Are European banks more active in the OTC derivatives markets than US banks?  A look at their balance sheets might lead you to think so. For example, reporting under IFRS, Deutsche Bank’s total assets amounted to $2.1 trillion, of which 40% (or $863 billion) were derivatives. Bank of America, by contrast, has $2.2 trillion in assets, of which derivatives constitute just 4%.

How can this be?

The difference, of course, lies in the accounting treatment of derivatives. US GAAP accounting standard setters have consistently agreed that derivatives be reported on a “net” basis instead of on a “gross” basis on the face of the balance sheet. Historically, the Europe-based International Accounting Standards Board (IASB) has permitted significantly less balance sheet offsetting than the US-based Financial Accounting Standards Board (FASB). (Note: the table below shows the actual derivatives outstanding of some US and European banks as of year-end 2009.)

ISDA believes that net presentation, in accordance with US GAAP, provides the most faithful representation of an entity’s financial position, solvency, and exposure to credit and liquidity risk. Individual derivative transactions that are subject to enforceable master netting agreements should be eligible for netting in the balance sheet on the basis that such financial statement presentation is most faithfully representative of an entity’s resources and claims and provides the most useful information for investment decisions.

The fact is, netting is recognized for legal, regulatory and regulatory capital purposes. The treatment of netting under US GAAP ensures the accounting practices regarding netting are appropriately aligned with this state of affairs. The IFRS approach, in our view, creates distortions and misperceptions in the treatment of derivatives.

This matters, particularly in today’s environment, where OTC derivatives are castigated for reasons both fair and foul. The gross presentation, for example, fuels critics who believe that too much financial activity serves no useful purpose or that it diverts resources from more productive activities.

To help clear the air, ISDA recently published a paper, Netting and Offsetting: Reporting Derivatives Under US GAAP and Under IFRS. It really helps to explain an issue that’s important but all too often misunderstood.