Perspective on Risk - March 11, 2024
Financial System Structure; Take The Over (on Basel Endgame); Troubled Bank List; One year later: Lessons learned from the March 2023 bank failures; GAO's Recommendations To Improve Bank Sup; More
Something of a grab bag this week.
Changes To Financial System Structure
Levine Gets Around To The Re-tranche
So, if you’ve been following along, I’ve been discussing changes to the structure of financial intermediation. Steven Kelly has coined the phrase “the great bank re-tranche” for what is occurring.
Matt Levine got around to the issue in Trading Desks Trade Less, Lend More (Bloomberg Money Stuff) and does his usual excellent job of describing things with many more words than I use. He appears to have been prompted to write his piece by this IFR article, Prime brokerage: the multi-billion dollar cash cow redefining banks’ trading divisions.
The IFR article starts with a few facts:
Prime brokerage accounted for more than half banks’ equities revenues in 2023, a record share that underlines how providing financing and market access to hedge funds is simultaneously anchoring and redefining banks’ trading divisions.
The top 30 banks made an unprecedented US$32bn in prime services and futures in 2023, according to Vali Analytics, up from US$26bn in 2020 when activities represented 43% of equity trading revenues.
The benefits of this boom have mostly accrued to the biggest firms. Goldman Sachs, JP Morgan and Morgan Stanley hold a market share of nearly 60% … and are each closing in on US$1trn in client balances.
IFR suggests
… the high-profile exits of Deutsche and Credit Suisse from prime have thinned out the competition … [and] the looming implementation of Basel III capital rules … may constrain the largest prime brokers … [causing them to forgo] less profitable client business in a bid to improve returns.
And while they are talking their book, they highlight that the risk here is competition on leverage and terms.
The top prime brokers, for their part, say some smaller firms are guilty of lowballing margin requirements to win client business.
“Despite the vocal scrutiny from the regulators, we're surprised to still see some fairly aggressive behaviour from banks competing on margin terms that we wouldn’t agree to. We don’t think that’s prudent or sustainable in the long term,” said Zlotnik.
So back to Levine.
In 2024, a bank’s trading division is increasingly in the business of lending the bank’s money to hedge funds, which do the trading.
Instead of being in risky [trading] businesses themselves, banks have a diversified collection of senior claims on risky businesses; the other businesses run the risks, and the banks get the relatively safe first claim on their revenues. In some loose sense maybe this is true of securities trading too, and in the long run the right business for bank trading divisions to be in is lending money to other businesses that do the actual trading.
Anat Admati on OddLots
You probably know that I do not subscribe to most of Admati’s thinking, but that she does sometimes raise interesting issues. Recently, she was on OddLots discussing The Thorny Question of Why We Treat Banks Differently At All?
I think the discussion is a jumbled mess. They get off to a very confused start by trying to define what “equity” or “capital” is and is not, and conflating the two along with regulatory accounting and investor decisions.
… capital, is not something that actually the banks hold. It's something that investors hold.
Huh? What?
We're talking about equity funding for banks
… for actual people who understand banking, the idea of having more capital means that more of their funding needs to come from equity.
So…yes and no.
In the regulatory context that they are discussing, “equity” is simply the regulatory accounting difference between the value of the assets and the value of the liabilities. For banks, this is GAAP. “Capital” in the regulatory definition starts with equity, but then can add and subtract elements.
What Admati is arguing for is a world where there are more assets for each dollar of deposits and other contractual liabilities (like debt).
Tracy Alloway then leads Admati into a discussion of regulatory capital ratios, and Admati says:
the [capital] metrics are so bad, and the metrics include not recognizing fair market value on hold-to maturity assets. So the bank is pretending to have these assets that they bought at par value, even though they're losing value like Treasuries. In addition, capital ratios depend on risk weights and the risk weights ignore interest rate risk entirely, only credit risk.
So we’ve spoken about this in the past, and these are two apparently obvious changes to the capital metrics.
The first point, recognizing the FV changes on HTM assets, is a partial economic argument. In this case, advocates are suggesting marking to market the asset side of the balance sheet without marking to market the liability side of the balance sheet. This will make her beloved “equity” more volatile. At a minimum, they should then allow long-term debt to be marked as well. But marking assets and not liabilities makes core deposits less valuable, which creates the wrong incentive for a bank.
The second point, ignoring interest rate risk, is again an apparently obvious change. But here she is talking about a risk-based charge that is different from her earlier leverage argument. And there is an argument to be made that the intermediation function of a bank, bridging between the maturity preferences of creditors and depositors, is an essential function that banks play in a fractional banking world, which is why Banks Are Special with access to the Discount Window. There is also the question about the duration to assign to core deposits; they are contractually overnight, but in practice have a longer duration in normal times, with significant convexity to credit quality.
