It's always good to have something to ruminate on over the weekend. With bank reform being the "trill thrill" of the week, what's this derivative thing? And more important, who's got how much in play at the casinos? So print this out and ponder it with your buddies while watching that ball game.
Remember, this is all about life inside the Matrix. "It'll feel ... a little weird." Derivatives are made up transactions. Two people, each of whom thinks he or she has the brass to out model the other, agree to bet on what will happen to an arbitrary amount of money. The winner of the bet gets the difference in the outcome. The winnings or losses are leverage that helps the bank participate in more betting both on-balance sheet real investments - they call that improving liquidity - or, if they like the trader/analyst team that did it, authorization from the risk and compliance officers to do more innovating.
They call the imaginary bet the "notional balance". Because it's not real money auditors won't let you book it on a balance sheet and that's why it's tracked as an off-balance sheet line item. For you aficionados, please see form RC-L of the Call Reports. To get the bigger picture, IRA sums these amounts across the individual FDIC Certificate (CERT) units of a bank holding company (BHC) and runs a variety of calculations on these numbers. One of my personal favorite measures is the ratio of the OBS notional balance versus the balance sheet assets of just the operating bank portion of the BHC. This figure gives you an idea of how much leverage derivative activity within the bank contributes to ongoing business operations.
There's one final thing to note before flashing the stash. These families of instruments were originally meant to be back office activities that served primarily to offset market risks against things like interest rate or currency exchange rate fluctuations. In many cases they still are. This aspect of derivatives is what people mean when they say they serve a financially useful function. Many of the banks listed below can and do use derivatives for these purposes. It's the appropriateness of innovating leverage for leverage sake that accelerates systemic speculation we need to assess as we reform.
Ok here goes. What ya'll make of these?