Which representation of a bank’s derivative portfolio provides a fairer picture of the risk it presents, the net or gross balances? US banks, operating under US Generally Accepted Accounting Principles (GAAP), report the balance after netting out offsetting exposures with the same counterparty together with collateral. European banks, operating under International Financial Reporting Standards (IFRS), report the balance gross. Consequently, a naïve comparison of banks using total assets as reported under the two different standards gives an erroneous impression that US banks are much smaller relative to their European counterparts. Were the assets reported on a comparable basis, US banks would climb in the rankings. But which comparable basis is the right one? Should the US bank assets be adjusted upward with the netted derivative assets added back, or should the European bank assets be adjusted downward by netting out more of their derivative assets. A number of US banking regulators and experts have recently started calling for putting the gross exposure onto the balance sheet. Not surprisingly, the big US banks and derivative trade associations like the International Swaps and Derivatives Association (ISDA) argue that the net exposure is the right one.
What is at the root of the disagreement?
It’s all about whether we examine the bank before or after it fails. Are we concerned about losses incurred in bankruptcy, or the danger that the bank may be driven to bankruptcy?
The US bankers and ISDA make their case based on how a bank’s derivative assets and liabilities are treated after the bank fails, in bankruptcy. They argue that the Master Netting Agreement negotiated between a bank and its customers governs the settlement in bankruptcy, allowing the offsetting of derivative assets and liabilities. Suppose the bank currently owes a customer $100 on a derivative, but the bank also is currently owed $70 by the same customer on another derivative, then in bankruptcy those two amounts are netted so that the bank only owes the customer $30. Therefore the maximum exposure to the customer of a potential failure by the bank is the $30 net derivative position.
The problem is that this netting only takes place if we arrive at bankruptcy with those same exposures in place. A lot can happen before a bank fails which changes the picture dramatically. More importantly, what we first need to be concerned about are the forces that drive a bank towards failure. Here the gross exposures are important.
For a bank that deals in derivatives, a large fraction of the derivatives should be thought of as short-term positions in the same fashion as demand deposits. Counterparties expect their dealers to stand ready to liquidate or novate positions, just as people expect to be able to withdraw the balances in their checking and savings accounts–on demand. Were a dealer bank to hold up liquidations and/or novations, it would only adds fuel to the fire of suspicion that the dealer bank is insolvent. Consequently, a small net exposure at a dealer bank can suddenly balloon to a large net exposure over the next few days as counterparties liquidate or novate the positions on which the bank owes them money. It is the gross scale of positions that reflects the potential scale of such a run. A regulator that paid attention only to the banks net exposure would not have appreciated the dangers. Moreover, should the bank ultimately arrive in bankruptcy where the derivative assets and liabilities are netted against one another, the scale of actual netting will now be much smaller than originally anticipated due to the intervening bank run. The original net exposure was deceptive in measuring the ultimate losses to those parties left holding the bag.
We need only look back at the two major bank runs of 2008 to see the point—Bear Stearns and Lehman Brothers. The Report of the Financial Crisis Inquiry Commission is especially detailed on how derivative counterparties participated in the run on Bear–see esp. pp. 287-288 & 291. See also their conclusion on Lehman, p. 343. Bryan Burroughs’ account of the run on Bear in Vanity Fair also discusses the role played by derivative counterparties in the run on the bank, as does William Cohen’s book House of Cards. Finally, Darrel Duffie’s article on the Failure Mechanics of Dealer Banks in the Journal of Economic Perspectives makes the same point.
 It is a little sloppy to say that US GAAP allows netting while the IFRS do not. Both standards permit netting under certain circumstances. US GAAP allows significantly more netting than the IFRS.