an illustration. The contract size of a treasury bond future traded on the Chicago Board of Trade is $100,000. To open an unhedged position in this futures contract requires an original margin of $2,700 and a maintenance margin of $2,000. Accordingly, for an initial layout of $2,700, the trader of a T-bond future controls $100,000. Each price move of one point in treasury bonds translates into a premium move of about $1,000 for the T-bond futures contract. If the T-bond future is treated as an investment of $100,000, the price move would represent 1 percent of capital invested. If, however, the T-bond future is treated as an investment of $2,700, the price move would represent more than 37 percent of capital invested. It can easily be seen how such leveraged treatment of derivatives can produce spectacular gains and devastating losses. It seems obvious that, for purposes of measuring their risks, banks should be required to account for leveraged derivatives not at cost but at the value of the assets underlying the derivatives.

How effective is the new prudential approach to risk management in leveraged derivatives trading under extreme market conditions? The reference to extreme market conditions is of the essence. It seems logical to demand of a proper risk-management system that it protect primarily against catastrophic losses that cause ruin. To use an analogy: like an insurance policy, a proper risk-management system should provide protection against unsustainable losses, and need not (also) protect against losses that can be sustained and could therefore be excluded from the insurance cover as a deductible. Nevertheless, there are indications that the new risk-management systems are biased toward protecting a part of the risk spectrum that could be left uncovered because the losses that it produces are sustainable, while leaving the balance of the risk spectrum uncovered, even though this could produce losses that cause ruin. Such a bias would be counterintuitive and would require a careful justification.

For example, it appears that the new risk-management guidelines, adopted by the Basle Committee on Banking Supervision3 and endorsed by the Group of Ten central bank governors in December 1995, measure value at risk with reference to historical price volatilities encountered during a specified period of time, taking into account a standard probability range. The selection of the length of this period and the range of probabilities is crucial. If the period over which volatilities are taken into account is too short, the system could fail to capture the ruinous volatility spikes that occur only at longer time intervals. The same would apply if the chosen probability range is too restrictive to include catastrophic events.4 There are reasons to fear that the Basle risk-management guidelines would be least effective in the extreme market conditions where their effectiveness would be most needed.

These observations have been countered with the argument that it would be too expensive for banks to cover the entire spectrum of risks to which they are exposed as a result of leveraged derivatives trading and that it is the function of a country’s monetary authorities, as lenders of last resort, to protect the banking system from ruin in exceptional circumstances. Although this counterpoint is not altogether unreasonable, it could transfer the ultimate costs of leveraged derivatives trading by banks onto the shoulders of the taxpayer. This unpopular prospect leads to the provocative question of whether banks should be permitted to engage in leveraged derivatives trading at all.


1. Should depository institutions be permitted to maintain speculative (that is, unhedged) positions in derivatives for their own account?

2. If so, should depository institutions be required to observe limits set by law or regulation on the speculative positions in derivatives that they maintain for their own account?

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