Perspective on Risk - Dec. 1, 2023

Basel End-game Capital Rule Comment Letter; Financial Stability Reports; First Republic; Financial Conditions Lag; Minsky; Argentina; Risk Management 101; If You Want More

I remember when Sid would yell at me for telling our clients to “go fuck yourself” - he’d say I wasn’t being sufficiently commercial.

Basel End-game Capital Rules

I submitted a comment, 7 pages. If you’d like to read it, here is the link.

Still haven’t heard back on my FOIA request.

Financial Stability Reports

Germany, Italy and Japan have all recently released financial stability reports. All note concerns about securities portfolio losses, real estate valuation, and increasing corporate defaults. The Japanese report also highlights concerns with rising foreign interest rates and the US real estate market, suggesting the later is a source of contagion through “globally diversified funds.”

Taken at their word, the German banks unrealized losses were ~14% of tier 1 capital (but only ~6% at the systemically important banks) while Italy stated losses were only ~2% (smells fishy). Japan did not disclose unrealized loss levels.

The German report expresses the most concern, probably followed by Italy and then Japan. The German report is most open about the level and effect of unrealized losses. Germany and Japan face risks from overvaluation in their real estate markets, while Italy sees a more stable but slowing market. Corporate credit risk is highest in Germany and Italy due to economic pressures and rising interest rates, while Japan demonstrates stability with active lending and stable default rates.

I will take a little dive into the Bundesbank report.

Germany

Deutsche Bundesbank Financial Stability Review 2023

German banks have experienced interest-rate related losses on their securities portfolio. German banks often recorded the value of securities at the lower of cost or market, and the difference between the booked price and the current market price is called the “hidden reserves.”

The abrupt rise in interest rates led to direct valuation losses on interest-bearing securities in the German financial system. In the banking sector, resulting balance sheet losses were mitigated by reducing hidden reserves. However, these reserves were ultimately dissolved and unrealised losses were created.

In the US, under GAAP, it is very difficult to reclassify securities from trading or available-for-sale to held-to-maturity, but in German banking the reclassification of securities is much easier. The German banks have taken advantage of this accounting treatment to reclassify securities from “current” to “long-term” assets.

Over the course of the year, banks were able to reclassify securities to other measurement categories in order to avoid direct write-downs. Primary institutions, which predominantly report in accordance with the German Commercial Code (Handelsgesetzbuch), reclassified securities from current to long- term assets. As a result, the share of securities classified as long- term assets increased from 14% at end- 2021 to 44% at end- 2022, in relation to total securities in the banking book. O- SIIs, which report in accordance with International Financial Reporting Standards (IFRSs), reclassified securities from the fair value measurement categories to the amortised cost measurement category. Over the course of 2022, the share of O- SIIs’ securities measured at amortised cost grew from around 32% to roughly 41%.

This has had predictable effects on institution solvency.

In 2022, among primary institutions, the ratio of the banking book’s present value to its book value fell from 103% to 84% for savings banks and from 108% to 75% for credit cooperatives. … At the end of 2022, the ratio [of the banking book’s present value to its book value] was lower than 100% for more than two- thirds of savings banks and credit cooperatives, pointing to unrealised losses. At the start of 2023, the present value of the banking book was even negative for 15 savings banks and 37 credit cooperatives.

The Bundesbank very directly states:

Current capital reserves would be considerably lower if unrealised losses were realised. …

At present, capital adequacy in the banking system is high; however, banks have dissolved a considerable volume of hidden reserves. These are no longer available to offset losses going forward. For the banking system as a whole, hidden reserves have even turned into hidden losses, which will take time to dissipate.

JohannesBorgen does a great job of highlighting a few things in his twitter post. He points out that German insurers will face considerable solvency risk if the 10 year Bund rises to 3.5%.

Japan & Italy

• Bank of Japan Financial System Report (October 2023)

• Bank of Italy Financial Stability Report, No. 2 - 2023

First Republic

The FDIC issued their Material Loss Review of First Republic Bank. Summary conclusions pretty identical to other recent failures:

• The FDIC missed opportunities to take earlier supervisory actions and downgrade First Republic component ratings consistent with the FDIC’s forward-looking supervisory approach;

• The FDIC assessed First Republic’s uninsured deposits consistent with FDIC policies, but the magnitude and velocity of uninsured deposit outflows warrants the re-evaluation of assumptions and guidance pertaining to uninsured deposits; and

• First Republic was well-capitalized throughout each examination cycle based on defined capital measures, but that the bank’s failure may warrant changes to the guidelines establishing standards for safety and soundness, including the adoption of noncapital triggers requiring regulatory actions.

