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Derivatives

Citi Voices Concerns About French Banks' Vol Exposure

Citigroup has published a research report warning that French derivatives houses may have to curtail their equity derivatives structured products business because of the earnings volatility new accounting rules will generate when they kick in next year.

Citigroup has published a research report warning that French derivatives houses may have to curtail their equity derivatives structured products business because of the earnings volatility new accounting rules will generate when they kick in next year. Proposed international accounting standards are expected to require banks to mark earnings to market. They currently have some freedom to smooth these.

The French banks are likely to resist any move to slash derivatives activity because of the huge profits they make. The structured products business is seen as a cash cow, noted Bernard Desforges, global head of sales and structuring at Société Générale in Paris. "We have spent a lot of time preparing for the changes and we think that on both sides, clients and ourselves, we should be able to manage the changeover," he added. Celeste Matta-Brown, a spokeswoman for BNP, declined comment on the impact of the new rule--IAS 39--because, "The exact content and even eventual adoption of this particular standard are still unsure."

The structured products business at BNP and SG is estimated to be worth a total of EUR2.7 billion (USD3.26 billion), according to the report, published earlier this month. Any move to modify the size of the books to make the accounts look less volatile under mark-to-market accounting would cause a spike in volatility because of the size of the positions involved, explained Olivier Sarfati, v.p. in the equity derivatives research group at Citigroup in New York.

Another difficulty for the French banks is that because so much of their business comes from derivatives, under the proposed new accounting standards, their earnings may appear more volatile than other more diversified companies.

"If the banks need to decrease exposure to volatile products by closing some positions there could be liquidity issues because the positions are so big," noted Sarfati. The report says one option is to let the business run dry to decrease the risks, but adds that this would not be in line with the recent expansion by the banks. Another possibility suggested by the report is to merge. The report notes, "They could choose to merge with a large financial institution so that the percentage of the derivatives business (and the associated earnings volatility) becomes less of a concern on a larger balance sheet."

Two of the other largest players in the European structured equity market are Deutsche Bank and Credit Suisse First Boston, which Citigroup says will be moderately and lightly affected, respectively even though they use U.S. GAAP accounting. This is largely because of the International Accounting Standards Board and the Financial Accounting Standards Board commitment to converge accounting rules.

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