The Committee to Destroy the World. Lewitt Michael E.

of underlying obligations that brought the financial system to its knees.

      Seven years later, despite efforts to tame the derivatives beast, these instruments of financial mass destruction still pose an existential threat to the global finance sector. One of the stated aims of Dodd-Frank was to address the “too big to fail” problem in the financial industry. Unfortunately, the legislation left in its wake a much more highly concentrated financial industry with fewer firms that are no longer “too big to fail” but actually “too big to save.” One of the primary ways in which they are “too big to save” is by holding hundreds of trillions of dollars of derivatives on their balance sheets whose true risks their managements don’t understand (because if they did understand these risks, they wouldn’t allow their institutions to hold them).

      The Bank for International Settlements reported that the notional amount of outstanding over-the-counter derivatives stood at $630.1 trillion at December 30, 2014.21 The “gross market value” of outstanding derivatives contracts, which measures the cost of replacing them at prevailing market prices and the maximum loss that market participants would suffer if all counterparties failed to perform, increased over the second half of 2014 from $17 trillion in June to $21 trillion at the end of December 2014.22 A third measure of derivatives exposure, “gross credit exposure,” which adjusts gross market values for legally enforceable bilateral netting agreements but does not take account of collateral posted with respect to the contracts, rose to $3.4 trillion at the end of December 2014 from $2.8 trillion in June 2014.23 In a moment, we will see why the “gross market value” and “gross credit exposure” figures, which are large enough to shatter the financial system in the next crisis, are important but still don’t tell the whole story.

The Office of the Comptroller of the Currency tracks the exposure of U.S. banks to derivatives and reported that just four large U.S. banks (JPMorgan, Bank of America, Citigroup, and Goldman Sachs) carried a combined $220.4 trillion of derivatives on their books at the end of December 2014. This figure dwarfed their combined $769.2 billion in equity capital by multiples ranging from 151 at Bank of America to an astounding 565 at Goldman Sachs (see Table I.4).

Table I.4 Exposure of U.S. Banks to Derivatives ($ in billions)

      SOURCE: 2014 Annual Reports; Office of the Comptroller of the Currency Quarterly Report on Bank Trading and Derivatives Activities Fourth Quarter 2014.

      Since then, these banks have reduced their derivatives books by several trillion dollars each, but their derivatives exposures still remain dangerously large. Excluded from this list is the world’s largest known purveyor of derivatives, Deutsche Bank AG, which as of late 2015 held $60 trillion of derivatives contracts on its books. Deutsche Bank may well pose the single biggest systemic risk of any financial institution in the world.24 This is because it suffers from severe management, operational, and regulatory deficiencies that have gone unremedied for more than a decade. These problems finally burst into the open in July 2014 when The Wall Street Journal disclosed that the Federal Reserve Bank of New York’s concerns about the bank had been growing for years.

      On December 11, 2013, Daniel Mucca, a New York Fed senior vice president responsible for supervising Deutsche Bank, wrote the following to the bank’s senior management: “Since 2002, the FRBNY has highlighted significant weaknesses in the firm’s regulatory reporting framework that has remained outstanding for a decade. Most concerning is the fact that although the root causes of these errors were not eliminated, prior supervisory issues were considered remediated and closed by senior management.” He added that financial reports produced by the bank “are of low quality, inaccurate and unreliable. The size and breadth of the errors strongly suggest that the firm’s U.S. regulatory reporting structure requires wide-ranging remedial action.” The New York Fed had voiced concerns about the quality of the data reported in 2002, 2007, and 2012. The letter said that the bank had made “no progress” at fixing previously identified problems and examiners found “material errors and poor data integrity” in its U.S. public filings, which are used by regulators to evaluate its operations. Mr. Mucca added that the shortcomings amounted to a “systemic breakdown” and “expose the firm to significant operational risk and misstated regulatory reports.” The bank’s external auditor, KPMG LLP, also identified “deficiencies” in the way the bank’s U.S. entities were reporting financial data in 2013 according to an internal email reviewed by The Wall Street Journal.

      As heartening as it is to hear that the Fed is on the case, the real question is how six years after the financial crisis an institution holding enough derivatives to blow up the global financial system could be permitted to operate with financial controls that would force a corner drug store out of business. People have asked how Bernie Madoff was able to escape the attention of regulators for so many years, but in that case regulators never flagged the fraud that was occurring under their noses. In the case of Deutsche Bank that – to repeat – holds enough derivatives on its books to blow up the world, regulators repeatedly flagged problems but failed to either require them to be fixed or to rein in the bank’s operations in order to protect investors and the system. This is simply inexcusable.

      Not only has the issue of concentration risk in the financial system been inadequately addressed, but it was exacerbated by the extinction of several large firms during the financial crisis and a new regulatory regime that blindly favors size over flexibility while allowing derivatives risk to fester right under regulators’ noses. This is one more example why that White House official wanted me to explain to the people advising President Obama that relying on regulators to police derivatives is going to end in tears.

      Those who like to downplay the risks of derivatives, all of whom are grossly conflicted because they have an economic interest in the instruments’ continued growth, argue that focusing on notional derivative contracts exaggerates the risks they pose. They argue that systemic risk should be measured in terms of the lower “gross credit exposures,” which, as noted above, stood at $21 trillion at December 31, 2014. Even this number, however, should make the hair stand up on the back of the neck of anyone who understands how these instruments work. But focusing on anything other than the larger notional amounts of outstanding derivatives demonstrates a basic failure to understand how modern markets operate.

      James Rickards, who among his many accomplishments was brought in to help restructure the insolvent Long Term Capital Management hedge fund after it blew up after using too much leverage and too many derivatives in 1998, explains why the much larger notional figures are the relevant ones to focus on in terms of evaluating risk:

      In complex systems, shorts are not subtracted from longs – they are added together. Every dollar of notional value represents some linkage between agents in the system. Every dollar of notional value creates some interdependence. If a counterparty fails, what started out as a net position for a particular bank instantaneously becomes a gross position, because the “hedge” has disappeared. Fundamentally, the risk is in the gross position, not the net.25

      In other words, lower “total gross credit exposure” or “gross market value” are relevant when it doesn’t matter, i.e., when markets are functioning normally. In a crisis, as Mr. Rickards explains, counterparties either will be unable and/or unwilling to perform and the volume of broken contracts will overwhelm these institutions and render them instantly insolvent.

      Financial markets are complex systems. They exhibit exponential rather than linear change because their constituents are interlinked and interdependent; any change in one component affects all of the other components in the system. Since financial markets involve human actors, they involve an additional, unquantifiable factor: the issue of trust. A market is ultimately built not on a foundation of money but on a bedrock of trust, which Francis Fukuyama defined as “the expectation that arises within a community of regular, honest, and cooperative behavior, based on commonly shared norms, on the part of other members of the community.”

21

Bank for International Settlements, BIS Quarterly Review, June 2015, p. 4; Bank for International Settlements, Derivatives Statistics, June 8, 2015, Table 19, www.bis.org/statistics/derstats.htm.

22

Ibid., 5.

23

Ibid.

25

James Rickards, Currency Wars: The Making of the Next Global Crisis (New York: Penguin, 2011), 210.