About the Scheerpost in Joe's Friday EBs
Friday, Joe highlighted a Scheerpost titled:
What Will Happen When Banks Go Bust? Bank Runs, Bail-Ins and Systemic Risk
( https://scheerpost.com/2023/02/23/what-will-happen-when-banks-go-bust-ba...). The article engendered a certain amount of discussion, but failed to discuss one fundamental assumption/presumption underpinning the entire discussion.
The article somewhat echoes and reiterates a concern that has been discussed in various financial circles for some time now. Though the concern is legitimate, I suspect that it might be overstated so some unknown degree. Glossing over a lot of things, the worry stems from the fact that the magnitude of outstanding derivative contracts is larger than total bank assets. In order that one might assess total risk, or one's own risk, the article links a table of the exposure of various banks to the derivatives market(s).
( https://www.usbanklocations.com/bank-rank/derivatives.html ) The chart is identified as Banks Ranked by Derivatives and claims to be "a ranking of all banks in the United States in terms of "Derivatives". This comparison is based on data reported on 2022-09-30." In introducing this chart to our attention, the article states:
As of May 2022, according to the most recent data from the Bank for International Settlements (BIS), the total notional amounts outstanding for contracts in the derivatives market was an estimated $600 trillion; and the total is often estimated at over $1 quadrillion. No one knows for sure, because many derivatives are “over the counter” (not traded on an exchange). In any case it is a bubble of ominous size, and pundits warn it is about to pop. Topping the list of U.S. derivatives banks are J.P. Morgan Chase ($54.3 trillion), Goldman Sachs ($51 trillion), Citibank ($46 trillion), Bank of America ($21.6 trillion), and Wells Fargo ($12.2 trillion). A full list is here.
This is the "AHA!" moment and the problem with the problem as stated; note what is under discussion:
the total notional amounts outstanding for contracts in the derivatives market was an estimated $600 trillion; and the total is often estimated at over $1 quadrillion.
I can't recall seeing this issue discussed except in terms of notional amounts and this is very important. Worse yet, these, with some exceptions, are gambling instruments they could be anything and have any imaginable terms and we simply don't know what. Nonetheless, let's look at what is involved, using one of the older, more straightforward and usually non-gambling versions -
A US bank somehow acquired about a million bux worth of floating rate debt, so that its interest expense with respect to a million bux is unpredictable and hard to budget for. For a nominal fee it buys an income stream (somewhat like buying an annuity) equal the the monthly interest on a million bux computed at LIBOR (London Inter-Bank Offering Rate) one of the benchmark "floating rates". Thus, it has an income stream that varies with market rates which should more or less match its interest expense on its floating rate debt. Problem solved. The foreign bank needs to to disclose to shareholders and assorted others that it has a million bux of derivatives exposure, the contract's notional amount, but it is not on the hook for a million bux but only for the interest on a million bux. More commonly, there is a balancing tap dance where Foreign bank pays US bank LIBOR on a million, and the US bank pays foreign bank fixed rate interest on a million bux at prime +/- some points and one or the other pays a small fee. In this case there is 2 million of global notional debt, 1 million each for US bank and Foreign bank. but nobody owes even one million and the two interest streams are likely to largely offset each other. In this case it's no big deal. Similarly there are currency rate swaps where we agree that next friday you give me a million bux in Euros and I give you a million bux in dollars, or maybe yen. Again, notional amounts are a million bux each, but actual obligation is far less, though arguably a bit riskier.
The whole reason that we can't just ignore all this is that we don't know what they're betting and in some cases, the entire notional amount might actually all be at risk, maybe the value next December,in yuan, of one million bux worth of non-fungible laughing monkey tokens at today's prices in Berlin. Anything goes. The total real risk depends on the percentage of these contracts that are crazy-ass speculation. One might assess that risk to be low because, "Hey, these are BANKS, fer gawds sake" or one might assess it to be high because "Hey, these are friggin' banks, ya know". ymmv
be well and have a good one
Edit - fixed only one type so far, que mirac!