Perspective on Risk - April 27, 2023 (Banking Update)

Bank Sup Politics; CS Is Still A Risk; The Existing Rules Are Unusable; Kaplan; What Gillian Tett Learned; Tett & Fuhrman Debate; Reg Can’t Prevent Crisis; IR Hedging; Runs; Snark

I’m sending this out in advance of tomorrow’s report from the Fed on their review of the learnings from the SVB failure. I will write up my reaction to that after I have a chance to review. Trying to clear the queue.

Fed Bank Supervision Politics

The Federal Reserve, in the bank supervision space, is an interesting triangle of politics. Technically, supervision conducted by the Reserve Banks is done under delegation from the Board of Governors. The three players traditionally are Board staff, the NY Fed, and the other 11 regional Reserve Banks. The NY Fed is a bit different from the other Reserve Banks due to the large systemic banks in the NY district, as well as the other Fed functions such as the Markets desk and Fedwire that are all run out of NY.

The politics is usually a coalition of convenience where two of the three align to keep the power of the third in check. Following the GFC, it was convenient for the Board to blame the NY Fed for ‘mistakes’ as this kept Congressional attention away from DC. The 11 Reserve Banks generally aligned with the Board as they were angry at the NY hubris, and desirous of getting a bigger say in supervision (such as by becoming a ‘center of excellence’).

Now, Bloomberg has a piece Fed Bosses Steered Examiners Away From Probing Problems Like SVB where the smaller Reserve banks are seeking to apportion some of the blame with DC Board staff.

“The question is not what rules were changed, but what the attitude toward supervision was at the Board of Governors,” said former Kansas City Fed President Thomas Hoenig, who also served as vice chairman of the Federal Deposit Insurance Corp. from 2012 until 2018.

Examiners at the regional Fed banks found they were being asked more questions about why they were devoting so much time to lenders that were deemed too small to be systemically risky, according to several of the people. They say the bar was raised for escalating concerns via formal supervisory actions. Attempts by regional staff to flag novel kinds of risk, from crypto to new financial technologies, didn’t result in supervisory direction from the Washington board.

Interviewees with hands-on experience of supervision describe persistent friction with the Fed Board, as it gradually shifted its approach toward too-small-to-threaten banks.

“Not only were the rules weakened, but there was a change in supervision to much lighter supervision, with messaging that fewer issues should be escalated, that examiners should not be as intrusive for this size-class of banks,” Brainard said at an April 12 event in Washington, in one of her first comments on the topic. “In retrospect, we know that was a mistake.”

I find it all delicious.

And IMHO the Federal Reserve does not have a comparative advantage in the supervision of small banks - they should be left to the FDIC. The Fed does have a comparative advantage in determining what risks are systemic, and in understanding the most complex banks. The mistake was either 1) not understanding that SVB was systemic, or 2) declaring SVB was systemic, and not using existing regulatory powers, when it was not.

Anyway, rethinking Board staff and a bit of power flowing back to the Reserve banks would be a positive.

Credit Suisse Is Still The Systemic Risk

So let’s be clear, there is still considerable execution and legal risk surrounding the forced acquisition of Credit Suisse by UBS. Let’s start with what CS has to say in its risk disclosures:

If the merger were not to be completed, our financial viability could be jeopardized, which would raise substantial doubt regarding our ability to continue as a going concern.

The acquisition is subject to a number of conditions, predominantly around UBS either acquiring CS or disposing of its assets. These approvals are not just from the Swiss authorities, but from polities globally. I generally do not view this as a particularly difficult risk to overcome, but it is there nonetheless.

The Swiss prosecutors are investigating whether the deal broke criminal laws: UBS and Credit Suisse shares drop as Swiss prosecutor investigates takeover.

The office of the attorney general said on Sunday that the prosecutor opened an investigation into the state-backed takeover of Credit Suisse by UBS Group last month, looking into potential breaches of the country's criminal law by government officials, regulators and executives at the two banks.

