Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable

The world’s scariest story: trading in derivatives

Bad as these scandals are and vast as the money involved in them is by any normal standard, they are mere blips on the screen, compared to the risk that is still staring us in the face: the lack of transparency in derivative trading that now totals in notional amount more than $700 trillion. That is more than ten times the size of the entire world economy. Yet incredibly, we have little information about it or its implications for the financial strength of any of the big banks.

.. Public confidence in banks is now at a record low. According to Gallup, in the late 1970s, around 60 percent of Americans said they trusted big banks “a great deal” or “quite a lot.” In June 2012, less than 25 percent of respondents told Gallup they had faith in big banks.

But it’s not just public confidence. Specialists are equally bewildered. The Atlantic cites:

Ed Trott, a former Financial Accounting Standards Board member, when asked whether he trusted bank accounting, he said, simply, “Absolutely not.”

Several financial executives told The Atlantic that they see the large banks as “complete black boxes.”

A chief executive of one of the nation’s largest financial institutions considers banks “uninvestable,” a Wall Street neologism for “untouchable.”

Paul Singer, who runs the influential investment fund Elliott Associates, wrote to his partners this summer, “There is no major financial institution today whose financial statements provide a meaningful clue” about its risks.

Arthur Levitt, the former chairman of the SEC, lamented to us in November that none of the post-2008 remedies has “significantly diminished the likelihood of financial crises.”

A recent survey by Barclays Capital found that more than half of institutional investors did not trust how banks measure the riskiness of their assets.

When hedge-fund managers were asked how trustworthy they find “risk weightings”—the numbers that banks use to calculate how much capital they should set aside as a safety cushion in case of a business downturn—about 60 percent of those managers answered 1 or 2 on a five-point scale, with 1 being “not trustworthy at all.” None of them gave banks a 5.

A disturbing number of former bankers have recently declared that the banking industry is broken, including Herbert Allison, the ex-president of Merrill Lynch and former head of the Obama administration’s Troubled Asset Relief Program, Philip Purcell (ex-CEO of Morgan Stanley Dean Witter), Sallie Krawcheck (ex-CFO of Citigroup), David Komansky (ex-CEO of Merrill Lynch), and John Reed (former co-CEO of Citigroup) and Sandy Weill, another ex-CEO of Citigroup. The Atlantic notes that “this newfound clarity typically follows their passage from financial titan to rich retiree.”