Perspective on Risk - Feb. 19, 2024
Credit Conditions; The Structure of the Financial System; Bank Supervision; Bank Regulation & Policy; Are Supervisory Focused In The Right Area? Liquidity Developments; Concentration Risk
TL;DR
Credit growth flat YoY; credit conditions still tightening
Bank lending to non-bank financial institutions up; banks retranching into super-senior position
Supervisors still active around counterparty and money laundering controls
Basel Endgame distracting regulars from forward-looking risks
Liquidity and concentration risk issues
Credit Conditions
Credit Growth Has Gone Negative YoY
The blue line is all commercial bank credit; red is commercial real estate; 2000-3Q2023. Credit creation has gone negative on a year-over-year basis for only the second time since 2000.
And Banks Continued To Tighten Lending Standards
The Structure of the Financial System
Whether intended or not, we are witnessing the evolution of the financial system where the regulated banking sector becomes a funder of credit extension in the ‘shadow banking’ or ‘private credit’ sector.
In a (bad) way, this is what happened with subprime - banks sold and lent to SIVs, etc. that purchased the subprime securities. In some cases, the banks hadn’t understood that they were lending as the exposure came through ‘liquidity puts.’
Now, so far, it appears more responsible, with the borrowers being large, well-known intermediaries like Blackrock. In theory, the banks are in something akin to a super-senior position - Blackrock will take losses before exposures come back to the banks. We’ll see.
Lending to Non-bank Financial Institutions
US lenders’ debt to shadow banks passes $1tn (FT)
The amount US financial institutions have loaned to shadow banks such as fintechs and private credit groups has passed $1tn, as regulators warn that growing ties between traditional and alternative lenders could present systemic risks.
That amount is up 12 per cent in the past year, making it one of banking’s fastest-growing businesses when overall loans growth has been sluggish, up just 2 per cent.
For all banks, shadow bank financing now makes up more than 6 per cent of all loans, putting it just above auto loans at 5 per cent, and just below credit cards, which crossed $1tn for the first time just last year, at 7 per cent.
In this new world, banks management of counterparty risk comes to the fore, as it has with collateralized lending to hedge funds.
Private Credit
I’m very glad Steven Kelly of Yale has written Does Private Credit Really Reduce Systemic Risk?, mostly because I was thinking about writing a similar piece (and he does a much better job).
Private credit tends to be relatively duration-matched. Its investors face long lock-up periods. On its surface, this looks like a net stabilizing trend. It’s essentially bank loans without the fickle deposit funding, right? Just ask Apollo CEO Marc Rowan:
“Every dollar, every euro that moves off of a regulated bank balance sheet de-risks the system. […] Everything on a bank balance sheet is levered 10 to 12 times. When you move it to a mutual fund, it gets zero leverage. When you move it to an institutional client, it gets zero leverage. When you move it to a BDC, it gets 1.5 times leverage. And so on and so on and so on. So, every time you move something out of a banking system, you de-lever the system.”
Ok, so, is the growth of private credit—now at about $1.6 trillion and projected to approximately double by 2028—a free lunch? At least systemic-risk-wise?
He makes the following points:
The rise of Private Credit will at the margin give large banks the incentive to shrink.
Funds may reallocate excess savings to more productive investments (an efficiency argument).
A limitation is that Private Credit “ can only reallocate existing money; they can’t create money that banks and the Fed can.”
While not stating it explicitly, and while talking about elasticities, he is making the argument that the presence of large uninsured cash pools can better fund loans directly without funding through opaque bank investments.
And he points to the risk I would worry about - that while v1.0 of Private Credit tends to be less levered and better duration matched, competitive pressures will push towards higher leverage and duration mismatches. He closes with this statement:
The bank’s balance sheet is, in practice, receiving additional protection from the private credit fund’s capital, potentially its collateral, and from its relative skill in, well, private credit. This is banks retranching their place in the economy. Retranching is just banks being good banks as: higher interest rates raise the credit risks and resource demands of various assets; depositors (particularly since last March) are relatively stir-crazy about what’s protecting them on banks’ asset side; and, of course, Basel Endgame.