This last bullet is code for “we ignored unrealized losses in thinking about capital.”

I’m not going to go through the whole report: it has perhaps one of the better descriptions of how a firm eventually dies from a lack of liquidity..

Background conditions

… although First Republic and SVB had very different business models, their geographic proximity and interrelationships amongst their customers likely contributed to the runs on deposits experienced by First Republic. Specifically, many First Republic and SVB customers knew and communicated with each other, and the failure of SVB likely caused concern among customers about First Republic.

First Run on First Republic Deposits:

First Republic experienced a run on deposits beginning [Friday] March 10, 2023, following the SVB failure and negative media attention.

• … the run on deposits was amplified by the ease and speed by which funds can transfer with electronic banking.

• Additionally, … several large money center banks began advising their clients to pull their funds from First Republic.

• As a result, First Republic had to draw significantly on its credit lines with the Federal Home Loan Bank and Federal Reserve.

• On March 16, a consortium of 11 major U.S. banks placed $30 billion in uninsured deposits at First Republic ... Despite the $30 billion in consortium deposits, deposit withdrawals continued before stabilizing during the week ending March 24.

Second Run on First Republic Deposits:

• On April 24, 2023, First Republic reported its financial results from the first quarter of 2023, which … triggered another significant decline in First Republic’s stock price, and resumption of net deposit outflows ...

• April 26, 2023 … the Federal Reserve Bank of San Francisco restricted future Discount Window21 borrowings to overnight terms.

• On April 29, 2023, the Federal Reserve Bank of San Francisco reclassified First Republic’s borrowing status to Secondary Credit and advised the FDIC that adjustments made to collateral values had eliminated any additional borrowing capacity that had existed.

• Combined with continued outflows, the low level of on-balance sheet liquidity, the short term nature of current funding sources, and the lack of additional borrowing capacity rendered First Republic’s liquidity position critically deficient.

• On May 1, 2023, the DFPI closed First Republic and appointed the FDIC as receiver. On the same day, the FDIC announced that it was entering into a purchase and assumption agreement with JPMorgan Chase Bank

I’d note that the P&A was key in insuring that losses were not imposed on the 11 major banks.

Financial Conditions Lag

This BIS paper hit several of my current hotspots: financial conditions summary statistics, economic recessions, and lags. Monetary policy, financial conditions and real activity: is this time different? (BIS)

Key takeaways

• During the current monetary policy tightening episode, financial conditions co-moved closely with policy rates, especially in the initial stages but with some differentiation across countries.

• For advanced economies, the tightening of financial conditions was stronger this time than in the past, while its full impact on real activity appears to be taking longer than usual.

• Financial conditions may continue tightening long after central banks stop raising policy rates, with possible implications for financial stability.

At the beginning of the cycle, the link in AEs is stronger on this occasion: rates and financial conditions have moved in lock step, while in the past there was a notable lag. … Several factors may explain this pattern in AEs.

• One factor could be monetary policy itself – in particular, the large size and the synchronisation of rate hikes.

• A second factor concerns changes in the structure of the financial system. In particular, the rising role of non-banks may have expedited and strengthened the response of financial conditions.

• A third factor could be that the initial exceptional burst of inflation came, to a large extent, from negative supply shocks

It is well known that the transmission of monetary policy to real activity works with lags. What is less clear is how long these lags are, and whether they are longer today than in the past. The range of estimates is wide. Even so, a common rule of thumb would posit that a policy rate hike of 1 percentage point shrinks GDP by approximately 0.3–1.5% over a horizon of around one and a half to two years. About half the impact occurs within the first year. As the first link in the chain and as one would expect, financial conditions respond much faster: indeed, they react immediately and the peak effect is generally reached within the first year.

What could the future path of financial conditions look like?

• The historical regularities suggest that a significant tightening could still lie ahead, even if central banks stop raising policy rates. In AEs and EMEs alike, in some past episodes, corporate spreads spiked and equity valuations plummeted in the second year of the cycle

• Such patterns are more likely to emerge when private debt is high, the inflation burst is more pronounced and asset valuations, especially property prices, are stretched – a picture not dissimilar to today’s.