Joe Weisenthal then asks whether there will be less lending in Admati’s regime with drastically higher regulatory capital ratios. She answers in a way I consider disingenuous and doesn’t answer the question:
Well, first of all, they can make any loan.
Her answer is that banks just need to retain their earnings:
I said this with 20 academics and lots of people, is to retain their earnings and use them for loans. So what's the problem now? So I've been asking for 15 years, tell me again what would go wrong if they retain their earnings? Just take me through an argument, an economic argument, of how the economy would suffer?
OK, she wants an argument, here it is.
The cost of equity to a bank is higher than the cost of debt. Reducing the portion of contractual liabilities on the right side of the balance sheet will raise banks overall weighted average cost of capital. When making a loan, banks will need to cover their cost of capital, so the cost of bank credit will rise. In simple supply/demand terms with elastic functions, a rise in the cost will result in less demand.
Now, this might not be a bad policy decision. It is a tradeoff between the cost of bank credit to borrowers and the overall effect on the economy vs. reducing the probability of a bank failure and a loss that exceeds what the Deposit Insurance Fund can handle requiring the sovereign to intervene.FDIC
Banks Are Special, and all banks in a fractional reserve banking system are in some ways extensions of the sovereign. For any large enough loss, the sovereign will bear the deepest part of the tail risk.
Told You To Take The Over (on Basel Endgame)
Current proposal is dead.
Fed’s Powell Says Significant Changes to Bank Capital Plan Likely (Bloomberg)
“I do expect there will be broad and material changes to the proposal,” Powell told lawmakers on the House Financial Services Committee on Wednesday. He added that no decisions had been made, but that it was possible regulators could scrap the plan floated last July and propose a new version. “It’s a very plausible option,” he said.
Exclusive: US regulators expected to significantly reduce Basel capital burden (Reuters)
U.S. regulators are expected to significantly reduce the extra capital banks must hold under a proposed rule that has drawn aggressive pushback from Wall Street, said eight industry executives in regular contact with the agencies and regulatory officials.
Officials have not decided whether to re-propose the rule, three said, which would delay its completion and potentially push it into a new presidential administration. In his testimony, Powell did not rule out reproposing the rule, calling it a "very plausible option."
Continue to take the over.
Troubled Bank List Grows
FDIC published their Quarterly Banking Profile for year-end. They report that there are 52 banks totaling $66.3 billion in assets. I went to the FFIEC website and was unable to reverse engineer 52 banks to a total of $66.3 billion (using downloaded data and GPT4). Closest I could come was $66,553,982. As such, I hesitate to name the banks. Too bad - these LLMs make it easy to drill into the data.
One year later: Lessons learned from the March 2023 bank failures
Brookings held a conference with the title One year later: Lessons learned from the March 2023 bank failures. Both the video and a transcript are available at that site. There were a lot of my former colleagues speaking: Tobias Adrian, Susan McLaughlin, Alexa Philo. I’m going to ignore their comments and instead focus on the remarks from Bill Demchak, the CEO of PNC, and Rep. Patrick McHenry, Chairman of the House Financial Services Committee.
Let’s start with Demchak. I’ve always found him to be exceptionally thoughtful and clear-headed.
Regulation is Uneven
My primary lesson learned was that regulation is uneven. It astounded me, what the First Republic and Silicon Valley were able to do inside of what I thought was, well, I know is inside of the FDIC handbook. Regulators didn't do their job. The management was bad and risks were, you know, lots of different things. But it just, you know, bluntly, if that was an OCC bank, that never would have happened.
Supervisors Didn’t Do Their Jobs
The regulation is there. The supervisors didn't do their job. Silicon Valley Bank was was the day they put on their fixed rate bond position, long before the Fed started raising rates. They should have been red flagged or they had embedded leverage in their balance sheet. That was unsustainable inside of any sort of rate rise in any interest rate risk manager would have known that and stopped it. It shouldn't have happened after the Fed raised rates. It was a position that was a long term capital position. I'm going to go buy a hundred billion of bonds and fund it with hot money. Nobody in their right mind would do that. And the regulators shouldn't allow that to happen. So and you don't need new rules to tell a regulator to not allow that to happen.
There Is Regulatory Arbitrage
I think there's a regulatory arbitrage in this country. I think it is uneven. I think we purposefully have allowed and, I'm sympathetic to this, smaller banks to have lighter touch regulation. But in the course of doing so we've allowed banks to, to charter shop.
