Perspective on Risk - May 3, 2024
The Risk Of Risk Management; Income Inequality, Growth of NBFIs, & Financial Stability; Commercial Real Estate; What Would Minsky Say? Banks with Stuff
The Risk Of Risk Management
In Jane Street is big. Like, really, really big the FT Alphaville crew go through a Jane Street prospectus and note the following:
Jane Street even includes its risk management as a risk factor, arguing that its extra layers of safety — a series of preset risk controls on messages leaving its trading desks — can mean it might lose out on business.
“In certain cases, this layer of risk management, which adds latency to our process, may limit our ability to profit from acute volatility in the markets. This would be the case, for example, where a particular strategy being utilized by one of our traders is temporarily halted for violating a preset risk limit. Even if we are able to quickly and correctly resume the trading strategy, we may limit our potential upside as a result of our risk management policies. As a result, our risk management systems could have a material adverse effect on our business, prospects, results of operations, financial condition and/or cash flows.”
Income Inequality, Growth of NBFIs, & Financial Stability
Karen Petrou sends The Inexorable, Inadvertent Inequality Vise which comments on and highlights findings from a Fed Board paper Inequality and financial sector vulnerabilities
Starting with the Board paper:
The purpose of this note is to take first steps toward a broader understanding of the potential channels through which inequality may affect financial stability. Using predictive regressions, we conduct a broad analysis to establish stylized facts about the relationship between income inequality and financial sector vulnerabilities.
Our analysis reaffirms findings in the literature determined through an extensive review, such as inequality increasing household leverage and equity valuations relative to GDP. Relative to the existing literature, we also have several novel findings.
First, we find that an increase in income inequality is associated with an increase in corporate bond debt relative to GDP.
Second, we find that a rise in income inequality is associated with an increase in the ratio of assets to GDP for mutual funds and life insurers.
Lastly, we find that an increase in income inequality is positively correlated with the prevalence of nonbank short-term wholesale funding in the financial system.
We also provide intuition for our results: … higher inequality increases the stock of savings and demand for riskier assets, which can explain why inequality is positively related to nonbank sector size and debt as well as higher valuations of riskier assets relative to GDP.
So, as we have been obsessing about, inequality is driving the rise of the large pools of uninsured cash (which has been the driver of MMMF concerns, the SVB liquidity run, and the general development of private credit.
The Fed piece does not describe the role of non-bank financial institutions in this equation, but Karen does. She asks:
… does economic inequality lead to greater NBFI reliance and resulting risk or do NBFIs on their own have a still more pernicious inequality effect that makes the risk of financial crisis still more acute?
She suggests the answer is yes, and describes “a potent negative-feedback loop of prodigious power.”
… breaking down the income and wealth components of economic inequality into the key drivers of systemic risk … suggests a causal connection between more inequality leading to more NBFIs and more risk leading to more inequality and still more NBFIs and then heightened financial risk and consequential inequality.
NBFIs through no fault of their own, increase the equality gap because wealthier households have another ready alternative to traditional bank savings. These are MMFs and mutual funds thought to provide the same safety as a bank deposit at a considerably higher rate of return that generates more capital income compared to bank-deposit interest rates.
In all-too-short, income and wealth inequality put more and more households at greater risk as NBFIs offer products banks can’t or shouldn’t, banks chase scant profit opportunities and NBFIs recycle high-risk borrowing for the vulnerable into high-yield investments for the comfortable. Inequality gets still worse, NBFIs chase dollars, banks chase NBFIs, the financial systems become more fragile, and the macroeconomy turns still more financialized and thus more prone to booms and busts.
I pretty much subscribe to this, and it is another way of saying many of the things we have been discussing over the last several years. I’m not sure that the financial system per se must become more fragile, but I would agree that unless we adapt the regulations and oversight to the new order it will.
Balance Sheet Rental & Retraunching The Financial Sector Structure
More market observers are catching on to the big trend. This time including Matt Levine, Tracy Alloway and Oliver Wyman.
In essence, Barclays is renting Blackstone’s balance sheet.
Banks Sell Loans to Private Credit in Balance Sheet Twist (Bloomberg)
The British lender came up with a solution in February, by selling $1.1 billion of card assets to private equity firm Blackstone Inc. The transaction, part of an ongoing financing arrangement, allows Barclays to collect fees for servicing the loans, but not have to hold them on its books. In return, Blackstone gets to generate high yields for insurance clients.
The Barclays-Blackstone deal got little attention at the time but may have marked a new chapter in the evolution of the lending industry since the global financial crisis.
As capital rules have gotten tougher, banks have had to exit certain businesses or else cede market share to non-bank rivals. Now, they are partnering with those rivals in ways that benefit both parties — even if it is unclear how regulators might react.
Matt Levine gets some credit here. In Banks Are Still Where the Money Isn’t (Matt Levine on Bloomberg) he’s reflecting beyond the immediate deals.
One thing I wonder about is: If you were designing a financial system from scratch, in 2024, would you come up with banking? … using a shifting pile of demand deposits to fund long-term loans.
The traditional business of banking is necessarily crisis-prone; using risky long-term loans to back risk-free short-term demand deposits involves a fundamental mismatch, and every so often that flares up into a crisis.
