Jim Armitage: Bank is right to seek a clearer picture of risk

Outlook The Old Lady of Threadneedle Street likes drama to be reserved firmly for the stage. So yesterday's announcement from her Financial Policy Committee on "potential amplification channels" of financial risks was characteristically short on hyperbole.

But, beneath the dry words, the regulator's update on the risks of the City and Mayfair's finest to Britain's financial stability need careful heeding, because there remain many concerns for regulators about how the City still operates.

Key questions: Does the so-called shadow banking system – where derivatives lurk out of view from banks' balance sheets – pose a risk in the complex and intertwined network of financial firms? Do hedge funds, with the limited disclosure of their accounts and secretive offshore domiciles, take debt-fuelled gambles that could trigger multi-billion-dollar losses if interest rates start to rise? What would happen if, as occurred with Lehman Brothers five years ago, a major player went bust or, less dramatically, was forced suddenly to sell a large bunch of assets quickly as security to a creditor (known in the biz as making a margin call)?

The answer? Er, we don't know.

From the banks that responded to the FPC's requests for details on what would happen to them if interest rates rose significantly, answer came their none. They declined to put in their assessments "more significant stresses" on the banking system.

Meanwhile, hedge funds have still not come clean about how much risk, in the form of debt or leverage, they are taking on a daily basis.

This opacity really matters. Take derivatives, for example. You'll struggle to find it on the books, but in the first quarter of this year, JPMorgan had nominal derivatives outstanding of more than $72trn. Bank of America had $61.5trn, Citigroup $58.2trn, Morgan Stanley $47trn and Goldman Sachs $46trn. The banks tell you the figures are irrelevant because the derivatives issued are "hedged" with mirror-image products that rise in value by an identical amount if the derivative plummets. So, no net exposure from all those trillions of dollars.

Setting aside the social uselessness of all this derivative action, the problem is that the "netting out" is art rather than science – in some cases, primary-school doodles rather than Rembrandt. The value of the derivatives on either side of the hedge can change unexpectedly and leave the firm exposed, sometimes brutally.

In the case of JPMorgan's London Whale, the true exposure of its derivatives was hundreds of millions of dollars higher than its books suggested. And, lest we forget, the Whale's trades blew up in a market that was not under any "significant stresses", to use the Bank of England's lingo.

Meanwhile, what happens to those hundreds of trillions of dollars of derivatives when one or two major counterparties go bust, or have to stage a fire sale to make a margin call? Extreme pain for shareholders in the best scenario, systemic crisis in the worst.

Little wonder the Bank, for all her reserved language, wants more transparency.

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