“It was not the highly visible acts of Congress but the seemingly mundane and often nontransparent actions of regulatory agencies that empowered the great transformation of the U.S. commercial banks from traditionally conservative deposit-taking and lending businesses into providers of wholesale financial risk management and intermediation services.”
— Professor Saule Omarova, “The Quiet Metamorphosis, How Derivatives Changed the Business of Banking” University of Miami Law Review, 2009
While the world is absorbed in the U.S. election drama, the derivatives time bomb continues to tick menacingly backstage. No one knows the actual size of the derivatives market, since a major portion of it is traded over-the-counter, hidden in off-balance-sheet special purpose vehicles. However, when Warren Buffet famously labeled derivatives “financial weapons of mass destruction” in 2002, its “notional value” was estimated at $56 trillion. Twenty years later, the Bank for International Settlements estimated that value at $610 trillion. And financial commentators have put it as high as $2.3 quadrillion or even $3.7 quadrillion, far exceeding global GDP, which was about $100 trillion in 2022. A quadrillion is 1,000 trillion.
Most of this casino is run through the same banks that hold our deposits for safekeeping. Derivatives are sold as “insurance” against risk, but they actually add a heavy layer of risk because the market is so interconnected that any failure can have a domino effect. Most of the banks involved are also designated “too big to fail,” which means we the people will be bailing them out if they do fail.
Derivatives are considered so risky that the Bankruptcy Act of 2005 and the Uniform Commercial Code grant them (along with repo trades) “super-priority” in bankruptcy. That means if a bank goes bankrupt, derivative and repo claims are settled first, drawing from the same pool of liquidity that holds our deposits. (See David Rogers Webb’s The Great Taking and my earlier articles here and here.) A derivatives crisis could easily vacuum up that pool, leaving nothing for us as depositors — or for the “secured” creditors who are junior to derivative and repo claimants in bankruptcy, including state and local governments.
As detailed by Pam and Russ Martens, publisher and editor, respectively of Wall Street on Parade, as of Dec. 31, 2023, Goldman Sachs Bank USA, JPMorgan Chase Bank N.A., Citigroup’s Citibank and Bank of America held a total of $168.26 trillion in derivatives out of a total of $192.46 trillion at all U.S. banks, savings associations and trust companies. That’s four banks holding 87 percent of all derivatives at all 4,587 federally-insured institutions then in the U.S.
In June 2024, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board jointly released their findings on the eight U.S. megabanks’ “living wills” – their resolution or wind-down plans in the event of bankruptcy. The Fed and FDIC faulted all of the four largest derivative banks on shortcomings in how they planned to wind down their derivatives.
How Banks Guarding Our Deposits Became the Biggest Gamblers in the Derivatives Casino
Banks are not just middlemen in the derivatives market. They are active players taking speculative positions. In this century, writes Professor Omarova, the largest U.S. commercial banks have emerged “as a new breed of financial super-intermediary—a wholesale dealer in financial risk, conducting a wide variety of capital markets and derivatives activities, trading physical commodities, and even marketing electricity.” She notes that the Federal Reserve has allowed several financial holding companies to purchase and sell physical commodities (including oil, natural gas, agricultural products and electricity) in the spot market to hedge their commodity derivative activities, and to take or make delivery of those commodities to settle the transactions.
It was not Congress that authorized that expansive definition of permitted banking activities. It was the Office of the Comptroller of the Currency (OCC), part of the “administrative deep state,” that permanent body of unelected regulators who carry on while politicians come and go. As Omarova explains:
Through seemingly routine and often nontransparent administrative actions, the OCC effectively enabled large U.S. commercial banks to transform themselves from the traditionally conservative deposit-taking and lending institutions, whose safety and soundness were guarded through statutory and regulatory restrictions on potentially risky activities, into a new breed of financial “super-intermediaries,” or wholesale dealers in pure financial risk. …
Moreover, some of the most influential of those decisions escaped public scrutiny because they were made in the subterranean world of administrative action invisible to the public, through agency interpretation and policy guidance.
The OCC’s authority to regulate banks dates back to the National Bank Act of 1863, which grants national banks general authority to engage in activities necessary to carry on the “business of banking,” including “such incidental powers as shall be necessary to carry on the business of banking.” The “business of banking” is not defined in the statute. Omarova writes:
Section 24 (Seventh) of the National Bank Act grants national banks the power to exercise all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes.
No mention is made of derivatives trading or dealing.
The powers of banks were further limited by Congress in the Glass-Steagall Act of 1933, which explicitly prohibited banks from dealing in corporate equity securities, and by other statutes passed thereafter. However, the portion of the Glass-Steagall Act separating depository from investment banking was reversed in the Commodity Futures Modernization Act in 2000. Omarova writes that this allowed the OCC to articulate “an overly expansive definition of the ‘business of banking’ as financial intermediation and dealing in financial risk, in all of its forms, and … this pattern of analysis allowed the OCC to expand the range of bank-permissible activities virtually without any statutory constraint.”
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