DIGGING INTO DERIVATIVE´S CAPITAL HOLE / THE WALL STREET JOURNAL

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AUGUST 14, 2009, 3:30 P.M. ET

Digging Into Derivatives' Capital Hole

By PETER EAVIS

How big is the capital hole at the heart of derivatives market?

That's a key question right now, as the Obama administration attempts an ambitious overhaul aimed at putting the over-the-counter derivatives market on a sounder footing. The market is massive: The notional value of OTC derivatives at U.S. commercial banks was $195 trillion in the first quarter. This market contributed to the credit crisis, because large bets were made that certain firms struggled or failed to honor.

One way to improve the market is making sure more capital is held against derivatives trades. This can be done by putting as many OTC contracts as possible onto adequately capitalized trading platforms -- and by making banks hold more capital against OTC trades that aren't sufficiently standardized to make it onto such entities.

It's hard to estimate the scale of the potential capital deficiency. However, a recent paper from the International Monetary Fund provides some clues. It shows how much certain large banks potentially owe on their derivatives, adjusted for cash collateral and netting with counterparties. If this adjusted liability at a bank came to $20 billion, that would be the amount counterparties would likely struggle to collect if the bank cratered. In theory, one way to strengthen the system would be to increase the capital buffer against potential losses on these outstanding liabilities.

The IMF calculates Goldman Sachs had the largest adjusted liability at $91 billion, at the end of March, followed by J.P. Morgan Chase, at $86 billion, and Citigroup, with $81 billion.

No one knows how much extra capital banks are going to have to deploy, but the scale of these liabilities suggests it could be substantial.

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