Perspective on Risk - April 13, 2024
G-SIB resolution; Random Liquidity Stuff; Risk Attention & Perception; The Real Risk Regulators Are Concerned About
The Orderly Resolution Of Globally Systemic Banks
Stefan Takes The Helm At FINMA
Stefan is a former FRBNY colleague who has had a rather illustrious career in supervision. He now has taken the extremely important job of regulating UBS. Excellent hire by them.
On at least one dimension, UBS is the most systemically important institution in the world.
As I have stated before, all banks in a fractional fiat system are to some degree extensions of the sovereign. There is always SOME tail risk born by the sovereign. By this measure, UBS is by far the most systemic institution. Here are the top 5 institutions sorted by assets/country GDP.
For reference, the large Chinese banks are 20-25% of GDP, and the largest US bank is only 14% of US GDP.
Stefan Walter to become new CEO of FINMA
Switzerland Is Reworking Its Rulebook to Stop Another Banking Meltdown
Walter is also a former secretary general of the Basel Committee on Banking Supervision and senior vice president at the Federal Reserve Bank of New York, two of the most significant bodies in the world of financial oversight.
He helped build a system at the ECB which challenged banks on the risks they were taking. That approach continues to be seen, for instance in the recent crackdown on the leveraged lending businesses at Deutsche Bank, BNP Paribas SA and others.
Gruenberg Asserts US Can Resolve A G-SIB (or SIFI)
Addressing Too big to fail: FDIC update on orderly resolution of global systemically important banks (Youtube; Peterson Institute)
FDIC Chair Gruenberg and Tobias Adrian, former NY Fed economist and colleague and currently the financial counselor and director of the Monetary and Capital Markets Department at the IMF, led the morning session.
The nominal reason for the conference was the release by the FDIC of Overview of Resolution Under Title II of the Dodd-Frank Act. Here is the text of Gruenberg’s remarks.
Now, as I indicated, the ability of the FDIC and other US regulatory authorities to manage the orderly resolution of large, complex financial institutions remains foundational to US financial stability.
…
Let me be clear that an orderly resolution, an orderly failure, is far more preferable to the alternatives, particularly the alternative of resorting to taxpayer support to prop up a failed institution or to bail out investors and creditors.
He has to say this, doesn’t he. He can’t come out and say that it is trivial or unimportant. He can’t for political reasons say ‘but of course we will use taxpayer resources to prevent a bigger catastrophe.’ We have to pretend that there is market discipline in place even for these large institutions.
With this paper, the FDIC is reaffirming that, should the need arise, we are prepared to apply the resolution framework that the FDIC and other regulatory authorities in the United States and globally have worked so hard to develop over these past years.
Listen to what we say, not what we do. Let’s refer back to our previous discussion of UBS. UBS represented 200% of Swiss GDP. By contrast, SVB, which in the US received the systemic risk exemption, represented less than 1% of US GDP.
He then, for some reason, decides to throw the Swiss under the bus.
This paper is particularly timely in light of the decision by Swiss authorities last year not to place Credit Suisse into a resolution process … [and] instead, the Swiss chose to facilitate an open institution acquisition of Credit Suisse with public support.
So let’s again look at the aforementioned asset/GDP ratio. JP Morgan is about 16% of GDP. In total, the eight US SIFIs would total ~65% of US GDP. So I think that these remarks, which of course got press coverage, was unnecessary (and frankly downright rude).
Now, of course any bank can fail. The question is whether it can fail in a way that does not uncontrollably spillover to other financial institutions and significantly harm economic performance. And here, perhaps, the US has made some headway. What the FDIC document lays out is an approach called the Single Point of Entry resolution strategy. Gruenberg lays out in considerable detail the approach the FDIC will take.
In a Single Point of Entry resolution, only one legal entity - the parent holding company of the organization - is placed into resolution. The ownership interests in the underlying subsidiaries of the company are transferred from the failed parent, from the failed holding company, to a new bridge financial company under the control of the FDIC.
Under the Single Point of Entry strategy, material subsidiaries remain open and operating while we proceed through an orderly resolution. This protects depositors, preserves value, and promotes financial stability.
In a Single Point of Entry resolution, the failed holding company's shareholders and unsecured creditors are not transferred to the bridge financial company. They become claimants against the receivership and they will ultimately absorb the losses of the firm. There would be no taxpayer support, and the board and senior executives of the failed firm would be removed.
This is important because, up until now, the FDIC had power to place the US banks into receivership, but not the US holding company. That was the decision of the companies Board, and they may have had viable reasons for not declaring bankruptcy. This was clearly an issue when Lehman failed, as the regulators did not have the authority to put the HC into receivership but could only use ‘moral suasion’ to have the company’s Board make that determination.
