Perspective on Risk - March 16, 2023 (More SVB, Credit Suisse, Signature)

Fed Failed Their Own Guidance; SVB Failure at 3 Levels; Do As We Say, Not As We Do; ASC 815-20-25-43(c)(2)Credit Suisse; Systemic Risk Exemption; Moral Hazard; Mad At The Signature Bank Bailout

Seriously, I think I need a drink.

The Fed’s Stress Test Failed Their Own Guidance

The Fed’s guidance, SR 12-7 Supervisory Guidance on Stress Testing for Banking Organizations with More Than $10 Billion in Total Consolidated Assets, states:

“stress testing” refers to exercises used to conduct a forward-looking assessment of the potential impact of various adverse events and circumstances on a banking organization. An effective stress testing framework provides a comprehensive, integrated, and forward-looking set of activities for a banking organization to employ in order to assist in the identification and measurement of its material risks and vulnerabilities.

From a risk manager’s point of view, the key aspect of crafting a stress test is that it is TAILORED to the risks of the firm and the environment. In fact, Principal 1 of the guidance states:

A banking organization’s stress testing framework should include activities and exercises that are tailored to and sufficiently capture the banking organization’s exposures, activities, and risks.

The Fed released their Dodd-Frank hypothetical stress tests on Feb. 9, 2023. The Fed’s scenario stated:

Inflation, measured as the quarterly change in the CPI and reported as an annualized rate, falls from below 3¼ percent at the end of 2022 to about 1¼ percent in the third quarter of 2023 and then gradually increases to above 1½ percent by the end of the scenario.

At that time, the most recent CPI print was from December 2022, which was published on Jan. 12th. That print was 6.5%. As can be seen from below, a higher level of inflation was clearly observable throughout 2021 and 2022.

As of year-end, the Fed had raised the Fed Funds rate seven (7) times.

Nevertheless, Fed Funds was still running below the level of inflation.

Despite high inflation, and a Fed Funds rate that was still below the level of inflation, the design of the scenario envisioned a recession driving rates back down to zero.

Short-term interest rates, as measured by the 3-month Treasury rate, fall significantly to near zero by the third quarter of 2023 and remain there for the remainder of the scenario. Long-term interest rates, as measured by the 10-year Treasury yield, fall by nearly 3¼ percentage points by the second quarter of 2023, and then gradually rise in late 2023 to about 1½ percent by the end of the scenario. These interest rate paths imply that the yield curve remains inverted through the second quarter of 2023.

At year-end 2022, the 3 month Treasury (CMT basis) stood at 4.45%.

It is notable that despite knowing that falling rates significantly benefit banks asset values during stress, they increased the size of this benefit:

The current scenario features a significantly higher starting level of interest rates compared to the previous year’s scenario, which allows interest rates to decline more forcefully in response to the hypothetical drop in economic activity and inflation.

So this scenario was clearly not TAILORED to the risks of rising inflation and the monetary policy needed to address this issue. It was simply a continuation of the historical approach to look at credit losses, with a few tweaks.

So What’s The Big Issue?

The Fed made one of the same mistakes that occurred during the global financial crisis of 2008. There was a disconnect between the monetary policy and supervisory wings of the organization. THIS WAS A LESSON THEY LEARNED AND APPARENTLY FORGOT. And this makes me mad. The primary value of having bank supervision within the central bank is to be able to make these connections. Without having this connection, it would be better to consolidate regulation away from the central bank to avoid the tension between monetary and financial dominance (discussed in the March 14 Perspective)

The SVB Failure at 3 Levels

One of my main observations from working at the Fed is that, on my career path, there were three distinct levels: the bank examiner, the bank supervisor, and the central banker.

The bank examiner knew HOW to examine a bank. Go in, look at the books, identify risks at an individual institution. The bank supervisor knew that examining was but one tool of controlling risk in banking; there are other tools such as capital and liquidity regimes, or application approvals, etc. to help control risk. The central banker understood both how bank supervision fit into the larger world of financial sector stability, and how it fit into the central banks ability to properly conduct its mission.

Bank Examiner

On the bank examiner level (and I write this without knowing if this was occurring behind the scenes), the big issue was letting the bank grow exceedingly rapidly with a very risky business model. Rapid growth, a reliance on uninsured demand deposits, a huge long-duration investment portfolio accounted for in a way that limits the ability to hedge and/or sell the portfolio are all things taught in bank examiner school.

Bank Supervisor

At the bank supervisor level, a capital regime that does not require capital for excessive interest rate risk seems problematic. The failure to apply liquidity coverage requirements is a failure. Allowing significant wrong-way risk (asset deposit correlation) is a problem. The supervisor should have understood the nature of SVB’s business, and the broader vulnerability of a bank run from networked deposits.

I suspect that the regulatory bodies have become overly obsessed with their stress testing process and enforcing the letter of the capital and liquidity rules, and have put less weight on the normal process of supervision.

Central Banker

The Fed did not tailor their stress test to the current environment and vulnerabilities. There appears to have been a breakdown in the communication and coordination between the monetary policy and bank supervision wings (and perhaps the financial stability function).

I think the most blame needs to fall at this level. But they will inevitably blame the examiners. It’s already started: The Regulatory Blunder That Gave Us the Silicon Valley Bank Disaster

Time to bring back aggressive supervision.

Do As We Say, Not As We Do

European regulators criticise US ‘incompetence’ over Silicon Valley Bank collapse (FT)

Europe’s financial regulators are furious at the handling of the Silicon Valley Bank collapse, privately accusing US authorities of tearing up a rule book for failed banks that they had helped to write.

