DealBook: Banks Increase Holdings in Derivatives

Even as federal regulators ratchet up scrutiny of the derivatives market, Wall Street is diving deeper into the $600 trillion industry, a new government report found.

The banking industry in the second quarter raised its stake in derivatives more than 11 percent from the same period a year earlier, according to the report by the Comptroller of the Currency, the federal agency that regulates national banks. Banks now hold nearly $250 trillion of the contracts, primarily futures and swaps, which derive their value from an underlying asset like an interest rate or a bundle of mortgages.

The nation’s four biggest banks — JPMorgan Chase, Citigroup, Bank of America and Goldman Sachs — are the biggest players, holding roughly 95 percent of the industry’s total exposure to derivatives. JPMorgan, which holds the most among commercial banks, carries some $78 trillion worth of derivatives on its books, according to the report. Citi is next on the list, with $56 trillion, up from $54 trillion in the first quarter.

“Derivatives activity in the U.S. banking system continues to be dominated by a small group of large financial institutions,” the report noted. While the number of banks holding derivatives increased modestly to 1,070, 99 percent are held by only 25 banks.

The derivatives industry — which allows banks, hedge funds and corporations to both hedge risk and speculate on market fluctuations – was at the center of the financial crisis. The American International Group became a symbol of the industry’s pitfalls, having sold billions of dollars in credit default swaps as insurance on risky mortgage-backed securities. When the mortgage market crumbled during the crisis, the insurance giant lacked the capital to honor their agreements.

Credit default swaps make up 97 percent of total credit derivatives at banks, though they are a small piece of the overall derivatives pie. Commercial banks primarily use interest rate products, which comprise 82 percent of the total value of derivatives.

The Dodd-Frank financial regulatory law overhauled the industry, forcing many derivatives contracts onto regulated exchanges. Many deals must also go through clearinghouses, which act as a backstop in case one party defaults. Regulators are writing more than 50 new derivatives rules, moving the once murky market onto Washington’s radar screen.

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