There is a chart doing the rounds courtesy for the CEC (an Australian Political Party, who is advocating the introduction of a Glass Steagall banking separation bill, and which is likely to tabled late June) which shows that the total value of financial derivatives in Australia is around $37 trillion dollars.
So you might net off the exposures, positive and negative, to get a baseline netted position. In a balanced position the exposures may be quite small, but changes in relative rates may create much larger exposures without much notice. Thus in a volatile market these exposures could be larger than anticipated, which creates the risks in the system.
The RBA said in 2010, the estimated market value of cross-sectoral bought (or sold) positions across all derivatives classes (both exchange traded and OTC) was around $350 billion, as opposed to the $15 trillion dollars notional exposure. The largest component of this was positions bought and sold between domestic financial institutions and offshore counterparties (largely financial institutions). However, the public sector and the non-financial corporate sector are also significant users, each with around $30 billion of bought and sold positions outstanding as at December 2010.
So the exposures can range from trillions of dollars to a few billions. It all depends what you mean by “exposures” in the first place.
And this is where it gets tricky. Banks have an obligation to assess their off-balance sheet exposures and use APRA approved formulations to discount the total exposures back to those which may appear in the balance sheet. Does APRA get inside these figures or validate them. We suspect not, leaving it to the accountants who work with the banks. An APRA spokesman after the GFC said, said: “We are not in the business of running banks, we are in the business of supervising them”, adding that the role of APRA was to set standards that the banks agreed to abide by.
But as we have described the exposures are highly leveraged, and in a time of crisis, these smaller deeply discounted exposure values may be insufficient to handle the demands from the derivatives they hold. If so, and in a crisis, a bank may find their exposures escalate and it might swamp their balance sheet, meaning that the other operations, including loans and deposits may get caught up.
This is especially relevant, because in the current environment, with interest rates shifting between the USA and Australia, as shown by the BBSW chart, (rates have move up around 30 basis points since February) things could get interesting.
And this is the point, banks who play in the derivatives area actually have additional risks in their business, which are not knowable, but potentially large. In a crisis, it risks the rest of the business. There is no ring fence.
And this is where Glass-Steagall comes in, because this legislation would separate the trading operations from core banking operations, and protect depositors as a result. The current “all mixed up” universal banks are totally exposed.
But such a change would also have an immediate impact on both the profitability and capability of banks, which is why they will resist any such move, despite it now being proposed in Italy, and already in existence in some form in China.
The bottom line is the $37 trillion is a good representation of the current gross exposures in our banking system, and this dwarfs the banks’ current balance sheets, and the countries total economy. The risks are literally enormous, and in a system-wide banking crash, when multiple parties are exposed, a bail-out if required would likely have profound economic effects. It might be enough to swamp the entire economy. That’s how big the potential risks are. That’s why Glass-Steagall is worth pursuing.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.