Minsky-ish Economics

Those who follow along know I like Minsky’s Financial Instability Hypothesis. Minsky asserts that financial crisis’ are endogenous to the system; this is often stated as “stability breeds instability.” For that reason, this paper caught my eye.

Credit Allocation and Macroeconomic Fluctuations (Review of Economic Studies)¹

We study the relationship between credit expansions, macroeconomic fluctuations, and financial crises using a novel database on the sectoral distribution of private credit for 117 countries since 1940. We document that, during credit booms, credit flows disproportionately to the non-tradable sector. Credit expansions to the non-tradable sector, in turn, systematically predict subsequent growth slowdowns and financial crises. In contrast, credit expansions to the tradable sector are associated with sustained output and productivity growth without a higher risk of a financial crisis. To understand these patterns, we show that firms in the non-tradable sector tend to be smaller, more reliant on loans secured by real estate, and more likely to default during crises. Our findings are consistent with models in which credit booms to the non-tradable sector are driven by easy financing conditions and amplified by collateral feedbacks, contributing to increased financial fragility and a boom-bust cycle.

Construction and real estate are considered non-tradeable for the purpose of this paper. This, I think, is their important conclusion (I’ve reformatted to highlight the important statements):

We document that credit expansions lead to disproportionate credit growth toward non-tradable sector firms and households.

• This pattern is in line with theories in which these sectors are more sensitive to relaxations in financing conditions and to feedbacks through collateral values and domestic demand.

The sectoral allocation of credit, in turn, has considerable predictive power for the future path of GDP and the likelihood of systemic banking crises.

• Credit growth to non-tradable industries predicts a boom-bust pattern in output and elevated financial fragility.

• Credit to the tradable sector, on the other hand, is less prone to large booms and is associated with higher future productivity growth.

Our evidence rejects the view that growth in private debt or leverage is uniformly associated with subsequent downturns.

• It suggests that previous work, which could not differentiate between different types of corporate credit, has missed an important margin of heterogeneity.

Without doing further analysis, it doesn’t feel as if credit provision in the US is currently skewed towards the non-tradeable sector, which from the perspective of future financial crisis should be good.

Both papers highlight the endogenous buildup of financial fragility during credit booms. Minsky argued that prolonged economic stability leads market participants to take on more risk, fueling speculative lending booms that eventually end in crisis. Similarly, this paper finds that rapid credit growth is often concentrated in sectors more prone to financial instability, especially construction, real estate, and households.

Minsky emphasized the role of collateral values and asset price feedback loops in amplifying the boom-bust cycle. The paper also finds that credit booms biased toward sectors more reliant on real estate collateral are more likely to end in crisis and falling asset prices.

Minsky saw the seeds of crisis being sown during the preceding boom. This paper shows that the sectoral allocation of credit during booms is indicative of whether the boom will end badly - booms biased toward non-tradable sectors tend to be followed by busts.

Minsky’s work is of course deeper and richer than the above paper. If after reviewing the paper you remain interested, you should read more Minsky.

I did find it strange that, standing on the work of such a giant, his work was neither referenced nor cited.

Argentina

I am not an expert on Argentina, but this is certainly on many people’s agenda.² My only advice is to never by Argentine debt at par. Here are a few things to read if you are interested.

Pro Dollarization (Cochrane)

Start with "why not?'' The dollar is the US standard of value. We measure length in feet, weight in pounds, and the value of goods in dollars.

Precommitment is, I think,  the most powerful argument for dollarization (as for euorization of, say, Greece): A country that dollarizes cannot print money to spend more than it receives in taxes. … must also borrow entirely in dollars, and must endure costly default … if it doesn't want to repay debts. 

Why and How to Dollarize Argentina (Caribbean Progress Studies Institute)

This is a podcast (and transcript) of an interview with Emilio Ocampo, who is tasked to coordinate and execute the transition to the dollar.

How Argentina Could Still Convert to the Dollar (Tyler Cowen)

The question is not how to adopt a new currency, it is how to adopt a new currency and retain a reasonable value for the old one.

A more practical plan, then, would be to borrow lots of money, stabilize Argentina’s fiscal position through a mix of tax hikes and spending cuts, and promise to convert pesos into dollar at some fixed rate. That is essentially how Ecuador dollarized in 2000, and it has stuck.