Some of the AT1 bondholders have filed lawsuits against Credit Suisse and UBS, claiming that the write-down was unlawful and unfair. They argue that Credit Suisse’s capital ratio was above the trigger level at the time of the deal and that the write-down was motivated by UBS’s desire to reduce its acquisition cost and avoid diluting its shareholders3. They also allege that the Swiss authorities pressured Credit Suisse to accept the deal and did not protect the interests of the bondholders. The acquisition may face legal risks and delays if the courts rule in favor of the bondholders or grant them an injunction to block the deal.

Evidently, The Existing Rules Are Unusable

It is worth noting that the SVB resolution did not use the mechanisms crafted following the global financial crisis.

And neither did the resolution of Credit Suisse, which ignored the EU resolution playbook.

I wonder whether the ‘living wills’ were worth a damn.

I’m Still Hard Pressed To Believe SVB Was A Systemic Risk

According to Kaplan the current bank crisis “is in the second or third inning, not the seventh inning,”

Why the Banking Mess Isn’t Over (WSJ)

Nick Timiraos has listened to a recent Evercore ISI interview with Robert Kaplan, the former President of the FRB Dallas, and channeled it into this piece from the WSJ. Kaplan is always an interesting read/watch.

“What’s going on nationwide is every one of these banks has either frozen their loan-to-deposit ratio or, more likely, is very intent on shrinking it,” said former Dallas Fed President Robert Kaplan on a call hosted by investment-banking advisory company Evercore ISI this month. “That is why a lot of small and midsize businesses in this country are getting a phone call saying, politely, ‘At the end of the year, we are not going to be able to give you a loan anymore, or we’re going to reprice your loan.’”

Kaplan argues that this is occurring not because of the deposit run, but rather because the SVB stress has woken banks up to the coming risks in their lending portfolios.

More bank executives realize they may face losses down the road on riskier commercial real-estate loans and commercial and industrial loans for which they haven’t set aside enough of a cushion.

What Gillian Tett Learned From Banking Crises

What I learnt from three banking crises (FT)

Gillian Tett (remember her?) has thoughtful reflections on how the speed of information has changed contagion risk

This latest panic was different — and more startling — than I have seen before, for reasons that matter for the future. The key issue is information.

• During the 1997-98 Japanese turmoil, I would meet government officials to swap notes, often over onigiri rice balls. But it was a fog: there was little hard information on the (then nascent) internet and the media community was in such an isolated bubble that the kisha (or press) club of Japanese journalists had different information from foreigners.

• A decade later, during the global financial crisis, there was more transparency: when banks such as Northern Rock or Lehman Brothers failed, scenes of panic were seen on TV screens. But fog also lingered: if I wanted to know the price of credit default swaps (or CDS, a financial product that shows, crucially, whether investors fear a bank is about to go bust), I had to call bankers for a quote; the individual numbers did not appear on the internet.

• [Today] CDS prices are now displayed online (which mattered enormously when Deutsche Bank wobbled). We can use YouTube on our phones, anywhere, to watch Jay Powell, chair of the US Federal Reserve, give a speech (which I recently did while driving through Colorado) or track fevered debates via social media about troubled lenders. Bank runs have become imbued with a tinge of reality TV.

She then relays five useful insights:

1. No bank is an island - The first lesson is that when a bank implodes, this is almost always a symptom — not a cause — of something askew in the wider financial world, affecting other institutions.

2. Don’t fight the last war - The second lesson is that investors and regulators often miss these bigger structural flaws because they — like the proverbial generals — stay focused on the last war.

3. Safety is a state of mind - A third, associated, lesson is that items considered “safe” can be particularly dangerous because they seem easy to ignore.

4. Beware blind spots - Fourth: bankers need to recognise that cultural patterns matter. They often ignore this — in themselves and others — because they are trained to focus on hard numbers. But it mattered hugely with SVB. Its culture emulated its client base, which was mostly from the tech and start-up worlds, which tend to have a “skew” in their concept of risk

5. Don’t bet against bailouts  - The fifth lesson is that banks are never “just” businesses. In calm times, bankers dress themselves up in free-market language and talk about their profits and business plans as if they were selling hamburgers, laptops or holidays. But that free-market mantra vanishes when panic erupts, since governments almost always step in to protect some depositors, buy bad assets or even nationalise entire banks.

