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DERIVATIVES Which banks are the potential Fukushimas?

11 December 2013

Christophe Nijdam Bank Equity Analyst

As bank equity analysts, we are concerned with the two channels by which bank systemic risk spread the most, i.e. liquidity and derivatives, destroying an enormous amount of shareholder value in the process, not to forget other stakeholders (the real economy, taxpayers, depositors, bank employees, society as a whole, etc.) Christophe Nijdam’s headstart exposure in derivatives: 1983 : co-founded the derivative group at CCF (now HSBC France) 1985 : co-invented the so-called CIRCuS (cross interest rate and currency swaption) Supervised the unwinding/running-off of an off balance sheet OTC interest rate derivative portfolio that had reached 6 times the size of the cash balance sheet at Crédit du Nord USA (then a Paribas subsidiary) in 1989-1990

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DERIVATIVES

Why this research memo?

3

Value-at-Risk (VaR) starts being disseminated around trading rooms

$80trn (3x 1998 GDP)

$630trn (10x 2012 GDP)

LTCM meltdown September 1998

Gramm-Leach-Bliley Act repeals the Glass-Steagall Act November 1999

Lehman failure September 2008

Bank of America, Derivatives 1995-2012

Source : FDIC

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($)

The notional amount is the face value of the derivative contract: it is used as a reference to calculate payments

e.g. IRS fixed rate (4%) against Libor (0.5%) on €100M swap agreement (€100M x 4%) – (€100M x 0.5%) = €3.5M net interest payment

e.g. CDS 75% loss/25% recovery €100M x 75% = €75M credit insurance net payment

The notional amount does NOT reflect the risk associated with such contract (see above IRS/CDS example)

However, the notional amount indicates the volume of activities of a bank in derivatives:

e.g., it’s the volume of credit insurance policies sold and/or bought (CDS),

the volume of interest rate insurance policies sold and/or bought (IRS),

etc.

The industry prefers to speak about « gross market values », ie the cost of replacing the contract at current market prices, as it downplays and understates the size of the actual risk (see CDS example) in a systemic crisis

If another indication of the relevance of the notional amount vs gross market value was needed, initial margin requirements for CCP (see further) are computed on notionals…

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DERIVATIVES

What is a NOTIONAL derivative amount?

($)

0,00%

1,00%

2,00%

3,00%

4,00%

5,00%

6,00%

7,00%

H1 2006

H2 2006

H1 2007

H2 2007

H1 2008

H2 2008

H1 2009

H2 2009

H1 2010

H2 2010

H1 2011

H2 2011

H1 2012

H2 2012

H1 2013

Gross Market Values/Notional Amounts Source: B.I.S., AlphaValue

See further about « how much a loss in notional is needed to wipe out equity »

GMV multiplied by c.3x from 2.16% in H1 07 to 5.89% in H2 08…

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DERIVATIVES

Gross Market Values vs Notional Amounts (%)

($)

It’s an off-balance sheet information which is disclosed in the footnotes attached to financial statements

Most banks do not split notional amounts between assets and liabilities, giving rise to double-count

The « counterparty risk » remains on full notional amounts (unless there is a valid netting agreement between, e.g., two banks, or a bank and a corporate)

What we find « on » balance sheets are fair (market, or worse, model) values of such derivatives, also roughly equivalent to « gross market values of contracts » (ie the theoretical cost of replacing the contracts at current market prices – see previous slide)

There are accounting differences in « on » balance sheets between US GAAP (partial netting of derivatives) and IFRS (no netting allowed); hence, IFRS balance sheets are larger vs US GAAP

But there is no accounting difference in NOTIONAL amounts between US GAAP and IFRS

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DERIVATIVES

Where do we find NOTIONAL derivative amounts?

($) On balance sheet

Off balance sheet

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DERIVATIVES

Notional derivative amounts (e.g. Goldman Sachs vs BNP Paribas)

($)

On balance sheet

Off balance sheet

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DERIVATIVES

Notional derivative amounts (e.g. Goldman Sachs vs BNP Paribas)

($)

-

100 000

200 000

300 000

400 000

500 000

600 000

700 000

800 000

H1 2006 H2 2006 H1 2007 H2 2007 H1 2008 H2 2008 H1 2009 H2 2009 H1 2010 H2 2010 H1 2011 H2 2011 H1 2012 H1 2012 H1 2013

Total notional derivatives o/w Interest rate o/w Forex o/w CDS

$692,908bn = 100% $706,884bn

$73,121bn = 11%

$561,299bn = 81%

$24,349bn = 4%

$683,814bn

$58,242bn = 10%

Source: B.I.S.