I’d just add one more point, from my obsession with Corrigan’s Are Banks Special? At the end of the day, liquidity provision comes from the banks and their access to central bank money. Just as with subprime, when the crisis (eventually) comes there will be linkage to the banks (or the Fed setting up a special bailout facility for non-banks).
Robbin Wigglesworth also asked Is private credit a systemic risk? (FT)
Alphaville’s eyes were therefore drawn by a report published this week by Goldman Sachs’ credit analysts examining the systemic risks posed by private credit.
Channel #1: An abrupt rise in financial distress among private debt borrowers leading to wealth destruction and causing an economic downturn or amplifying its severity.
Channel #2: Rising distress among asset managers fueling stress on risk intermediation and a potential fire sale of assets.
Channel #3: Rising distress among end-investors driven by larger than expected liquidity mismatches.
Wigglesworth concludes:
… private credit is too small and too little leveraged to cause major wider problems. When problems do arise, locked-up capital means that the pain is more contained. And if an investor does need to ditch a big private credit fund exposure, they can do so at a discount to another big institution.
Bank Supervision
Reuters is claiming that the Fed has issued three new Matters Requiring Immediate Attention (MRIAs) to Citi on its counterparty risk management practices. Three MRIAs are not much to worry about in the grand scheme of things; large banks probably have a dozen or more at any one time. It does show where the Fed is focused. This has been a focus of the NY Fed since at least the early 2000s, so it is somewhat surprising that some of these issues still exist.
Exclusive: Citi hit by new Fed rebuke, setbacks on consent orders (Reuters)
Late last year, the Federal Reserve sent Citi three notices directing the bank to address in the coming months how it measures risk of default by counterparties in derivative transactions
The three Fed notices sent to Citi late last year are called Matters Requiring Immediate Attention. The requests typically concern deficiencies and banks can have many outstanding MRIAs at any given time, but they are confidential and rarely come into public view.
… They instruct Citi to improve its data and governance around how it sets aside capital to account for counterparty credit risks … relates to data, laying out more than a dozen issues that the bank needs to fix... uses proxies in calculating counterparty credit risk when the data is not available, and the other … governance failings, specifically around lack of clarity over who is responsible in various legal entities of the bank.
Deutsche Bank also has repeat issues in an area of Fed priority, money laundering.
Deutsche Bank Told by Regulator to Fix Controls, Once Again (Bloomberg)
Germany’s financial regulator again refreshed its criticism of the slow progress Deutsche Bank AG has made on addressing deficiencies in its prevention of money laundering.
The latest order, which threatens fines, relates to the bank’s systems for processing transaction data and it has been in effect since late last year, BaFin said in a statement on Thursday.
Lastly, one might expect to hear about supervisory findings related to the underwriting and stress testing of commercial real estate, now that the Fed and OCC are looking more closely at these areas.
Worse Than Clawbacks
China Hands a Suspended Death Sentence to a Former Bank CEO (WSJ)
Tian Huiyu, former president and CEO of China Merchants Bank, was charged with bribery, among other crimes
The sentence has been suspended for two years.
Bank Regulation & Policy
CoCos Didn’t Work / Weren’t Used / Hindsight Is 20/20
Creditors, Shareholders, and Losers In Between: A Failed Regulatory Experiment
In the aftermath of the 2007-08 Global Financial Crisis, regulators encouraged many of the world’s largest banks to [issue] a new type of regulatory instrument … known as a “CoCo,” short for contingent convertible bond.
