Swaps boom worries regulators: The huge growth in derivatives poses problems for banks, says Lisa Vaughan

TEN years after international banks got swamped by the Third World debt crisis, they are frantically trying to extricate themselves from their latest quagmire, the property lending excesses of the late 1980s.

But bank regulators, including the Bank of England, have a fresh concern: the explosive growth in the derivatives markets. They hope to prevent derivatives - futures, options, swaps and other tailor-made financial instruments - from becoming the next black hole for international banks and the financial system.

Over the past decade, derivative financial instruments have transformed the way that companies manage risk, allowing them to hedge changes in exchange rates, interest rates, or commodity prices. In the equities markets, derivatives offer exposure to shares at a lower cost than buying the shares themselves.

The new financial instruments have been judged a great success by the banks and securities houses that market them. Swaps and options have been the most popular types of contracts traded off exchanges. In an interest rate swap, two counterparties agree to exchange interest rate payment obligations over a period of time, regardless of the uncertain market developments that affect those obligations.

An option gives the buyer the right to buy or sell a specified quantity of a commodity, currency or stock at a set price within a certain time, regardless of the then market price of the commodity.

Regulators fear that these highly specialised markets may be expanding too rapidly without proper supervision. The Bank of England, the US Federal Reserve and increasingly the Bank of Japan have started watching developments closely and are beginning to sound warnings.

Robin Leigh-Pemberton, Governor of the Bank of England, said a fortnight ago that derivatives could be used successfully to manage risk only if they were properly understood. This issue should be addressed by senior managements of banks and securities firms around the world and by central banks and other supervisors.

'We must be alert to the possibility that through increasing the links between different financial markets, heavy use of derivatives could in some circumstances actually increase systemic risk,' he said.

Latest figures from the International Swap Dealers Association show that the notional value of interest rate and currency swap contracts outstanding at the end of 1991 was dollars 3,800bn - and that is from almost nothing 10 years ago.

Regulators admit that they have no idea what percentage of the derivatives business is high-risk and that makes them nervous.

Gerald Corrigan, New York Federal Reserve Bank president and chairman of the Basle committee on banking supervision, publicly declared his concerns over 'high tech banking and finance' early this year.

Mary Schapiro, commissioner with the US Securities and Exchange Commission, said recently that derivatives represented 'the single biggest risk facing the financial system'.

The problem for regulators is that much of the derivatives business does not show up on banks' balance sheets, because of the highly customised nature of the instruments. That makes it harder for the authorities to assess banks' potential exposure, and to set capital requirements.

According to Richard Farrant, the Bank of England's deputy head of banking supervision, one of the biggest fears about the derivatives markets is that the complexity of the instruments means very few people understand them fully, not least the regulators and the senior management of banks.

In a March speech, he said regulators were also concerned that long-term transactions increased the banks' potential exposure to their counterparties defaulting. There is also a worrying lack of regulations for large exposures to a single counterparty and for commodity-related derivatives.

Counterparty credit risk is perhaps the biggest worry for banks. Annmarie Sasdi, a director of BZW's equity derivatives group in London, said: 'We do a rigorous assessment of our counterparty risk.' The firm's risk models are fine-tuned frequently.

The UK local authority swaps affair illustrates how expensive counterparty default can be. It cost 80 banks pounds 600m when local councils defaulted on swaps deals with banks going back to the 1980s, after a House of Lords judgment ruling the deals illegal.

But some banks and many swaps experts believe that talk of a derivatives 'meltdown' triggering widespread default are overdone. Elizabeth Ruml, a managing director of Bankers Trust's global markets department, a leading derivatives innovator, says that much of the alarming news about derivatives 'severely overstates the size and nature of the problem'. Yet she adds: 'The credit risk Bankers Trust and many other firms are taking in derivatives is not at all trivial.'

Large defaults have occurred in the past few years, but the risks have been contained. The derivatives portfolios of the failed Drexel Burnham Lambert, the Bank of New England in the US and British & Commonwealth in the UK were unwound in an orderly fashion.

Regulators believe that the biggest players in derivatives operate sophisticated risk assessment procedures. It is the peripheral players offering new products or becoming counterparties to deals who pose the greater credit risk.

Banking regulators are considering drafting new international rules for derivatives. A committee of the Basle-based Bank for International Settlements is examining whether banks' capital adequacy requirements for derivatives are right, and is looking into tailoring capital standards more closely to the risks.

Basle regulators are also studying legal uncertainties surrounding settlement risk and have asked banks for their views. In the US, the SEC and Financial Accounting Standards Board now require greater disclosure of off-balance sheet derivatives transactions.

Swaps practitioners fear that over-zealous regulation will damage their ability to do business.

They protest that forcing derivatives market on to organised exchanges to increase transparency will not work; that overly strict capital adequacy standards will be so expensive that they will curtail activity; and that if regulations are too tough in London, the business will go to other financial centres.

Regulators do not want to overdo it at this stage, but as Mr Farrant told the International Swap Dealers Association: 'Your activities are now too important for central banks to ignore.'

(Photograph omitted)