Supervisors Tend To Be Correct
One of the things I would tell you about our supervisory relationships, which is almost every time true, is when they smell smoke, they are correct. They can't necessarily distinguish between a one alarm fire and a five alarm fire. But when they say, hey, what do you think of this ? We're seeing that. They're almost every time correct in my experience.
The Fed Is Not Playing A Role In Regular Way Liquidity
There's a need in this country for regular way liquidity into the banking system, which today is served by the home loan banks, particularly for smaller banks, that has increased with the advent of money market funds and just excess reserves needed to be held as a function of liquidity ratios. The Fed should be playing that role, in my view, the Fed is not
Let’s turn to Rep. McHenry. He was pretty blunt (he’s not running for reelection). To start, he was asked by Aaron Klein:
Immediately after the crisis, the Federal Reserve promised, quote, an unflinching, end quote review of its regulatory practices both at the San Francisco Federal Reserve Bank, which regulated SVB, and at the board, which had regulatory authority delegated to the San Francisco. How would you grade a year later, that unflinching review.
McHenry Thinks The Barr Report Was Self-Serving
Self-referential. It is my review of of how restrained I was at my third trip to the salad bar. … I think it was, a self-serving report, with a conclusion that is disconnected from the reality of the situation. So I don't grade the Fed and Barr's report, very, very highly. I think it is an attempt to justify what Barr otherwise wanted to do.
The Fed’s Discount Window Is Antiquated
the Fed should have provisioned for the discount window much more quickly. So I agree with, Chairman Powell when he says the Fed Response was clunky. … They did not, act in an appropriate fashion commensurate with the rules that they had. And because they didn't do that, it had to then graduate up to, really, Chairman Powell and Secretary Yellen stepping in to calm things when it should have been done at lower levels.
the discount window closing at a time that didn't conform to the reality of the stress in the market. Well, this is kind of an obvious thing. Can't you open up the discount window?
you're telling me this is not technology enabled? So on the front side of this, you have a fast bank run based off consumer tech, which is how we live. And on the back end, the banks are getting provisions of capital at the way they did in the 1940s.
Signature Bank almost failed on a random day of a week because when they went to wire money Fed wire was closed. And you say, well, what do you mean it's closed? Well, we decided to close at 7 p.m. or 6 p.m.. You know, others have said, well, why isn't this thing open 24/7? Why isn't it open longer?
The FDIC Should Have Resolved SVB In A Weekend
The FDIC in resolving this institution, they had a weekend and they dithered. They delayed. They couldn't make a big decision in that first weekend.
Decisions Have Made Moral Hazzard Worse
So, the bad takeaway here is that a failed institution is completely backstopped based off some arbitrary line in the sand that the Treasury and the FDIC just dreamed up. That is a very bad take away from this crisis. We have to make it clear that uninsured deposits are uninsured.
Aaron Klein adds:
It's against, I've written about this, the principles of FDR were to protect the little guy, not the venture capitalists with 500 million bucks in the bank. I'm sorry, Bill Ackman. Your money is at stake.
As an aside, still no answer from the Fed on my FOIA request.
GAO Has Recommendations To Improve Bank Supervision
Hattip yet again to Steven Kelly for finding this.
Bank Supervision: More Timely Escalation of Supervisory Action Needed
Federal Reserve and FDIC examination staff generally adhered to their requirements for communicating concerns to SVB and Signature Bank.
The Federal Reserve’s procedures on when to escalate supervisory concerns often were not clear or specific. The procedures often did not include measurable criteria for examiners to use when recommending informal or formal enforcement actions. This lack of specificity could have contributed to delays in taking more forceful action against SVB. Better procedures could promote more timely enforcement action to address deteriorating conditions at banks in the future.
Something I Didn’t Know
More Stuff
The final updates provide additional clarity and specificity to existing requirements in four key areas of operational risk management: incident management and notification; business continuity management and planning; third-party risk management; and review and testing of operational risk management measures.
Quantifying Treasury Cash-Futures Basis Trades (Fed Board)
In this note, we introduce two kinds of metrics that allow us to assess the extent of Treasury cash-futures basis trades: (1) comprehensive estimates of hedge funds' Treasury holdings and their repo activity derived from SEC Form PF; (2) a near real-time estimate of likely basis trade volumes derived from FINRA TRACE data on cash-market transactions in Treasury securities.
We find that the basis trade has reemerged recently. We estimate that hedge funds have amassed at least $317 billion in Treasury holdings related to basis trades since the first quarter of 2022, although the volume of the trade is likely significantly lower than implied by leveraged funds' Treasury futures positions alone.
Grab bag? Perhaps, but full of goodies, nonetheless