Derivatives Limit for Banks Now Considered : Investing: Chief regulator, who had said the high-risk speculations were no threat to the industry, does an about-face.
In a surprise move, Comptroller of the Currency Eugene B. Ludwig said Wednesday he is considering placing strict limits on the ability of national banks to speculate in “exotic and complex “ derivative instruments.
The high-risk financial speculations -- which are resulting in big trading losses for major corporations such as Cargill Inc., Procter & Gamble and Kidder Peabody & Co.--could be especially dangerous for banks, the nation’s chief bank regulator warned in a speech.
Banks can be involved two ways in the market for derivatives: speculating themselves or, for six of the biggest banks, creating the complex financial packages for sale to others.
Just a week ago, Ludwig and other bank regulators indicated they were keeping a close watch on the complex financial instruments but saw no immediate threat to the nation’s banks.
But his warning Wednesday in a speech to the Exchequer Club marked a significant change: the first time a top government official said speculation in derivatives might be placed off-limits for banks whose deposits are protected by federal insurance.
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“We are looking at whether we should place capital or risk limits on (banks’) proprietary trading activities and whether some other type of regulatory response is appropriate,” Ludwig said.
Several major banks, including Citicorp, Bankers Trust and Chemical, are large dealers in derivatives, earning substantial fees for finding customers who want to speculate on or hedge against the future performance of commodities markets and interest rates.
Banks, along with other investors, have long used “plain vanilla” derivatives, such as futures and options contracts, whose values are derived from changes in interest rates and foreign currency values. Such securities, which require relatively little money down, allow investors to hedge against sharp moves in financial markets by granting the owner the right to buy or sell securities at set prices in the future.
Yet the explosion in ever-more-complex derivative contracts over the past two years has raised questions about their use in raw speculation, the severity of players’ potential losses if markets react in unforeseen ways, and the ability of parties on the other side of the transactions to honor promises to buy or sell the designated investment if necessary.
Ludwig said he asked one of his staff experts in October about financial derivatives and was offered a list of 900 products. They had “such interesting names as ‘harmful warrants’ and ‘worthless warrants,’ ‘death backed-bonds,’ ‘limbos’ and ‘heaven-and-hell bonds’--descriptions obviously designed to inspire confidence,” he said in a wry tone.
Since last year, the tally of derivative instruments “has expanded by at least one-third,” Ludwig said.
Banks can be winners and losers at the same time, earning fees as packagers and sellers of derivatives to others, but taking big hits on trading for their own accounts.
Bankers Trust, Chemical and Citicorp all reported Tuesday that they had suffered big declines in their trading revenues in the first quarter. On Wednesday, Chemical acknowledged that derivatives contributed to its problems.
Ludwig said he will issue 20 pages of “guidance” to bankers next week, covering such topics as “the duties of senior management and the board of directors for oversight of derivative activities” and the monitoring of risks.
Sources in the comptroller’s office said the speech Wednesday did not represent a response to recent losses in the corporate world, but rather Ludwig’s decision to deliver a definitive statement of his concerns after much research and preparation. Ludwig said his remarks were a yellow flag, not necessarily the precursor of a ban.