Chronicle of a Dollarization Foretold: Inflation and Exchange Rates Dynamics (NBER)

We focus on the pre-dollarization period. Our results are as follows. First, the announcement leads to a discrete devaluation on impact. Second, after this jump the devaluation rate also rises relative to the no dollarization benchmark. Finally, the devaluation and inflation rate may rises over time.

Dollarization Dynamics

We show that the resulting transitional dynamics are tantamount to that of a “sudden stop”: consumption of tradable goods fall, the real exchange rate depreciates abruptly by a discrete drop in domestic prices and wages followed by a gradual appreciation from positive inflation. With nominal rigidities the economy first falls into a recession. … The subsequent recovery in activity always “overshoots” the steady state

Risk Management 101

Cromwell's rule

Cromwell's rule, named by statistician Dennis Lindley, states that the use of prior probabilities of 1 ("the event will definitely occur") or 0 ("the event will definitely not occur") should be avoided, except when applied to statements that are logically true or false, such as 2+2 equaling 4.

• You should never allocate zero probability to a (prior) event.

• Always have at least one person arguing the exact opposite of the majority.

If You Want More

Dollar Dominance & Stablecoins

When Jay Newman Talks… US dollar dominance is facing a crypto-yuan hostile takeover (FT Alphaville). This will be discussed in high-level policy circles.

Crypto “dollars” won’t collapse the world financial system, but they could disrupt the cozy greenback-based settlement system. … events currently unfolding in Hong Kong accelerate, CCP-controlled crypto stablecoins and related exchange transfer platforms will eviscerate this prerogative.

On the ICBC Hack

The WSJ had a nice article on this under-reported and under-appreciated story: How a Hack Shook Wall Street’s Multitrillion-Dollar Foundations (WSJ).

On the OCC’s Ex-Fintech Chief's Fake Resume

OCC Ex-Fintech Chief's Fake Resume, DUIs Raise Fresh Questions (Fintech Business Weekly)

On FHLB Reform

FHLBank Reform and Concentration Risk (UponFurtherAnalysis)

Advances to PNC alone totaled $36 billion, representing 47% of the FHLB-Pittsburgh’s total advances and 34% of total assets. … the Pittsburgh FHLB’s advances to PNC represent 637% of the FHLB’s capital.

Greece’s Advice To Germany on Fixing Its Budget Problems

On the Systemic Risk of Unicredit

2023 List of Global Systemically Important Banks (G-SIBs)

Unicredit is no longer systemic

1. Playing around, I uploaded the paper to a LLM Claude and asked it if, as I was perceiving, there were strong echoes of Minsky’s work.

There are some notable parallels between the findings in this paper and Hyman Minsky's financial instability hypothesis:

1. Both highlight the endogenous buildup of financial fragility during credit booms. Minsky argued that prolonged economic stability leads market participants to take on more risk, fueling speculative lending booms that eventually end in crisis. Similarly, this paper finds that rapid credit growth is often concentrated in sectors more prone to financial instability, especially construction, real estate, and households.

2. Minsky emphasized the role of collateral values and asset price feedback loops in amplifying the boom-bust cycle. The paper also finds that credit booms biased toward sectors more reliant on real estate collateral are more likely to end in crisis and falling asset prices.

3. Minsky saw the seeds of crisis being sown during the preceding boom. This paper shows that the sectoral allocation of credit during booms is indicative of whether the boom will end badly - booms biased toward non-tradable sectors tend to be followed by busts.

4. Both highlight that while some credit expansions are sustainable, excessive credit growth financing unproductive investment or consumption can lead to crisis. The paper distinguishes "good booms" biased toward tradables from "bad booms" biased toward non-tradables and households.

5. Minsky thought financial crises often followed periods of risk underestimation. The paper notes that disappointed expectations following defaults, especially in the non-tradable sector, may play a role in turning booms to busts.

In summary, while not explicitly referencing Minsky, the paper provides empirical support for several aspects of Minsky's theory - especially the notions that stability breeds instability, booms sow the seeds of busts, and collateral values play an amplifying role over the cycle. The analysis of sectoral credit allocation dynamics seems highly consonant with a Minskian view of the economy.

2. Maybe McGinn will finally write a special piece for the Perspective!