The OCC Fourth Quarter Report of 2003 set forth preferred ways to measure the degree of risk quantitatively. The degree of risk is a function of aggregate trading positions, asset and liability structures, data describing fair values and credit risk exposure, as well as data on trading revenues and contractual maturities.
The OCC Fourth Quarterly Report of bank derivatives and trading revenues was based on call report data by the insured commercial banks in the USA. The notional amounts equal the nominal or face amount used to compute payments made on swaps and other risk management products. This amount doesn't change hands. Thus, the term nominal is used.
The Fourth Quarter of 2003 OCC Report documented seven banks with the most derivatives which comprised over 96% of the total derivatives in 573 commercial banks with derivatives. These derivatives were in futures, swaps, options and credit derivatives. The derivatives (notionals) by the type of user grew from $8 trillion dollars in 1990 to over $70 trillion dollars by 2003 and $244 trillion dollars today.
Counterparty risk exposure ignores collateral from clients to secure exposures from derivative contracts. A more meaningful analysis is to reduce the current credit exposure by liquid collateral held against exposures. This reduction is dependent upon the timeliness of a reduction in the liquid collateral. In addition, liquid collateral may change value in an environment where the VIX index of volatility is rising.
Contract banks have agreements customarily drawn by the legal counsel and experts in derivatives. The agreements permit the financial institution to close out the transaction if the counterparty cannot post collateral according to the contract terms.
The limit of losses may be dependent upon the timeliness of the financial institution close out of the transaction. This gaping hole begs for a superior derivative strategy program of implementation on the part of all parties to these transactions. The process may be helped by more definitive guidance from the Uniform Commercial Code on derivative products since the UCC is an evolving legal document historically.