We leverage insights from economic theory to show that CoCos were doomed from the beginning for two reasons. First, from a finance perspective, providing more equity only stabilizes a wobbling bank in normal times before the market and depositors ask questions about the bank’s health. Once they start asking questions and the bank faces a liquidity crisis (i.e., a bank run), having more equity on the bank’s balance sheet becomes meaningless. Only more liquidity can save the bank from complete collapse. Second, from a game theory perspective, controlling the public availability and flow of information is crucial in times of stress. If the market and depositors can ascertain which bank is weak or how much financial trouble that bank is in, a liquidity crisis will ensue, and that bank is as good as gone. The stigma effect is lethal. Ironically, the trigger mechanism built into CoCos can send a public signal that a bank is on its deathbed. It allows the market and depositors to differentiate between the weak and the strong, nearly guaranteeing a bank’s failure.
Source-of-Strength Doctrine
It Quacks Like TLAC (Karen Petrou)
Mr. Gruenberg was right in 2019 when he mourned the FDIC’s inability to resolve a large regional bank; he’s wrong now if he thinks lots of long-term debt will do the Fed and FDIC’s job for them. The agencies have all the tools they need to resolve super-regionals and they’ve one more knock-out punch to protect taxpayers: enforceable source-of-strength authority. None of these tools were used in the last four failures and the agencies should get their own house in order before mandating anything but urgent repairs at banks already struggling with structural market changes in the higher-for-longer regime.
Are Supervisory Focused In The Right Area?
Unanswered Questions From SVB Crisis
Rajan and Acharya, two consistently thoughtful economists, write The Danger of Forgetting the 2023 Banking Crisis (Project Syndicate)
Apart from die-hard libertarians, no one seems to care much about the extent of the intervention that was needed to rescue smaller US banks in March 2023, nor has there been any broad inquiry into the circumstances that led to the vulnerabilities. As a result, several questions remain unanswered.
“Too big to fail” was bad enough, but now we have “too many to fail.”
To what extent were the seeds of the 2023 banking stress sown by the pandemic-induced monetary stimulus and lax supervision of what banks did with the money?
Did advances by the FHLBanks delay failed banks’ efforts to raise capital?
Are banks that relied on official backstops after SVB’s failure keeping afloat distressed CRE borrowers, and therefore merely postponing an eventual reckoning?
Fixation on Capital Rules Is Distracting From Current Risks
The Risks New Capital Rules Can’t Cure (Petrou)
The agencies have so tightly wrapped themselves around the capital rule’s axle that they are unable to see how many even more critical challenges are going unaddressed.
The collective book reports issued by the Federal Reserve in its semi-annual systemic forecast and the FSOC’s annual reports are remarkably backward-looking. Focused more on not saying anything too frightening and bolstering ongoing initiatives, these tomes have long been and sadly still are poor auguries of risks to come perhaps all too soon.
The first points to the cause of the mid-March failures: not capital shortfalls, but liquidity chasms.
The second FT article is … new forms of embedded financial-system leverage – [that] isn’t even on the regulatory radar. One case in point is that debt is now frequently extended by nonbanks, making the level of a borrower’s leverage opaque to all of its lenders and to regulatory efforts to spot macroprudential trouble spots.
Liquidity Developments
Destigmatizing the Discount Window
The Intersection of Monetary Policy, Market Functioning, and Liquidity Risk Management (Fed. Gov. Barr)
Firms, even those with large stocks of high-quality liquid assets (HQLA), were not sufficiently prepared to monetize these assets—that is, to turn them into cash.
Challenges with monetization can be especially acute for securities designated as held-to-maturity (HTM). … selling even a portion of an HTM portfolio results in a firm needing to recognize losses on the entire portfolio, a hit to capital. The ability to turn HTM assets into cash, particularly when sales are not feasible, is limited by a firm's ability to ramp up access to secured funding sources, which proved problematic in large size last March.
I mean, the simple answer is either to change the accounting rules on tainting a portfolio, or the capital rules to force banks to recognize MTM losses on HTM securities for regulatory capital. Instead, we won’t address those, we’ll just figure out how to better use the Discount Window to allow banks to maintain the fiction of HTM.
