OCC Reports Bank Quarterly Derivatives Earnings of $4.7 Billion

WASHINGTON – Insured commercial banks earned $4.7 billion trading cash instruments and derivative products in the second quarter of 2006, the Office of the Comptroller of the Currency reported today in its quarterly Bank Derivatives Report.  For comparison purposes, banks earned $5.7 billion from trading activities in the first quarter of 2006 and $1.96 billion in the second quarter of 2005.

"We expected to see a drop off from the record first quarter earnings performance, and we did," said Deputy Comptroller for Credit and Market Risk Kathryn E. Dick.  "However, when compared to the same quarter last year, the earnings performance this quarter was actually quite strong."

Average trading revenues for the past 11 second quarters is $2.8 billion, Ms. Dick noted.  "Both interest rate and foreign exchange revenues increased from the first quarter.  In fact, foreign exchange revenues of $2.7 billion were a new record," Ms. Dick said.   "It was the sharp decline in equity revenues, resulting from difficult conditions in some overseas markets that caused overall industry trading revenues to decline."     

The notional amount of derivatives held by U.S. commercial banks increased by $9 trillion in the second quarter of 2006, to a record $119 trillion, 8% higher than the previous quarter and 24% higher than the same quarter last year.  Consistent with previous quarters, bank derivatives activity remains concentrated in interest rate contracts, which represent 83% of total notionals. Foreign exchange products represent 9% and credit derivatives 6%. 

Credit derivatives are a fast growing component of the derivatives market, increasing 20% in the second quarter to $6.6 trillion.  "Credit derivatives have grown 60% since the second quarter of 2005 and the continued strong growth in credit derivatives is an area receiving close attention from the OCC," Ms. Dick said.  "While credit derivatives can be a very effective credit risk hedging tool, most of the activity in this business is creating structured products that can meet the increasingly aggressive yield requirements of investors." 

Ms. Dick noted that, of metrics available from Call Report information, net current credit exposure is the metric most representative of credit risk in derivatives portfolios.  Net current credit exposure is calculated by subtracting netting benefits from the gross positive fair value of contracts (i.e., the total fair value of only those contracts where the bank is owed money by its counterparties).  At the end of the second quarter, legally enforceable netting agreements allowed banks to reduce the $1.320 trillion gross positive fair value of contracts by $1.121 trillion, or 84.9%, to yield a net current credit exposure of $199 billion.

"Although credit exposure of $199 billion is a large number, we find that the credit quality of these derivative exposures is generally higher than in the commercial loan portfolio, and much of this exposure is secured by cash or other readily marketable collateral," Ms. Dick said.  "These factors explain why charge-offs of derivatives exposures are so low."    

The OCC second quarter derivatives report also noted that:

Foreign exchange revenues increased 16% to $2.7 billion, a new record.  Interest rate revenues increased 34% to $1.7 billion.  Equity revenues fell 94% to $103 million, and commodity/other revenues fell 12% to $274 million.

Derivatives contracts are concentrated among a small number of institutions.  The largest 5 banks hold 97 percent of the total notional amount of derivatives, while the largest 25 banks hold 99 percent.

The number of commercial banks holding derivatives increased by 20 in the second quarter to 902.

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• OCC Reports Bank Quarterly Derivatives Earnings of $4.7 Billion