In Stockholm: Risk of the banking iceberg

IT IS instructive to take stock of the chief concerns of the world's leading banks as they head into the uncharted waters of 1990s financial deregulation and global competition. From this exercise, it is possible to draw a reasonably accurate picture of the main challenges facing the industrial countries at large. These almost certainly include employment, the competitiveness of industry, creating effective leadership within rapidly changing structures, and, possibly most challenging, the lack of clear-cut rules.

The last is particularly applicable to banks. At last week's International Monetary Conference, the annual gathering of the heads of the world's 100 largest commercial banks, the operative words were risk and risk management. These were the dominant themes underlying discussions that covered continued shrinkage of bank employment bases, emerging and re-emerging international markets and, of course, capital allocation among a dazzling array of competing choices. For banks, the last adds up to more freedom both to provide and to price services. It also means even more risk than accompanied banking over the past five to seven years - arguably among the worst.

From the viewpoint of regulators, having weathered the US banking and savings and loans crises, an eruption of international scandals and the widespread decline in bank profits in the early 1990s, this is a disturbing trend.

According to Alexandre Lamfalussy, general manager of the Bank for International Settlements, the result has been a 'growing opaqueness' of financial activity that is making it hard to assess the build-up of systemic risk. He describes the 1990s as one of the toughest periods, measured by asset quality and profitability, since the instability of the inter-war years.

Derivatives, the generic title for a host of new financial instruments encompassing swaps and options, are the dominant symbol of this new, riskier banking environment. In the minds of many, it is only a matter of time before they are brought under a new regime of international regulation.

Mr Lamfalussy does not say this explicitly. He points, however, to the massive movement of capital into these off-balance-sheet assets, which are very unevenly regulated. For example, from the early 1980s to 1990, non-interest income rose as a share of the total income of the world's largest banks from 30 per cent to over 40 per cent in the US, from 20 per cent to over 35 per cent in Japan, from less than 30 per cent to over 40 per cent in the UK and from 15 per cent to 25 per cent in France. By 1986 the notional principal amount of key derivative products amounted to about 25 per cent of the international claims of BIS reporting banks; five years later it rose to 100 per cent. An April BIS survey of foreign exchange markets revealed that almost 70 per cent of foreign exchange options had reporting dealers, mainly banks, on both sides of the trade. In several US banks, the ratio of off-balance-sheet assets to those on the balance sheet can easily exceed 700 per cent. This is what Mr Lamfalussy means by opaqueness. No one knows how much of this capital is at unacceptable risk.

It has not been lost on the leading market participants that the BIS and others are exploring ways to extend the 1988 capital standards for banks into the securities areas. Speaking at the IMC, Deryck Maughn, the chairman and chief executive officer of Salomon Brothers, said that he would welcome a more uniform set of regulatory standards governing global market risks. He said that Salomon Brothers' current on-balance-sheet activity was about dollars 175bn, while its off- balance-sheet was estimated at an additional dollars 800bn.

'Our objective is to maximise risk-adjusted returns to shareholders, not to minimise risk. That means taking the occasional loss,' Mr Maughn said.

The fear of central bankers and key international regulators is that losses will get out of hand before anyone can prepare for a seismic adjustment in the system. Gerald Corrigan, the retiring head of the New York Federal Reserve Bank, has warned of the potential dangers of derivatives in this regard. However, many banks worry that regulators will overreact by imposing strict international standards that, in effect, will kill the goose that laid the golden egg.

The reverse of Mr Maughn's 'occasional loss' is the huge profit on derivatives reported by many institutions, J P Morgan among them. Thus, it is not surprising that Dennis Weatherstone, chairman and chief executive of Morgan, is heading a group that has undertaken a comprehensive study of derivatives, with the aim of producing an industry code of conduct. Leading banks have contributed resources and manpower to the Group of 30 study, which is due out soon.

It is a good sign banks are in this way accepting Mr Lamfalussy's challenge to 'influence the process'. The stakes are so large that the balance between the judgement of regulators and that of market participants had better be right.