I remain focused on how we can improve bank readiness to tap the Fed's discount window.
Sovereign Bond Market Dash for Cash
This first paper shows a well-known phenomenon; when stress arrives you sell what you can, not what you want.
In March 2020, the economic disruptions associated with the COVID-19 pandemic prompted a global dash for cash by investors. This selling pressure occurred across advanced-economy sovereign bond markets and caused a deterioration in market functioning, leading to central bank interventions. The authors show that these market disruptions occurred disproportionately in the U.S. Treasury market and were due to investors’ selling pressures being far more pronounced and broad-based. Furthermore, the authors assess differences in key drivers of the market disruptions across sovereign bond markets, based on an analysis of the data as well as outreach to a range of market participants.
FHLB
‘Pig Butchered’ Bank Drew $21 Million From Federal Backstop Before Collapse (Bloomberg)
They certainly had some fun with the headline.
A Kansas bank that failed last July after its chief executive officer allegedly siphoned off funds to buy cryptocurrency drew $21 million from the Federal Home Loan Bank System shortly before collapsing, according to a regulatory review.
Heartland Tri-State Bank’s sudden use of FHLB financing in its final weeks was an abrupt turnabout, the inspector general of the Federal Reserve and Consumer Financial Protection Bureau found in a Feb. 7 report. In the prior three years, the firm didn’t borrow anything from the US-backed system, which helps support home lending.
Steven Kelly sat down with the Oddlots crew Steven Kelly on Rethinking Bank Rules After the Collapse of SVB. Most of the discussion touched on liquidity topics; the Discount Window, the FHLBs (or FLUBs as he calls them), the end of the BTFP and the term repo facility. Not much new for readers of the Perspective, but a good overview of the issues. Steve and I tend to agree on a lot of issues. Some quotes:
… basically it's hopeless to say ‘Oh, the discount window is going to work,’ once you have a name that's in the headlines.
FHLBs are a lot more commercial in nature than the Fed. But that was sort of the contingency funding plan writ large across the system. And, you know, it sort of works if you need a billion or $5 billion if you're SVB. It doesn't work if you need $40 billion because the FHLBs take government collateral, they take mortgage collateral. If you need to start posting commercial and industrial loans, something like that, or corporate bonds, you’ve got to go to the Fed. And if you're not set up at the Fed because it's annoying to do that, it's too expensive.
Unaligned Settlement Times
Equity settlement is moving to T+1. This has implications for foreign investors USD liquidity needs for settlement.
Crunch Time Nears for FX Traders Grappling With Faster Trading (Bloomberg)
… a shift to halve the settlement time for US equities to just one day is the key concern for many [FX market] participants.
Known as T+1, that change in May will leave the FX market out of sync with its equity peers. Currency trades that usually take two days to complete will need to accelerate to keep up, potentially creating a rush for currencies at the end of the day and increasing the risk of failed trades. Indeed, CLS Group Holdings AG, the world’s largest foreign-exchange settlement firm, says about one third of asset managers aren’t ready yet.
Switzerland-based CLS estimates around $65 billion of trades it processes could miss the cut-off time for next day settlement.
Faster US Stock Settlement Has Currency-Market Anchor Scrambling (Bloomberg)
From an operational risk point of view, there’s issues around the fact these trades could fall out of CLS,” said Gordon Noonan head of foreign exchange trading at Schroders. “It’s a bit of a retrograde step for the market — in an ideal world we would still be able to settle those trades in CLS.”
Concentration Risk
As far back as the Dec. 31, 2021 Perspective, I was citing evidence of ‘liquidity driven markets.’ This Perspective focused on David Merkel’s model of equity returns that was based on changes to investor allocation to equities. In this Perspective, I also linked to a video by Michael Green Lunch at the Club who argued that passive investing is based on assumptions of how markets work that are ‘just not correct. Excerpting from that Perspective:
He argues
On a flow basis, the marginal activity is now passive, and hence weakens the role of ‘active’ management in relative price discovery.
