OCC Reports Record Bank Quarterly Derivatives Earnings

WASHINGTON – Insured commercial banks earned a record $5.7 billion trading cash instruments and derivative products in the first quarter of 2006, the Office of the Comptroller of the Currency reported today in its quarterly Bank Derivatives Report.  For comparison purposes, banks earned $3.1 billion from trading activities in the fourth quarter of 2005 and $4.4 billion in the first quarter of 2005.  

"Historically, trading revenues are the strongest in the first quarter of the year and 2006 is no exception," said Deputy Comptroller for Credit and Market Risk Kathryn E. Dick.  "Favorable market conditions and healthy client demand for risk management products lead to strong performance, including record quarterly revenues in foreign exchange and equities contracts." 

The notional amount of derivatives held by U.S. commercial banks increased by $8.7 trillion in the first quarter of 2006, to a record $110.2 trillion, 9% higher than the previous quarter and 21% higher than the same quarter last year.  Consistent with previous quarters, interest rate contracts represent 84% and foreign exchange products represent 9% of all bank derivatives. 

Credit derivatives are the fastest growing component of the derivatives market and stand at $5.5 trillion, an increase of 77% from the first quarter of 2005.  Ms. Dick pointed to the continued strong growth in credit derivatives as an area receiving close attention from OCC examiners on-site at the large trading banks.

"Credit derivatives can be a very effective credit risk hedging tool, but they can also be used to create some very complicated investment structures," Ms. Dick said. "This market is still young and relatively untested and therefore presents some meaningful challenges from a risk management perspective." 

Ms. Dick underscored that two key aspects of the OCC’s supervision program for credit derivatives activities in the large trading banks are the evaluation of risk management systems used to ensure that products they sell to clients are appropriately managed and that middle and back-office functions are keeping pace with innovations in product structures.

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 first quarter, the gross positive fair value (GPFV) of contracts was $1.21 trillion.  Netting benefits of $1.02 trillion, or 84.3% of GPFV,  yield a net current credit exposure of $189 billion.

"The large trading banks have many contracts with other large dealers and institutional investors, and legally enforceable netting agreements are a useful risk mitigation technique, allowing a trading bank to use the negative value it owes a counterparty to offset the positive value owed to it by that same counterparty," Ms. Dick said.  

The OCC first quarter derivatives report also noted that:

Foreign exchange revenues increased by $545 million, to $2.31 billion from the previous quarter; equity revenues increased by $959 million, to $1.8 billion; interest rate revenues increased by $434 million, to $1.25 billion; and commodity/other revenues increased by $605 million, to a gain of $313 million.

The 25 largest banks account for more than 99 percent of the total notional amount of derivatives.  The largest 5 banks account for 96% of the total notional amount of derivatives.

The number of commercial banks holding derivatives increased by 46 in the first quarter to 882 banks, and increased by 187 banks from a year ago.

Related Links

• A copy of the OCC Bank Derivatives Report: First Quarter 2006.