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DERIVATIVES

Global OTC derivative notional amounts (in US$ Billion, no double-count)

($)

$bn

Asian banks

other European banks

Swiss banks

French banks

British banks

American banks

In addition, please note that Liborgate / Euriborgate is driven by derivatives « within » Universal banks (only deposit-taking banks can participate in the rate-fixing panels; pure investment banks can’t)

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DERIVATIVES

Following the repeal of the Glass-Steagall Act, derivatives growth went haywire

Total notional derivatives by country of banks 1998-2013 (source: Berruyer, B.I.S. and bank annual reports)

H1 98 H1 00 H1 02 H1 04 H1 06 H1 08 H1 10 H1 12

($)

A naked CDS is buying a credit insurance policy without owning the underlying credit risk (bonds, loans, etc.), i.e. without an « insurable event »

In the insurance industry, you must own the underlying risk to have an « insurable event » and be allowed to insure that risk with an insurer

In essence, a naked CDS is like bying a fire insurance policy on your neighbour’s house

On top of that, with naked CDSs, there are no limits on the numbers of fire insurance policies you can buy on your neighbour’s house

Guess what happens next?

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DERIVATIVES

What is a NAKED Credit Default Swap (CDS)?

($)

• Report dated 20 September 2013 (extracts)

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DERIVATIVES

What does the ESMA say in its latest report on « Trends, risks, vulnerabilities »?

($)

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DERIVATIVES

What does the ESMA say in its latest report on « Trends, risks, vulnerabilities »?

($)

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DERIVATIVES

What does the ESMA say in its latest report on « Trends, risks, vulnerabilities »?

($)

* Core Tier 1 ratio of…20.7% (sic!) on 30 September 2013

Dexia failed twice on liquidity despite sufficient solvency ratios* both in September 2008 and September 2011

Dexia is still a systemic institution despite its shrinking balance sheet (« only » €238bn on 30 September 2013, down from €651bn on FYE 2008), hence the €85bn government refinancing guarantees (running until… 2076)

Dexia has latent losses of €29bn on €450bn in notional interest rate derivatives (6.4%... Who said that IRS were riskless?) – source: testimony of Dexia’s management in front of the French parliament on 22 May 2013

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DERIVATIVES

Dexia remains systemic through the liquidity and derivatives contagion channels

($)

« Propagator » of the value at risk (VaR) through its listed subsidiary RiskMetrics from the mid-nineties onwards – VaR is equivalent to managing risk by looking in the rear window mirror while not watching the blockroad ahead. Additionnally, danger comes from the blind spot (« angle mort ») in the mirror (« 99% confidence level does not tell you how much you will lose in the 1% occurrence/fat tail « Black Swan » syndrome)

VaR is responsible for the bloating of trading activities and the outgrowth of derivatives

Stumbled with the London Whale in the Spring 2012: $6.2bn loss on a $100bn CDS derivative portfolio (supposedly a « hedging » gone wrong) = a 6.2% loss in a few weeks

AIG London/Banque AIG France (efficient French « home supervision » from the ACP!), SwissRe, CDPCs, etc. all needed « bailouts » on CDSs

Tantamount difference in risk between an IRS and a CDS, but IRS is not riskless (see Dexia)

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DERIVATIVES

JPMorgan, the « best of class » in risk management, tripped over the London Whale

Usual suspects… the Global Trading and Universal Banks

(G-TUBS)

The Bank for International Settlements (BIS) identified 20 « universal banks » as part of the 28 « Global Systematically Important Financial Institutions » (G-SIFIS)

(April 2013)

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DERIVATIVES

« Universal banks » overweighted in the list of world systemic banks

Fitch has coined a specific category: the G-TUBS (« Global Trading and Universal Banks »), a select group of 12 banks (7 European – o/w 2 French, 5 American)

(10 October 2013)

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DERIVATIVES

Usual suspects… the Global Trading and Universal Banks (G-TUBS)

($)

-

10 000 000

20 000 000

30 000 000

40 000 000

50 000 000

60 000 000

2006 2012

e.g. €55,605bn for Deutsche Bank

No data for BBVA, Caixabank, Sabadell; no data in 2006 for Credit Suissse

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DERIVATIVES

Notional derivative amounts – 38 European banks – AV universe (€bn)

($)

-

500 000

1 000 000

1 500 000

2 000 000

2 500 000

3 000 000

3 500 000

2006 2012

No data for Caixabank, Sabadell; no data in 2006 for Credit Suisse and BNP Paribas

e.g. €2,622bn for Deutsche Bank

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DERIVATIVES

Notional CDS amounts – 38 European banks – AV universe (€bn)

($)