And suggests this causes the following effects:
Increased correlation between securities
Increases in the valuation of securities regardless of fundamentals, as passive share grows
Reduced market elasticity raises risks of extraordinary price movements
Increase in market concentration as momentum leads to largest companies becoming larger
Reduced ability for new firms to become public
One can readily argue that we’ve seen all five of these effects.
Since then, we have only seen the passive share grow. At year-end, the total capitalization of the US market was around $50 trillion. Of that, ETFs focused on US equities totaled around $11 trillion, and mutual funds is another $10 trillion. So that’s now about 42% of assets in ETF or MF. And Morningstar (as reported in Bloomberg) reports that 50% of ETFs and MFs are now passive (from around 43% of a smaller pie of ETF/MF assets). So passive now represents ~20% of the US equity market.1
Now, within the market, concentration in specific firms has also risen to a high.
According to GMO in MAGNIFICENTLY CONCENTRATED (GMO)
The S&P 500 has become an increasingly concentrated index over the past decade, with the top seven stocks now comprising 28% of the total, and the returns of those stocks far outpacing that of the average stock in the index.
According to JPMorgan Quants Warn of Dot-Com Style Concentration in US Stocks (Bloomberg):
The top 10 stocks in the MSCI USA command a higher valuation premium relative to the rest of the index when compared to the height of the dot-com bubble, even though valuations in the early 2000s were significantly more extreme than now, the strategists said.
Further from GMO:
Active managers are systematically underweight the very largest stocks, and this is particularly true of concentrated high active share managers. If the purpose of a benchmark is to be a fair measuring stick to determine whether a manager has skill, a market capitalization-weighted index is not a good benchmark for most active managers, and this becomes increasingly true as the index becomes more concentrated. History suggests that the next decade is likely to see a reversal of the recent pattern with the capitalization-weighted version of the S&P 500 underperforming the equal-weighted version. In such an environment, active managers will suddenly look much better versus the S&P 500 and other capitalization-weighted benchmarks.
Now, to be clear, if you had taken the earlier warnings as gospel you would clearly have missed out on a pretty significant run in the ‘magnificent 7’ stocks - the overweight have gotten even fatter.
In looking at this topic, it appears some Fed economists were interested in this development as far back as 2018.
The Shift from Active to Passive Investing: Potential Risks to Financial Stability? (Fed Board)
The past couple of decades have seen a significant shift in assets from active to passive investment strategies.
Overall, the shift from active to passive investment strategies appears to be increasing some types of risk while diminishing others:
The shift has probably reduced liquidity transformation risks, although some passive strategies amplify market volatility, and passive-fund growth is increasing asset-management industry concentration.
We find mixed evidence that passive investing is contributing to the comovement of assets.
Finally, we use our framework to assess how financial stability risks are likely to evolve if the shift to passive investing continues, noting that some of the repercussions of passive investing ultimately may slow its growth.
Random Research
Financialization and assetization: Assets as sites of financial power struggles
Despite significant overlap, scholarship often distinguishes the concepts of financialization and assetization. While there are historical, ontological and conceptual reasons for this distinction, we argue that this may limit both perspectives’ analytical potential. In this paper, we develop a shared research agenda that brings together analytical strengths and core insights of both perspectives. We propose to use three notions of financial power developed in financialization scholarship – instrumental, structural and infrastructural power – and apply them to different sites of power struggles that are linked to the asset form: the challenge to create durable returns, the challenge to calculate and distribute risks, and the distribution of wider societal power relations linked to the control of larger asset classes. We illustrate the proposed perspective in three vignettes on topics pertinent to scholars working within both strands of literature: green and impact assets, asset management and housing.
Don’t @ me if my figures are a bit off. The trend holds.