This idea — that bank deposits should just sit in the vault (or, realistically, in electronic money at the Federal Reserve), while risky loans should be funded by long-term investors who intend to take those risks — is sometimes called “narrow banking.” … Private credit is the lending side of “narrow banking”
Meanwhile the deposit side of “narrow banking” is something like banks taking their customers’ money and parking it at the Federal Reserve. And in fact some money has shifted out of banks (which are not narrow) and into government money-market funds (which park the money in Fed repo or Treasury bills).
We are quite a long way from it, but you can see glimpses of a world in which:
Banks take deposits and park them at the Fed.
Banks also run the infrastructure to make loans: They have branches and loan officers and websites and credit-card processing.
All the money to make the loans comes from asset managers, who manage money for insurance companies, pensions, mutual funds, etc., and invest that money in loans that they buy from the banks.
The banks charge fees — to the customers, to the asset managers — for putting the loans together, but the risk of the loans is all borne by the investors, not the banks. Certainly not by the banks’ depositors, whose money is all parked safely at the Fed.
Bingo.
Oliver Wyman chimes in as well. Private Credit’s Next Act (Oliver Wyman)
So, have we reached peak private credit? The annals of banking suggest that, on the contrary, another wave of bank disintermediation is likely. The shift of lending away from banks has a long history. Astonishingly, bank lending as a share of total borrowing has been falling for 50 years. The 1973-74 inflation and interest rate shock created more profound disintermediation from banks than the rise of private credit today, as investment grade companies switched to borrowing from the market via commercial paper and bonds.
Commercial Real Estate
Office
Office-Loan Defaults Near Historic Levels With Billions on the Line (WSJ)
Over $38 billion of U.S. office buildings face loan defaults, foreclosures or other forms of distress, the highest amount since 2012
The U.S. office vacancy rate currently is at a record 13.8%, compared with 9.4% at the end of 2019, according to data service CoStar Group.
Multifamily
Lenders Race to Buy Back Delinquent Multifamily Mortgage Loans (Bloomberg)
As delinquencies on multifamily mortgages pile up, lenders who had bundled those borrowings into securitizations known as commercial real estate collateralized loan obligations are racing to stave off trouble.
To buy the defaulted loans, some lenders have been borrowing the money from banks and other third parties using what are known as warehouse lines, a type of revolving credit facility.
CMBS
#CMBS Delinquency Rate Spikes in April to Above 5%, First Time Since September 2021" (Trepp Wire)
What Would Minsky Say?
The Fed Listened To Minsky. At least they did back in 1967. Friedman not so much. Hattip Nathan Tankus
Banks with Stuff
JPMorgan Fined $348 Million for Gaps in Trading Surveillance (Bloomberg)
The Office of the Comptroller of the Currency fined the bank $250 million, while the Federal Reserve added a $98 million penalty …
According to the OCC, JPMorgan’s trade-surveillance program has operated with certain deficiencies since at least 2019. The firm failed to establish adequate governance over trading venues where it’s active, the regulator said, citing gaps in venue coverage and a lack of sufficient data controls.
Here are the OCC’s cease-and-desist order and the Fed’s C&D order (good to see Kevin Coffey on the job).
Key Takeaways from the Republic First Bank Failure (UponFurtherAnalysis)
It was a slow bleed. Republic had been losing money since Q4 2022.
Growth comes before a fall. Despite its poor financials, Republic grew by … 79% between 2019 and 2022.
Interest rate risk strikes again. Republic First had an outsized IRR position.
Reporting was a mess. The SEC requires companies to file the quarterly 10-Q report within 45 days of quarter end and the annual 10-K within 90 days of fiscal year-end. It took Republic ten months to file its 2022 10-K. It never filed a 2023 10-K.
An internal power struggle made things worse. The bank was embroiled in lawsuits, from [the notorious former CEO Vernon] Hill and from an activist investor group headed by George Norcross. … After stringing things along for four months, Norcross backed out of the [capital infusion] deal, citing the bank’s failure to file timely financial reports. The toxic mix of hubris, greed, and incompetence among the warring parties makes it hard to identify the good guys here.
Borrowings delayed the inevitable. Republic’s deposits fell by $900 million (17%) between December 2021 and December 2023. At the same time, the bank became increasingly reliant on borrowings. FHLB advances increased from zero as of September 2021 to $970 million as of March 2023. Advances started to decline after that, but “other borrowings” rose from zero to $663 million in Q2 2023. It is likely that these borrowings were part of the Fed’s Bank Term Funding Program (BTFP).
MM Warburg Said to Explore Sale After Role in Tax Scandal (Bloomberg)
M.M. Warburg, whose roots date back to 1798, has been rattled for years by the so-called Cum-Ex scandal in which traders exploited the way dividend tax was collected so that multiple investors could claim refunds on a tax that was only paid once.
The trio of problems dogging Deutsche Bank's Postbank arm (Reuters)
Deutsche Bank unexpectedly announced on Friday that it would make a provision to offset possible claims in a years-long litigation that it underpaid Postbank shareholders in its acquisition of Postbank.
Deutsche struggled to fully integrate Postbank, but it said last year that it had completed a final phase in the integration. … But glitches resulted in customers complaining they were locked out of their accounts for weeks, resulting in the regulator overseeing a clean-up and cuts in bonuses for some of Deutsche's top managers.