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The Fed's stress test may not be stressful enough

March 7, 2013: 7:44 AM ET

Bank examination may understate the risk of a huge and growing financial product.

130306104109-destroyed-fortress-614xaFORTUNE -- In the past year or so, bank executives have taken to referring to their balance sheets as fortresses. It could be a drinking game.

The phrase is supposed to signify how banks are better protected against loan and trading losses since the financial crisis. Later Thursday we'll get a chance to see just how strong the banks' surrounding walls have become ... or if they would come crashing down in the next crisis.

After the market closes, the Federal Reserve will release the first set of results of its annual bank stress tests.

In the first step, called the Dodd-Frank stress test, the Fed will reveal how it thinks the big banks and the industry in general would perform if the economy were to hit another major rough patch. A week later, the Fed will say whether the banks, based on those stress test results, have enough in their vaults to pay dividends and buy back shares.

Earlier: Stressing the Fed's stress test

But some economists and bank regulators think the stress tests may be missing a key vulnerability for banks -- their derivatives.

The issue has to do with the different way U.S. and foreign accounts treat derivatives, which are financial contracts used to bet on or hedge against price swings in things like interest rates or corporate debt. The derivatives market is huge - $600 trillion - and a potential source of instability for the banks, though you are likely to see little indication of that in the Fed's stress tests.

U.S. rules allow banks to net out the derivative bets they make with each other, essentially erasing them from their financial statements. European rules generally rely on total potential losses or gains while the Fed's stress tests are essentially based on the more lenient U.S. accounting rules.

That has alarmed some bank experts. In early February, FDIC governor and former JPMorgan Chase banker Jeremiah Norton criticized the reliance on U.S. accounting rules when it came to derivatives.

MORE: In reversal, JPMorgan to cut 4,000 jobs

MIT professor Simon Johnson, author of a well-known book on so-called too big to fail banks, recently wrote that when you apply European derivative rules to U.S. banks, many of their balance sheets don't seem nearly as fortress-like. JPMorgan Chase (JPM), one of the biggest players in the derivatives business, takes a particularly large hit. That's ironic since JPMorgan Chase CEO Jamie Dimon is particularly fond of comparing his bank's finances to a fortress.

According to JPMorgan Chase's financial statements, the bank's net derivative exposure - what it would owe minus what it would collect from others if it had to close all of those contracts today - was $4.3 billion at the end of 2012. That's down 75% from a year ago.

JPMorgan Chase does appear to have lowered its exposures during the year - probably in part due to the harpooning of its London Whale trader, whose specialty was credit derivatives. But if you account for the bank's derivatives the way Europeans do, its exposure is more like $23 billion ... down just 50% from a year ago. The bank was not immediately available for comment.

MORE: Why the Fed is failing to boost lending

So while the stress test is likely to show that JPMorgan Chase's capital ratios have improved, a good part of that improvement - about $9 billion's worth - will not be due to any real improvement in its finances but a change in its derivative bets, which may not actually have made the bank any less vulnerable in a financial crisis.

"I think the gross amount that the European balance sheets use is a better measurement of derivative risk," says Fred Cannon, who heads up research at investment bank KBW, which specializes in working with financial firms. "Do things the U.S. way and you are disguising things."

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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