One of the things I have been working on is investigating about a financial derivatives transaction of one state-owned bank which has incurred serious loss from exotic interest rate swap with another bank. Although derivatives can have many benefits in risk management but it can pose serious losses if not used properly. It is like a double edge sword. On the dark side, financial derivatives can create unproductive activities and lowering transparency. While the risk shifting function of derivatives serves the useful role of hedging and thereby facilitating capital flows, the increased use of derivatives also poses dangers to the financial system and the economy as a whole. The extensive use of derivatives can and does lead to lower levels of transparency between counterparties and between regulators and market participants. They can be used unproductively for speculating, leveraging or raising risk-to-capital ratios, dodging and outflanking regulations, manipulating accounting profits and evading taxation. Due to the use of derivatives, in the event of a large change in the exchange rate or other market prices, the greater will be the speed and depth of the impact on the financial sector and economy as a whole. This increases the risk of systemic failure and vulnerability of the financial sector and the entire economy. Derivatives lead to transparency problems in two basic ways. One, they can distort the meaning of balance sheets as the basis for measuring the risk return profile of firms, central banks and national accounts. Two when traded or booked over-the counter, derivatives lack adequate reporting requirements and government surveillance. A recent survey of US businesses reveals that 42 percent use derivatives mainly to manage reported earnings by moving income from one period to another. The lack of transparency results in distorted market information. A commercial or state bank may have derivatives that bet considerably on the interest rate levels in the financial markets and create contingent liabilities and potentially harmful losses. These derivatives then substantially alter the bank’s risk exposure from that reflected in the balance sheet. This is exactly what happened recently with one state owned bank. Lack of transparency can be created at the central bank level, when for example, a central bank reports the value of its foreign reserves, but does not report the amount of foreign currency derivatives that it has contracted through forwards and swaps. This can mislead the public about the true level of international reserve that it has and its ability to intervene in the foreign exchange market. Just such an incident actually happened in the case of the Bank of Thailand’s disclosure of its foreign exchange positions in 1997 which resulted in serious losses for the country. Derivatives can sometimes be used to outflank prudential regulations as well as to manipulate accounting rules in various ways, to dodge restrictions on foreign exchange exposure on financial institutions’ balance sheets and to lower required capital requirements. For example, structured notes are sometimes designed to manipulate accounting rules so that high yield notes can be treated like top rated credit instruments for the purpose of assigning capital charges. These types of structured notes have been also used to outflank regulations that prohibit institutional investors such as pension funds and insurance companies from holding foreign currency assets. Moreover, derivatives can be used so that payments, receipts and income can be shifted from one period to another. This method was used by one Thai bank and later suffered devastating setbacks. In many cases involving commercial banks, transactions can be restructured so that they appear to occur as capital gains instead of interest payments (or vice versa), or as long term capital gains instead of short term ones. By: Dr.Chodechai Suwanaporn emial: [email protected] Source: Fiscal Policy Office / www.fpo.go.th