0,00

10,00

20,00

30,00

40,00

50,00

60,00

70,00

80,00

90,00

100,00

Cred

it Su

isse

UBS

Barc

lays

Roya

l Ban

k O

f Sco

tland

BNP

Parib

as

Dans

ke B

ank

Deut

sche

Ban

k

Nor

dea

Hsbc

Soci

été

Géné

rale

Créd

it Ag

ricol

e

Skan

dina

visk

a En

skild

a Ba

nk

JP M

ORG

AN

Sant

ande

r

BOA

MER

RILL

LYN

CH

Lloy

ds B

anki

ng G

roup

Nat

ixis

CITI

GRO

UP

Swed

bank

MO

RGAN

STA

NLE

Y

Com

mer

zban

k

GOLD

MAN

SAC

HS

KBC

Groe

p

Dexi

a

Uni

cred

it

Sven

ska

Hand

elsb

anke

n

DnB

Inte

sa S

anpa

olo

Bank

of I

rela

nd

Stan

dard

Cha

rter

ed

Erst

e Gr

oup

Raiff

eise

n Ba

nk …

Banc

o Es

pirit

o Sa

nto

Banc

o Co

mer

cial

Por

tugu

es

CRED

IT M

UTU

EL C

IC

WEL

LS F

ARGO

Juliu

s Bae

r

Banc

a M

onte

Dei

Pas

chi …

Med

ioba

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Deut

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Pos

tban

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Banc

o Po

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anol

EFG

Inte

rnat

iona

l

Notional amount / domestic GDP (2012)

No data for BBVA, Caixabank, Sabadell

e.g. 86 times Swiss GDP for Credit Suisse (relevant to determine domestic SIFIs)

Nb of times (x) #1 bank market cap

in the world, Warren Buffett is a large shareholder

Swiss, British, Danish and Swedish « finishes »

No French or German « finish »....

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DERIVATIVES

Notional derivative amounts relative to domestic GDP (2012) – 45 banks

($)

0,00

0,50

1,00

1,50

2,00

2,50

3,00

3,50

4,00

4,50

5,00

Notional amount / EU GDP (2012)

No data for BBVA, Caixabank, Sabadell

e.g. 4.5 times European GDP for Deutsche Bank

Nb of times (x)

Listed benchmark

Unlisted « marker »

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DERIVATIVES

Notional derivative amounts relative to European GDP (2012) – 45 banks

($)

0,00%

2,00%

4,00%

6,00%

8,00%

10,00%

12,00%

14,00%

16,00%

Total notional equity wipe out

38 European banks – AV universe. No data for BBVA, Caixabank, Sabadell

Weighted average: 29bp

Higher risk

Lower risk

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DERIVATIVES

How much a loss in notional derivatives is needed to wipe out equity (2012)?

0,00%

0,10%

0,20%

0,30%

0,40%

0,50%

0,60%

0,70% Total notional equity wipe out

Focus on the top 15 out of 38 European banks

38 European banks – AV universe. No data for BBVA, Caixabank, Sabadell

Read: a 16bp loss on BNP Paribas’ €48,300bn notional amounts would wipe out its €78.6bn

group share equity

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DERIVATIVES

How much a loss in notional derivatives is needed to wipe out equity (2012)?

($)

0,00%

50,00%

100,00%

150,00%

200,00%

250,00%

Wipe out CDS only

Weighted average: 765bp

38 European banks – AV universe. No data for BBVA, Caixabank, Sabadell

Higher risk

Lower risk

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DERIVATIVES

How much a loss in notional CDS is needed to wipe out equity (2012)?

($)

0,00%

5,00%

10,00%

15,00%

20,00%

25,00%

Wipe out CDS only

Focus on the top 13 out of 38 European banks

38 European banks – AV universe. No data for BBVA, Caixabank, Sabadell

Read: a 374bp loss on BNP Paribas’ €2,100bn notional CDS would wipe out its €78.6bn

group share equity

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DERIVATIVES

How much a loss in notional CDS is needed to wipe out equity (2012)?

($)

0,00

10,00

20,00

30,00

40,00

50,00

60,00

38 European banks – AV universe. No data for BBVA, Caixabank, Sabadell

Notional amounts x times balance sheet size (2012 total assets)

Possible leverage problems

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DERIVATIVES

Notional amounts will be part of the denominator in the future leverage ratio

Basel 3/CRD4, EMIR

($)

National « finishes » (= regulatory ratios higher than Basel 3/CRD4):

• Swiss (Ti1) – we understand why when looking at the derivative sizes at CS and UBS! • US (leverage, LCR) • British (CT1, leverage) – ditto Barclays and RBS • Danish (CT1, LCR) • Swedish (CT1, LCR) • Norwegian (CT1) • Brazil (total capital of 11% vs 8%) • China (total capital of 9% vs 8%) • India (T1 of 7% vs 6%, leverage of 4.5%)

Ringfencing • (See US Volcker, US Tarullo rule, UK Vickers, CS in Switzerland, but Liikanen is burried in Europe) • but US bank « push-out » of derivatives (into specific subsidiary outside of government deposit guarantee) has been overturned by the lobby on 30 October 2013