Now, the operational process to execute on this authority looks cumbersome, but I suspect that in reality it would work pretty efficiently. A G-SIB (or SIFI) will not fail unexpectedly overnight (like SVB) so there will be runway for the relevant policymakers (principally Treasury) to get on board, and for the lawyers to line up the execution of the ‘three keys’ approach.
When a G-SIB approaches failure, the FDIC and other US authorities would take up that specific case... It's a multi-agency process, and the statutory factors guiding this decision are clearly laid out in Title II of the Dodd-Frank Act.
… This process is often referred to as the "three keys" process because it requires recommendations from two federal agencies, the Federal Reserve and the FDIC in the case of most of the US G-SIBs, followed by a determination of the Secretary of the Treasury, in consultation with the President, to actually commence a Title II receivership.
Part of the decision-making is a determination that using Title II would mitigate the adverse effects of the firm's failure and resolution in bankruptcy.
I was quite interested in how the FDIC proposes to exit from a G-SIB resolution.
The FDIC expects that the most likely mechanism for exiting resolution will be what we call a "securities-for-claims exchange." In this approach, new debt and equity securities in the successor company or companies are distributed to the former creditors of the failed firm to satisfy the claims against the receivership. They'll be taking big losses, by the way, in this process.
Adam Posen of Peterson closed out the session with a number of questions:
Does making the orderly resolution seem more tangible, more doable, affect the willingness of policymakers to be preemptive? (probably somewhat)
Does this provide any behavioral pressure on the banks or on investors to make them behave differently? (remains to be seen)
Are all participants operationally ready to execute (they weren’t in the SVB case)?
Do you have all of the powers that are needed? (this is a big step forward)
Are investors actually prepared for what it means when TLAC, long-term debt, … are being converted? (probably not, as the Swiss example suggests)
I started out this post wanting to be substantially more cynical and snarky in my response than where I have ended up. The FDIC (and other US authorities) appear to be making a good-faith effort to put in place a possible process. And from a practical point of view, if anything this will make the FDIC more comfortable (and perhaps even intransigently insistent) on using this process.
I would note that the Federal Reserve still has not responded to my FOIA request for the information on the systemic risk determination wrt the regional bank failures.
Liquidity
Money Market Funds
This is possibly an important development to monitor. With new rules coming into effect, there may be a material shrinkage in institutional Prime Money Market Funds. Where this money goes remains to be seen.
Managers to shut or convert $220bn of US money market funds before rule change (Bloomberg)
The $674bn US institutional prime money market funds sector is set to shrink by at least one-third this year, as large investment firms shut down these vehicles rather than pay for upgrades needed to meet new regulations.
Under the new rules, institutional prime funds must impose a fee on departures whenever net redemptions top five per cent of total net assets in a single day.
Discount Window Liquidity
Bank Liquidity, Regulation, and the Fed's Role as Lender of Last Resort (Fed-Bowman)
Bowman asks some important questions that relate to the changing nature of the financial system:
As activities continue to migrate out of the regulated banking system, what are the implications of more activity occurring outside the banking system as it relates to the effectiveness of the discount window as a tool?
Are there ways in which the Fed can enhance the technology, the operational readiness, and the services underpinning discount window loans to make sure that they are available when needed?
Are there changes that need to be made to support contingency liquidity on the borrower side?
The first bullet is addressed by one of my favorite papers, Corrigan’s Are Banks Special? If any of you are at the Board, perhaps send her the paper. You can also refer her to read former Fed. Gov. Olson’s 2006 Are Banks Still Special? Perhaps it is time for yet another refresh.
To address the second and third bullets, part of the standard prescription now is to have the banks preposition collateral at the Discount Window. Bowman does have a more nuanced view than is typically articulated:
The notion of required collateral pre-positioning has also been proposed as a complementary liquidity requirement for banks, in part to ensure greater liquidity certainty to balance perceived "runnable" funding sources, as with SVB's significant proportion of uninsured deposits. While this could be an effective approach, we do not fully understand the consequences of a new pre-positioning requirement …
I continue to believe that this is routed in an out-dated understanding and reliance on Bagehot. To address uninsured deposits in the regulated banking sector, a more efficient and effective was would be for the Federal Reserve to require banks to purchase priced liquidity insurance from the Fed. See Perspective on Risk - May 19, 2023 (Bagehot is out of date) and Perspective on Risk - January 29, 2024 (Wonkish Central Banker Stuff)
Internal Liquidity In A Crisis
NY Fed economists have penned a blog article Internal Liquidity’s Value in a Financial Crisis that discusses a staff paper The Value of Internal Sources of Funding Liquidity: U.S. Broker-Dealers and the Financial Crisis.
They find there is an advantage to being a bank-affiliated broker-dealer.