Is The Banking System Safer Than In 2008

Gillian Tett and Jason Furman debate this question in an Open to Debate podcast. Excellent debate and worth the 50 minutes to listen. Tett hits several nails directly on the head.

[Tett] I think the reality is that 2008 reforms did some really good things they missed a lot and they also had some unintended consequences one of which [is that] it's become harder to find market makers in the treasury bond markets which means that when a crisis hits um there aren't people to act the lubricant to keep the wheels of the system going and you'd only get a much worse crisis in the treasury bond market … that's a very very serious issue that we've not seen play out properly yet but we could see play out quite soon

[Tett] The really big issue is this if you're arguing that the fact we've not had anything more than Silicon Valley break in the last decade is a sign that the system is fixed and or safer then I think you're ignoring the really obvious point that we've had the Fed provide this extraordinary safety blanket putting foam on the runway as Tim Geithner used to say on a massive unprecedented scale in the last 15 years and that has in many ways protected the system from many of the bigger shocks I mean we've had you know the FED balance sheet has increased tenfold that is a big big number and that's not even counting what the ecb's done what the bank of England done or most critically what the bank of Japan has done and is still doing and I should say by the way we've not really had proper quantitative tightening yet because much of what the FED has been doing has been offset by the fact that bank of Japan is still going for quantitative easing and so if you look at it globally you've not really had yet a proper quantitative tightening period for any length of time

we've not had a proper test yet because we've had so much foam on the runway

[Tett] we cannot keep putting foam on the runway indefinitely they're trying to take the foam off the wrong way because they know how badly it's assorted the financial system

[Fuhrman] in March 2023 they stood up emergency lending facilities because Banks were potentially going to have runs and run out of money and they said

we're willing to lend to you in ways that maybe we shouldn't even lend to you but we're sort of desperate enough that we need to do it

[Tett] {Point 1:] By keeping money super super cheap to help the economy what it did to finance is turn everybody into someone who's going to play the carry trade and so almost every aspect of financial institutions have been engaged in borrowing short and borrowing cheaply to invest in higher yielding assets with duration.

Point two is by essentially having interest rates super low for the best part of 15 years what you've done is stop defaults in the real economy and the credit losses have been tiny across the financial system and … now you start raising interest rates you start taking the foam off the runway … you're going to have a lot of defaults going forward

The noose is tightening.

Regulation Can’t Prevent the Next Financial Crisis

Tyler Cowan writes in Regulation Can’t Prevent the Next Financial Crisis (Bloomberg)

I have bad news: Regardless of what laws are passed, or which regulations are issued, banking crises will recur — and not infrequently.

the reason stems from nature of regulation itself … [the] more restrictions imposed on banks will inevitably lead to more financial intermediation taking place outside the banking system.

It is easy enough to say, “We can write regulations so this won’t happen again.” But those regulations won’t prevent new kinds of mistakes from happening.

So true.

There were some things that we clearly understood when I worked at the NY Fed.

1. All risks ultimately come back to the banks. As Gerry Corrigan wrote, banks are special.

2. Financial markets will drive risk-taking to where it is most capital efficient. At times this will be in banks (so the risk is direct) and at times it will be outside the banks (and hence become counterparty risk)

3. At the Fed, we only had direct authority over the banks, and at times had very limited insight into non-banks.

4. At the end of the day, the sovereign was bearing the deepest tail risk in the financial sector. Bank earnings and capital absorb first losses, then the FDIC insurance fund, but at some level the losses can become so large they are a sovereign issue.

Banks & Interest Rate Hedging

Do Banks Hedge Using Interest Rate Swaps?

We ask whether banks use interest rate swaps to hedge the interest rate risk of their assets, primarily loans and securities. To this end, we use regulatory data on individual swap positions for the largest 250 U.S. banks. We find that the average bank has a large notional amount of swaps-- $434 billion, or more than 10 times assets. But after accounting for the significant extent to which swap positions offset each other, the average bank has essentially no net interest rate risk from swaps: a 100- basis point increase in rates increases the value of its swaps by 0.1% of equity. There is variation across banks, with some bank swap positions decreasing and some increasing with rates, but aggregating swap positions at the level of the banking system reveals that most swap exposures are offsetting. Therefore, as a description of prevailing practice, we conclude that swap positions are not economically significant in hedging the interest rate risk of bank assets.

