Are Banks Hiding Derivatives?

Every once in a while, regulators get a little carried away. That's the case with the Financial Accounting Standards Board's latest suggestion that banks should report their gross derivatives exposures on their balance sheets. Since the financial crisis, derivatives became seen as scary, dangerous, complicated, horrible, messy, despicable financial instruments. This misguided view may have led to FASB's new proposal.

On one hand, it sounds quite noncontroversial to say that a bank's total derivatives exposure should be reported on its balance sheet. After all, if a bank can lose $1 billion if the prime rate rises by 0.5%, shouldn't investors know that?

Of course they should, and they would under current accounting rules. Right now, banks are able to net out derivatives exposure. Let's continue on with the example above. Imagine that the same bank also has another set of derivatives that will cause it to gain $1 billion if the prime rate rises. So while one batch loses $1 billion, the other gains $1 billion -- what's the total effect of the rate rising? That's right: the bank loses zero dollars. That's netting.

So what would be more misleading: to say that the bank has a $2 billion derivatives exposure or to say that the bank has a net zero derivatives exposure? In reality, the bank faces no liability if the prime rate rises. The new standard would more likely confuse investors than the old one.

Now it's true that some investors might be interested in the total derivatives exposure of a bank and would want to do the netting calculation themselves. But that's doesn't mean that full exposures should be reported on a bank's balance sheet as liabilities. It doesn't make sense to say that banks' liabilities should show gross derivatives exposure if some portion of that exposure is effectively zero due to netting.

There's an easy solution offered by the American Bankers Association, according to a Reuters article on this topic:

Balance sheets should report the net information, with gross amounts in footnotes, it said.

This is the logical solution. The balance sheet then reflects liabilities in a meaningful way, while still giving investors the ability to play with gross derivatives figures if they desire to do so.