One senior eurozone official described their shock at the “total and utter incompetence” of US authorities, particularly after a decade and a half of “long and boring meetings” with Americans advocating an end to bailouts.

Europe’s supervisors are particularly irate at the US decision to break with its own standard of guaranteeing only the first $250,000 of deposits by invoking a “systemic risk exception” — despite claiming the California-based lender was too small to face rules aimed at preventing a rerun of the 2008 global financial crisis.

Systemic Risk Exemption

Pitchbook has a nice description of the systemic risk exception that you keep hearing about. SVB triggers return of FDIC's Systemic Risk Exception

The SRE was created by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), as the national banking crisis of the 1980s was winding down.

The FDICIA was implemented to increase the FDIC’s powers. … The act also empowered the FDIC to wind up insolvent banks in a way that, as the act says, “is the least costly to the deposit insurance fund of all possible methods for meeting the [FDIC’s] obligation” to provide insurance coverage for depositors.

The FDICIA includes an exception to the least cost test. A congressional study done while preparing the legislation noted that “the presence of systemic risk could require a decision to protect uninsured depositors even if it is not the least costly resolution method,” according to the FDIC.

In order for the systemic risk exception to be invoked, the FDICIA requires written recommendations from the boards of both the FDIC and the Federal Reserve, with both boards needing the voting approval of two-thirds of their members to make the recommendation. Then the Secretary of the Treasury signs on after consulting the President. Congress must then be notified.

The exception was first used on Sept. 29, 2008, 14 days after Lehman Brothers filed for bankruptcy protection, to facilitate the sale of Wachovia Corp.’s banking business initially to Citigroup (Wells Fargo & Co. eventually purchased it).

FASB rule ASC 815-20-25-43(c)(2)

Some people have asked “why didn’t SVB hedge” its interest rate risk. The first reason is that they likely didn’t want to payout the earnings. The second is that they probably didn’t want the margin posting risk that would come from a derivatives transaction. Finally, they couldn’t put a fair-value hedge specifically on the assets because of accounting rules.

ASC section 815 provides guidance on derivatives and hedging. Subsection 20 provides specific guidance on hedging (815-20).

Drilling down further, ASC 815-20-25-12(d) provides guidance on the eligibility of held-to-maturity debt securities for designation as a hedged item in a fair value hedge.

If the hedged item is all or a portion of a debt security (or a portfolio of similar debt securities) that is classified as held to maturity in accordance with Topic 320, the designated risk being hedged is the risk of changes in its fair value attributable to credit risk, foreign exchange risk, or both. If the hedged item is an option component of a held-to-maturity security that permits its prepayment, the designated risk being hedged is the risk of changes in the entire fair value of that option component. If the hedged item is other than an option component of a held-to-maturity security that permits its prepayment, the designated hedged risk also shall not be the risk of changes in its overall fair value.

PWC explains:

The notion of hedging the interest rate risk in a security classified as held to maturity is inconsistent with the held-to-maturity classification under ASC 320, which requires the reporting entity to hold the security until maturity regardless of changes in market interest rates. For this reason, ASC 815-20-25-43(c)(2) indicates that interest rate risk may not be the hedged risk in a fair value hedge of held-to-maturity debt securities.

Why The SNB Needed To Step In To Support Credit Suisse

Bloomberg had an interesting headline, BNP stops accepting swaps reassignments involving Credit Suisse, that has somehow disappeared from their site (but lives on via Yahoo). I have presumed that most banks have already limited their exposure to CS; when you see actions like this, banks pulling away from dealing with each other, that’s when you have a crisis, and that’s why the Swiss National Bank had to act.

Understanding Moral Hazzard

You’ve probably heard this term thrown around, and some of you may not understand it.

Moral hazard is a term used to describe a situation where one party is protected from risk and therefore may behave differently than if they were fully exposed to the risk.

It can also refer to a situation where one party has an incentive to take unusual risks because they know that any negative consequences will not affect them.

Scott Sumner has a nice writeup describing moral hazard: The wrong way to think about moral hazard.

Modern Americans pay little or no attention to the relative safety of various banks. Why should they? But I assure you that back in the 1920s people cared a great deal about bank safety. Banks knew this, and managed their balance sheets far more conservatively than do modern banks. That’s why big city banks used to look like massive Greek temples; they had to convince depositors that they had the capital to survive hard times.

But you certainly cannot expect average people to evaluate the safety and soundness of large complex banks … or can you?

Most average people don’t read academic papers and attend lectures at lots of universities, hence you cannot possible expect average people to know that Harvard and Stanford are better that South Dakota State and Western Michigan University. Most people are not able to evaluate the quality of carburetors, anti-lock brakes, and fuel injection mechanisms, so they couldn’t possibly be expected to know that a Mercedes is better than a Ford. Most people are not able to evaluate the quality of surgeons, so they cannot possible be expected to know that Johns Hopkins is better than Missouri Valley Hospital.

Why I’m Mad At The Signature Bank Bailout

How the US gov’t bailed out USDC stablecoin (Protos)

The Federal Deposit Insurance Corporation (FDIC) has taken over two banks at which Circle held billions of dollars worth of backing for its stablecoin, USDC. By making depositors whole at these insolvent banks, the US government has essentially bailed out USDC’s $1 peg.

In other words, on Saturday, at least 8% of the value of USDC’s $39 billion market capitalization was locked within two insolvent banks. By Sunday, the US government had restored that loss.

The price of the so-called stablecoin had slipped into the $0.80s. After a joint statement from the US Treasury, Federal Reserve, and FDIC, traders regained confidence and bid the token’s price back up to $1.

The US declared that the bank that held funds that backed stablecoin reserves as systemic. Another mistake.

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