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Non-Tech : Derivatives: Darth Vader's Revenge -- Ignore unavailable to you. Want to Upgrade?

To: Henry Volquardsen who wrote (858)	3/27/1999 9:26:00 AM
From: accountclosed	Read Replies (3) \| Respond to of 2794

Henry, without going back to reread the thread for the last several days, I am going to try to summarize what has been discussed that forms the basis of a counterargument to the idea that the derivative exposure of banks is a prescription for disaster. See what you would add or subtract: 1. Gross exposure tells us little about net directional bets. The vast majority of gross derivative exposure is offsetting another position. 2. A large portion of derivative holdings are exchange traded which removes the counterparty risk issue on that portion by virtue of exchange clearing mechanisms and margin requirements. 3. Much of otc derivative activity takes place with the same circle of banks. If one fails, the counterparty bank has the right of offset to other otc derivatives written with the failing bank. Therefore again, it is the net exposure not the gross which is the issue. 4. Banks have due diligence operations and controls limiting net derivative exposure with counterparties which are subject to rigorous Federal Reserve audit and review. 5. Banks are restricted as to how much capital they can put at risk in directional bets with derivatives. 6. Although not a US commercial bank, the Barings Nick Leeson affair was not an issue of derivative exposure as much as an issue of fraud. Leeson hid his trades from his superiors. It represented a control structure failure. Fraud is an important issue, but is not restricted to derivatives nor a feature peculiar to derivatives. 7. Yes, anyone can make market judgment mistakes, but again this feature is not a feature peculiar to derivatives. Some of the issue is that we can't effectively legislate against stupidity. No one tried to say that banks shouldn't loan money any more after the S&L crisis. However again, by restricting the amount of capital allowed to be deployed in derivative activities, the Federal Reserve is addressing the capital sufficiency of banks to withstand bad judgments. 8. The Federal Reserve does still remain as the lender of last resort to insure that if a major financial institution endangers the entire system, appropriate action is taken. 9. Derivatives are an important mechanism of capital formation that allocate risk to parties most able to bear risk. Legislation would likely only create more complexities for banks to work around with the goal of allocating risk away from their portfolios.