The analysis reveals that affiliation with a BHC makes broker-dealers more resilient to the aggregate liquidity shocks that prevailed during the GFC. This results in these broker-dealers being more willing to hold riskier securities on their balance sheet relative to broker-dealers that are not affiliated with a BHC.
Bank affiliation should lead to more intermediation in a crisis:
Our main result provides evidence that broker-dealers that are not associated with BHCs dramatically re-structured their balance sheet during the GFC, pivoting away from illiquid assets and toward more liquid government securities. Dealers associated with BHCs did not need to undergo such extreme changes in part because they had access to internal liquidity. This allowed BHC-affiliated dealers to provide more intermediation services in a range of financial markets that were under stress, likely reducing the extent of the disruptions.
FHLB
The GAO has issued Federal Home Loan Banks: Actions Related to the Spring 2023 Bank Failures.
We were asked to review the role of the FHLBanks with regard to the recent bank failures. This report provides information on the FHLBanks’ funding to the failed banks, their communication and coordination with FDIC and the Federal Reserve System (the failed banks’ primary federal regulators), and repayment of the failed banks’ outstanding advances.
The report provides some interesting color on the actions of the FHLBs in monitoring the credit risk posed by the banks, and the interactions between the FHLBs and the Federal Reserve. Otherwise, unremarkable.
Risk Perception
Market discipline is one of the central tenets of regulation. We saw that in the FDIC proposal discussed above. In general, market discipline is thought of from a creditor perspective, but a related line of research relies on equity market investor behavior. In fact, changes in equity prices (and the related price/book ratio) is one of the more effective leading indicators of bank distress.
NY Fed economists published two pieces on investor attention during and following the regional bank crisis. They found that the bank market only paid attention when rating agency downgrades occurred, and investors seemed to rationally read across from the banking sector to possible risks in the life insurance sector.
The Fed Board published an interesting piece looking at risk perceptions around commercial real estate, and found that, conditioned on implied volatility, the GFC did not materially change LTV terms.
Limited Investor Attention & Discipline
Investor Attention to Bank Risk During the Spring 2023 Bank Run (NY Fed)
We examine how investors’ perception of bank balance sheet risk evolved before and during the March-April 2023 bank run. To do so, we estimate the covariance (“beta”) of bank excess stock returns with returns on factors constructed from long-short portfolios sorted on shares of uninsured deposits and unrealized losses on securities.
We find that the market’s perception of bank risk shifted in both the time series and the cross-section. From January 2022 to February 2023, both factor betas were mostly insignificant, but after the bank run started, they became positive and significant for all banks on average.
However, in the cross-section, only the factor betas of banks put on downgrade watch on March 13 were significant, consistent with our finding that this announcement was informative. When additional banks were downgraded in April, their factor betas also became significant, even though we find the April announcements to be noninformative for these banks. We suggest that investors with limited attention focused on the banks included in the April announcements to update their priors on balance sheet risk.
A Retrospective on the Life Insurance Sector after the Failure of Silicon Valley Bank (Liberty Street)
In this post, we examine the possible factors behind the reaction of insurance investors to the failure of Silicon Valley Bank.
Our first hypothesis is that the size of life insurers’ unrealized losses on bond investments in 2022 relative to total adjusted capital may have played a role in driving insurance investors’ response to the failure of Silicon Valley Bank. … We hypothesize that the size of withdrawable liabilities relative to total liabilities could be an additional factor behind insurance investors’ concerns after the failure of Silicon Valley Bank. … we hypothesize that the size of variable annuities with minimum guarantees to total liabilities could be a third factor explaining investors’ response to the failure of Silicon Valley Bank.
In particular, insurance firms with unrealized losses exposure, withdrawable liability exposure, and variable annuity exposure above the median experienced negative cumulative returns that are 8 percent, 4 percent, and 5 percent lower than below-median firms, respectively.
Risk Perception and Loan Underwriting in Securitized Commercial Mortgages (Fed Board)
We use model-implied volatility to proxy for property risk perceptions in the commercial real estate lending market. Although loan-to-value ratios (LTVs) unconditionally decreased following the Global Financial Crisis, LTVs conditioned on implied volatility and other theoretically motivated fundamental determinants of optimal leverage show no conclusive trend before or after the crisis. Taking reported property and loan attributes at face value, we find no clear pattern of unwarranted credit being extended to commercial real estate assets. We conclude that systematically higher LTV decisions pre-crisis would have primarily stemmed from risk misperceptions rather than imprudent practices. Our findings suggest that the aggregate LTV level should be interpreted as a proxy for lending standards only after controlling for aggregate risk perceptions, among a host of asset and lending market factors. Our findings also highlight the importance of measuring and tracking aggregate risk perceptions in informing regulators and policymakers.
The Real Risk
ECB staff in uproar after lunch canteen downgrades olive oil (Politico)