U.S. banks earned $5.7 billion trading derivatives and cash investments in the third quarter, as the level of credit risk continued to decline in the global market, a government report released Friday shows.
Derivatives, traded in an unregulated $600 trillion market, were partly blamed for the financial crisis that ignited last year. The value of derivatives hinges on an underlying investment or commodity — such as currency rates, oil futures or interest rates. The derivative is designed to reduce the risk of loss from the underlying asset. Derivatives trading is dominated by about 20 big banks worldwide.
The primary measure of credit risk in derivatives trading — called net current credit exposure — fell $70 billion, or 13 percent, in the third quarter to $484 billion, according to the report by the U.S. Office of the Comptroller of the Currency.
As financial markets have stabilized, the gap between the rates at which banks are willing to lend and what borrowers are willing to pay has narrowed significantly and helped to reduce the derivatives credit exposure, said Kathryn Dick, the deputy comptroller for credit and market risk at the Treasury Department agency.
The last two quarters have been positive for banks that trade derivatives "as financial markets have started to gather a little bit in terms of activity," Dick said in a conference call with reporters.
The report said that banks overall hold collateral to cover 64 percent of their net current credit exposure.
A total of 1,065 U.S. banks reported holding derivatives at the end of the third quarter, down 45 from the second quarter. Still, five big banks — JPMorgan Chase & Co., Goldman Sachs Group Inc., Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. — account for 97 percent of the total derivatives reported to be held by U.S. commercial banks.
The $5.7 billion in banks' trading revenues in the July-September period was up from $5.2 billion in the second quarter, as financial markets continued to revive. The third-quarter revenues were the fourth-largest since the agency began keeping records in 1996.
Credit default swaps, a form of insurance against loan defaults, account for an estimated $60 trillion of the over-the-counter derivatives market. The collapse of the swaps brought the downfall of Wall Street banking house Lehman Brothers Holdings Inc. last year and nearly toppled American International Group Inc., prompting the government to support the insurance conglomerate with more than $180 billion in aid.
Contracts on interest rates and foreign exchange rates also figure prominently in the derivatives market.
Sweeping legislation to restructure financial regulation that cleared the House last week includes new oversight on derivatives, aimed at preventing manipulation and bringing transparency to the opaque global market. But consumer advocates said the derivatives legislation falls short. It creates an exception for nonfinancial companies that use derivatives as a hedge against market fluctuations rather than as a speculative investment, exempting businesses considered too small to pose a risk to the financial system.
Under the bill, banks that trade derivatives would be subject to new requirements for holding capital reserves against risk and other rules.
Last year as the credit crisis raged, U.S. commercial banks recorded their first industrywide loss on derivatives trading. The $836 million loss compared with trading revenue of $5.49 billion in 2007, according to the comptroller's office.
The agency's third-quarter report found that the total value of derivatives held by U.S. commercial banks rose to $204.3 trillion, up by $804 billion, or 0.4 percent, from the second quarter.
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