confirmed several months later by The McKinsey Global Institute. In a report entitled “Debt and (Not Much) Deleveraging,” McKinsey reported that between 2007 and 2014, global debt had grown by $57 trillion to $199 trillion, raising the ratio of global debt-to-GDP by 17 percentage points. Developing countries have accounted for half of this growth; government debt has soared (by $25 trillion) and private sector deleveraging has been limited. Households in the U.S., UK, Spain, and Ireland had deleveraged somewhat, but elsewhere they had not. In particular, as noted earlier, China’s total debt quadrupled from $7 trillion in 2007 to $28 trillion by mid-2014, fueled by real estate and shadow banking, and China’s total debt as a percentage of GDP exceeded that of the United States (but honestly, who knows how bad China’s opaque debt figures really are?). McKinsey summed up the last five years of the global economy: “[i]t is clear that deleveraging is rare and that the solutions are in short supply.”19 Actually, it is not solutions that are in short supply but rather the political and moral courage to implement them.
Both the McKinsey and the Geneva reports illustrate beyond a shadow of a doubt the unsustainable and dangerous path on which the global economy is set. Even worse, the policy mechanisms that brought the world to this point largely destroyed the market’s ability to send meaningful pricing signals to market participants. Since the crisis, central banks have been the largest buyers of government bonds, distorting the market’s normal supply/demand dynamics and “snapping the antenna” off the bond market in the words of economist Dr. Philippa Malmgren.20 Governments have distorted the price of benchmark bonds as well as the price of money and made it virtually impossible to determine the natural rate of interest or inflation.
One of the primary forms that global debt has assumed in the modern economy is the derivatives contract. AIG blew up because it wrote too many derivatives contracts on collateralized bond obligations that held billions of dollars of subprime mortgages. But the derivatives threat in the market in 2008 was much broader and deeper than that – there were roughly $60 trillion of credit default swaps that were written on a wide variety of underlying obligations that brought the financial system to its knees.
Seven years later, despite efforts to tame the derivatives beast, these instruments of financial mass destruction still pose an existential threat to the global finance sector. One of the stated aims of Dodd-Frank was to address the “too big to fail” problem in the financial industry. Unfortunately, the legislation left in its wake a much more highly concentrated financial industry with fewer firms that are no longer “too big to fail” but actually “too big to save.” One of the primary ways in which they are “too big to save” is by holding hundreds of trillions of dollars of derivatives on their balance sheets whose true risks their managements don’t understand (because if they did understand these risks, they wouldn’t allow their institutions to hold them).
The Bank for International Settlements reported that the notional amount of outstanding over-the-counter derivatives stood at $630.1 trillion at December 30, 2014.21 The “gross market value” of outstanding derivatives contracts, which measures the cost of replacing them at prevailing market prices and the maximum loss that market participants would suffer if all counterparties failed to perform, increased over the second half of 2014 from $17 trillion in June to $21 trillion at the end of December 2014.22 A third measure of derivatives exposure, “gross credit exposure,” which adjusts gross market values for legally enforceable bilateral netting agreements but does not take account of collateral posted with respect to the contracts, rose to $3.4 trillion at the end of December 2014 from $2.8 trillion in June 2014.23 In a moment, we will see why the “gross market value” and “gross credit exposure” figures, which are large enough to shatter the financial system in the next crisis, are important but still don’t tell the whole story.
The Office of the Comptroller of the Currency tracks the exposure of U.S. banks to derivatives and reported that just four large U.S. banks (JPMorgan, Bank of America, Citigroup, and Goldman Sachs) carried a combined $220.4 trillion of derivatives on their books at the end of December 2014. This figure dwarfed their combined $769.2 billion in equity capital by multiples ranging from 151 at Bank of America to an astounding 565 at Goldman Sachs (see Table I.4).
Table I.4 Exposure of U.S. Banks to Derivatives ($ in billions)
SOURCE: 2014 Annual Reports; Office of the Comptroller of the Currency Quarterly Report on Bank Trading and Derivatives Activities Fourth Quarter 2014.
Since then, these banks have reduced their derivatives books by several trillion dollars each, but their derivatives exposures still remain dangerously large. Excluded from this list is the world’s largest known purveyor of derivatives, Deutsche Bank AG, which as of late 2015 held $60 trillion of derivatives contracts on its books. Deutsche Bank may well pose the single biggest systemic risk of any financial institution in the world.24 This is because it suffers from severe management, operational, and regulatory deficiencies that have gone unremedied for more than a decade. These problems finally burst into the open in July 2014 when The Wall Street Journal disclosed that the Federal Reserve Bank of New York’s concerns about the bank had been growing for years.
On December 11, 2013, Daniel Mucca, a New York Fed senior vice president responsible for supervising Deutsche Bank, wrote the following to the bank’s senior management: “Since 2002, the FRBNY has highlighted significant weaknesses in the firm’s regulatory reporting framework that has remained outstanding for a decade. Most concerning is the fact that although the root causes of these errors were not eliminated, prior supervisory issues were considered remediated and closed by senior management.” He added that financial reports produced by the bank “are of low quality, inaccurate and unreliable. The size and breadth of the errors strongly suggest that the firm’s U.S. regulatory reporting structure requires wide-ranging remedial action.” The New York Fed had voiced concerns about the quality of the data reported in 2002, 2007, and 2012. The letter said that the bank had made “no progress” at fixing previously identified problems and examiners found “material errors and poor data integrity” in its U.S. public filings, which are used by regulators to evaluate its operations. Mr. Mucca added that the shortcomings amounted to a “systemic breakdown” and “expose the firm to significant operational risk and misstated regulatory reports.” The bank’s external auditor, KPMG LLP, also identified “deficiencies” in the way the bank’s U.S. entities were reporting financial data in 2013 according to an internal email reviewed by The Wall Street Journal.
As heartening as it is to hear that the Fed is on the case, the real question is how six years after the financial crisis an institution holding enough derivatives to blow up the global financial system could be permitted to operate with financial controls that would force a corner drug store out of business. People have asked how Bernie Madoff was able to escape the attention of regulators for so many years, but in that case regulators never flagged the fraud that was occurring under their noses. In the case of Deutsche Bank that – to repeat – holds enough derivatives on its books to blow up the world, regulators repeatedly flagged problems but failed to either require them to be fixed or to rein in the bank’s operations in order to protect investors and the system. This is simply inexcusable.
Not only has the issue of concentration risk in the financial system been inadequately addressed, but it was exacerbated by the extinction of several large firms during the financial crisis and a new regulatory regime that blindly favors size over flexibility while allowing derivatives risk to fester right under regulators’ noses. This is one more example why that White House official wanted me to explain to the people advising President Obama that relying on regulators to police derivatives is going to end in tears.
Those
McKinsey, “Debt and (Not Much) Deleveraging,” vi.
Dr. Philippa Malmgren,
Bank for International Settlements,
Ibid., 5.
Ibid.