Limited Hedging and Gambling for Resurrection by U.S. Banks During the 2022 Monetary Tightening?

We analyze the extent to which U.S. banks hedged their asset exposure as the monetary policy tightened in 2022. We use call reports data for interest rate swaps covering close to 95% of all bank assets and supplement it with hand-collected data on broader hedging activity from 10K and 10Q filings for all publicly traded banks (68% of all bank assets). Interest rate swap use is concentrated among larger banks who hedge a small amount of their assets. Over three quarters of all reporting banks report no material use of interest rate swaps. Swap users represent about three quarters of all bank assets, but on average hedge only 4% of their assets and about one quarter of their securities. Only 6% of aggregate assets in the U.S. banking system are hedged by interest rate swaps. We also find limited hedging of interest rate exposure by publicly traded banks and by banks which report the duration of their assets. The use of hedging and other interest rate derivatives was not large enough to offset a significant share of the $2.2 trillion loss in the value of U.S. banks’ assets (Jiang et al. 2023). The duration of bank assets increased during 2022, exposing banks to additional interest rate risk. We find slightly less hedging for banks whose assets were most exposed to interest rate risk. Banks with the most fragile funding – i.e., those with highest uninsured leverage -- sold or reduced their hedges during the monetary tightening. This allowed them to record accounting profits but exposed them to further rate increases. These actions are reminiscent of classic gambling for resurrection: if interest rates had decreased, equity would have reaped the profits, but if rates increased, then debtors and the FDIC would absorb the losses.

Runs

Social Media as a Bank Run Catalyst

Social media fueled a bank run on Silicon Valley Bank (SVB), and the effects were felt broadly in the U.S. banking industry. We employ comprehensive Twitter data to show that preexisting exposure to social media predicts bank stock market losses in the run period even after controlling for bank characteristics related to run risk (i.e., mark-to-market losses and uninsured deposits). Moreover, we show that social media amplifies these bank run risk factors. During the run period, we find the intensity of Twitter conversation about a bank predicts stock market losses at the hourly frequency. This effect is stronger for banks with bank run risk factors. At even higher frequency, tweets in the run period with negative sentiment translate into immediate stock market losses. These high frequency effects are stronger when tweets are authored by members of the Twitter startup community (who are likely depositors) and contain keywords related to contagion. These results are consistent with depositors using Twitter to communicate in real time during the bank run.

Academic Article On The Public/Private Tension On Banking

Risk, Discretion, and Bank Supervision

This article argues that bank supervision sits at the center of two foundational tensions in the governance of American finance. The first is the extent to which the financial system is controlled by public actors (i.e., the government) or private actors (i.e., the banks). The second is the extent to which the contest for that control occurs through bright-line rules or through the exercise of regulatory discretion. On the first tension, this article argues that supervision is the public and private participation in financial risk management such that public actors cannot relinquish control of residual risk while private actors do not relinquish control of frontline risk management. Risk management in that sense is shared, but not shared equally: bank supervisors represent a government that has essentially guaranteed the resilience of the financial system through formal and informal commitments to a variety of private actors, including the banks themselves. Supervision is the part of the government that is created and evolves, however imperfectly, to manage those relationships, those guarantees, and those commitments, each evolving in turn. The second tension, between rules and discretion in managing those commitments, represents the defining ethos of bank supervision. The process of supervision is therefore importantly distinct from the laws promulgated by Congress or the regulations written by the banking agencies themselves. Nor is bank supervision the verification of compliance with either laws or regulations, but is instead about the flexible use of discretion, within a system whose boundaries are defined by rules that are intentionally broad and vague. Using the rich history of supervision in the United States from the antebellum period to the present, this article presents a theoretical conception of supervision as the space where bankers and the government engage each other in sometimes cooperative, sometimes contentious disputes with substantial influence on the direction of financial and economic policy.

Snark