No « finish » at all or « ringfencing » in Germany and France (Deutsche Bank, BNP Paribas)

EMIR

• Required H2 14: Central Counterparty Clearing Houses (CCPs) for standard derivatives, but counterparty definition loopholes (SPVs, local authorities, etc.) • Required 12/02/14: 6 trade repositories with Legal Entity Identifier (LEI) approved by ESMA in Europe (DTCC in the US) – who/what/where • Required 01/12/15-01/12/18: Initial margins for non-CCP OTC (see next slide), Master Netting Agreements

Dodd Frank in the US • Swap Execution Facilities (SEF) since October 2013 = 18 electronic trading platforms increasing competition and transparency • Problematic of the US CFTC extra-territoriality rules when one US counterpart

In Europe • Projects for Organised Trading Facilities (OTF)

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DERIVATIVES

Risk mitigations: regulations (Basel 3/CRD4, EMIR), if not enucleated by lobby

ASSET CLASS Initial margin requirement (% of notional exposure)

Credit : 0-2 year duration 2

Credit : 2-5 year duration 5

Credit : 5+ year duration 10

Commodity 15

Equity 15

Foreign exchange 6

Interest rate : 0-2 year duration 1

Interest rate : 2-5 year duration 2

Interest rate : 5+ year duration 4

Other 15

($)

Source: « Margin requirements for non-centrally cleared derivatives », BIS & OICV-IOSCO, September 2013

Assuming a 3% p.a. funding cost for the margin requirement/collateral, a 1% initial margin on a 2-year IRS would cost 3bp p.a. (1% x 3%) while a 15% margin on an equity derivative would cost 45bp p.a. (15% x 3%), the price of safety against the systemic impact of the speculative portion of derivatives disguised as « market making »

An IMF report in 2010 estimated that ¼ of IRS, 1/3 of CDS and 2/3 of other OTC derivatives are not « standard » enough to be operated through CCPs. Based upon H1 13 notionals, it’s c.$220trn, or 1/3 of the total derivative market, which can’t be processed through the CCPs. Hence, margin requirements are crucial to help contain systemic risks on non-CCP OTC derivatives

With a cumulative 34% market share in equity derivatives in 2011 (source: JPMorgan research), the 4 listed French banks are reportedly currently lobbying the hardest against the 15% initial margins in equity derivatives and the 0.01% TTF on such equity derivatives

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DERIVATIVES

The initial margin requirements on non-CCP OTC that lobbyists want to kill

($)

Number of daily changes +/- 2% per year in the S&P 500

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DERIVATIVES

The case for initial margins in equity derivatives

Implicit volatility VIX Index

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DERIVATIVES

We live in a volatile world with Blackswans becoming the norm

The real challenge behind the European TTF

Deflating the derivative bubble

($)

10bp TTF on cash products (equities, bonds, money market funds) is plain stupid

1bp TTF on derivative notional amounts is smart as it reduces substantially the economics behind the market making/disguised prop trading bubble in derivatives

as a reminder, daily trade volume in F/X reached $5,300bn (BIS, April 2013), up from $4,000bn in 2010 and $3,300bn in 2007:

world trade ($18,300bn in merchandise and $4,300bn in services in 2012, WTO) is « covered » in 4 days

and world capital markets/global financial assets ($225,000bn, McKinsey, March 2013) are « hedged » in 42 days

or in 9 business weeks altogether (17% of a calendar year)

we wonder what F/X trader do at their desk the rest of the year? Counting beans or trifles?

by some estimates (BIS), only 7-8% of derivatives would be with end-users and 92-93% with « financial institutions » (the Merry-Go-Round of the G-TUBs with implicit state guarantees pertaining to their 2B2F status)

by some estimates, the TTF would induce a 75% reduction in European F/X volume and a contraction between 70% to 90% in other European derivative trading volumes (EC, 2013b) - (Great! What are we waiting for?) (100% - 75% = 25% - 7% end-users = 18% left for « real » market making)

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DERIVATIVES

The real challenge behind the European TTF: deflating the derivative bubble

($)

Which banks would lose the most from CCPs, initial margins [and European TTF on derivatives]

0,00%

0,05%

0,10%

0,15%

0,20%

0,25%

0,30%

0,35%

38 European (AV universe) + 6 American banks. No data for BBVA, Caixabank, Sabadell. Dexia excluded (in runoff)

Market cap on 30 November 2013 over 2012 notional derivative amounts

Highest market value sensitivity to derivatives

Banks in countries without domestic « finish » above Basel 3 requirements are underlined in pink

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DERIVATIVES

Which banks are the potential Fukushimas of the derivative time bomb?

Major shareholder of Wells Fargo, the world largest bank market cap

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DERIVATIVES

Remember what the smart money said