Danger: derivatives

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The Independent Online
Scene one: the 20th floor of the Manhattan headquarters of Citicorp, the biggest lender to Latin America. Date: April 1982, four months before the great Mexican default. Message from the bank's head of international lending: Latin America cannot default since the loans are to sovereign countries. 'And if they get into trouble we'll send a team down there to sort it out.'

Scene two: the top floor at Barclays head office in Lombard Street. Date: April 1988, as the property lending mania gets into full stride. Message from Sir John Quinton, then chairman, to institutions grumbling about being asked to subscribe to his record-breaking pounds 925m rights issue: Barclays will lend your money wisely and well.

Scene three: JP Morgan's UK headquarters in the old City of London Boys' School by the Thames. Date: this week. Message from a group of banking's creme de la creme, led by Sir Dennis Weatherstone, chairman of JP Morgan: all those claims that the derivatives market will be the next black hole for the banks' money and that it could pose a threat to the banking system as a whole are completely wrong-headed. We can look after ourselves fine, thanks.

The bankers were introducing a report by the Group of 30, a Washington-based financial markets think-tank, which concluded that the derivatives industry needed a set of flexible standards that would encourage the whole market to achieve the levels of expertise and management control of the best banks (widely thought to include the same JP Morgan).

Are these more of the assurances we have got so used to hearing from bankers before disaster strikes? Or should we still take seriously widespread fears about the potential destabilising effect of derivatives on the financial system, expressed as recently as this week by William McDonough, the new president of the Federal Reserve Bank of New York?

Derivatives have been suspect partly because they are a large and extremely fast-growing market, but mainly because they are so complex that it is hard to pin down the risks to the banking system as a whole if there are large defaults by individual banks. As Mr McDonough put it, 'We have to be careful, because they are very complicated intellectually.'

It is easy to understand what happens to bank balance sheets if property prices collapse, but the results of chaos and multiple default in the derivatives market would be another matter altogether. Because of the difficulty of grasping what they are, derivatives have become the half-seen bogeyman in the shadows of the markets, a menace all the worse for being so little-known.

In fact, derivatives such as swaps, futures and options are no more than contracts whose worth fluctuates with the value of an underlying asset, with an interest or exchange rate, or with an index, such as the FT-SE 100.

The arithmetic of the more sophisticated hybrids can be exceedingly difficult. But the mystery tends to be much exaggerated by the specialist language of the technicians.

As the report points out, all derivatives are ultimately constructed from two familiar building blocks that have been in widespread use for hedging and speculation for a long time - options and forward purchasing and selling agreements. Their mechanisms were well known to Midwest pork-belly farmers more than half a century ago.

And although Mr McDonough remains suspicious of the market, he may already be out of step with his peers. The Bank of England and the Basle-based Bank for International Settlements - the club of central banks - have softened their attitudes remarkably in the past year, after voicing their worries that derivatives could replace property as the next disaster area for banks.

Recent reports from the BIS and the Bank have taken a constructive line, encouraging banks to raise their management standards in the derivatives market and playing down fears of financial armageddon. The BIS has also published the outline of a new set of international capital standards for derivatives.

Computers and numerate bank managers are gradually getting to grips with the risks of the derivatives market. The rigour of their methods may even have important spin-offs in improving the notoriously poor risk-assessment of conventional banking, and perhaps insurance too.

It is arguable that this new positive attitude has emerged because the central banks have at last hired a few people who understand derivatives. But it is equally possible that mistrust of the market because of its technical complexity is in any case missing the whole point.

What should really ring the alarm bells about derivatives are much more basic characteristics that the market has in common with other recent banking disasters.

These are its enormously rapid growth, high profitability for those banks that got in early and a scramble by everybody else to catch up by hiring teams of dealers and bidding aggressively for business.

Many of the newcomers will fail to live up to the high management- control standards of the JP Morgans of this world and will not know what hits them come the next Black Monday, when they could cause more than a tremor in the financial system. This market urgently needs tighter regulation and higher capital standards, for old-fashioned reasons.