Perspective on Risk - Oct. 5, 2023
The Future Of The Financial System; Federal Reserve Material Loss Review of Silicon Valley Bank; Risk Premia; Masters Degree in Systemic Risk (or magic)
Had a nice vacation in Spain. Saw my niece Natalia wed her beau Ibrahim in Mallorca, then spent time in Granada, Malaga, Seville, Cordoba and Madrid. Nice break.
I have written many times now that, at least in the Fed, there is not a positive vision of how policymakers want the financial world to work. But it is becoming clearer what that world will look like, for better or worse: banking is being supplanted by non-bank finance.
The Future Of The Financial System
Are Banks Special?
A seminal central bank paper was written in 1982 by E. Gerald Corrigan titled Are Banks Special? It has been revisited by policymakers numerous times (but is probably only really known in central bank policy circles).
Back then, faced with changes to the financial system including the development of money market funds, Corrigan suggests that banks perform three essential functions:
they issue transaction accounts (i.e., they hold liabilities that are payable on demand at par and that are readily transferable to third parties);
they are the backup source o f liquidity to all other institutions, financial and nonfinancial; and
they are the transmission belt for monetary policy
In fact, it is the “specialness” of banks that he argues warrants “the fact of a heavy regulatory burden on banks.”
Another way of thinking about regulation is that this serves as a ‘barrier to entry’ that would enable banks to earn excess returns. But clearly the value of this “moat” has declined significantly.
Bank of England Proposes Lending Facility For Non-Bank Financial Institutions
In some ways, the Bank is better positioned to think about non-bank finance. Central Bankers fight the last wars, rarely focusing on the next war. And here the BoE has the advantage of recently experiencing the LDI problems in their insurance sector.
Andrew Hauser signaled the new approach with A journey of 1000 miles begins with a single step: filling gaps in the central bank liquidity toolkit - speech by Andrew Hauser. Read this speech.
Andrew Hauser sets out the Bank’s ambitious plans for tackling systemic risks in market-based finance by developing a new lending tool for non-bank financial institutions, starting with UK insurance companies and pension funds, including newly-resilient LDI funds. The tool, which will require the support of market participants and regulators, will be designed to address dysfunction in core sterling markets in the exceptional circumstances where there is a threat to UK financial stability.
My former AIG colleagues will remember that I viewed this as the Holy Grail for insurers; insurers tend to hold significant volumes of unencumbered securities. Unfortunately, in times of distress they faced the Jamie Dimon problem. Since the Fed (and other central banks) lent to banks, they would have to go to Jamie to obtain funding. Banks, per Corrigan, “are the backup source o f liquidity to all other institutions.”
JPM could then either rehypothecate the securities or take them to the Fed Discount Window for funding, and in the process rip your face off. A funding facility for insurers and pension funds would significantly reduce the firesale externality risk.
There is a key line early in the speech:
Second, in 2020, and again in 2022, traditional central bank tools for lending to banks were not enough to stabilise the financial system as a whole, because banks did not (or could not) on-lend to NBFIs in sufficient size, requiring central banks to reach for unconventional asset purchase and sale tools.
Hauser is essentially arguing that the second of Corrigan’s points is either no longer valid, or no longer effective. One can also argue that the Fed’s Standing Repo Facility has also at least weakened Corrigan’s third argument, that banks are the ultimate transmission belt for monetary policy.
US Regulators & Policymakers Don’t Seem To Get It
Fed Gov. Barr gave a speech
Fed Gov. Barr gave a speech Monetary Policy and Financial Stability. It is entirely bank-centric; it pays lip-service to risks outside of banking. It dwells on the SVB.
Of course, major portions of the financial sector are not subject to federal prudential regulation. As I noted in a speech on bank capital earlier this year, we also need to worry about how risk outside the banking sector can threaten financial stability, as stress in broader financial markets is often transmitted to the banking system.9 So we need to take a broad view of financial stability.
Karen Petrou Tries To Wake Up Policymakers
Karen Petrou, who regular readers of the Perspective will recognize that I do not always agree with, has recently had published two excellent pieces. She gets it in a way that the current US political dialogue totally misses.
First, at the Financial Services Forum Summit she presented Banking Without Banks: Regulatory Arbitrage and What to Do About It
Nonbank financial companies now have almost three times more macroeconomic impact than banks and are primed to grow still bigger without regulatory barriers.
Banking regulators are crafting rules with blinders on believing that others are responsible for nonbanks’ systemic risk and will clean up after them when it comes to product and service migration.
Others – i.e., the FSOC – are unable to limit much migration no matter how hard they now say they’ll try.
Bank regulation must take regulatory arbitrage into account and, where necessary standards adversely affect bank competitiveness, address inter-connectedness to give both banks and the financial system a fighting chance.
A critical and overlooked channel of systemic risk arises from massive nonbank providers of critical financial infrastructure. These can and should be quickly designated as financial market utilities.
Second, she testified before the House Subcommittee on Financial Institutions and Monetary Policy presenting A HOLISTIC REVIEW OF REGULATORS: REGULATORY OVERREACH AND ECONOMIC CONSEQUENCES
Optimizing financial stability is impossible wearing banking blinders. The U.S. financial system is uniquely dependent on nonbank financial intermediation – so called “shadow banks.” Finance abhors a vacuum as much as physics. If one sector cannot meet the market’s needs at a market price, then another will step in to serve that market even if regulators wish no one would do so because the market is unduly risky or predatory. The bank-centric rules promulgated after the 2008 crisis directly caused the explosion in U.S. nonbank financial services, a transformation my firm anticipated as early as 2011.4 Still more powerful and systemic, nonbanks are likely as a result of this batch of new rules a decade later because market dynamics are changed only by virtue of still more embedded power outside the regulatory perimeter.
It is clear that the raft of new, bank-centric capital and resolution proposals and of rules still to come has not been constructed with the best possible or even a good, credible effort to anticipate cumulative macroeconomic and systemic consequences. As a result, perverse effects are already all too evident. These perverse consequences will quickly and significantly impair financial stability and sustained, shared growth, as the discussion of key proposals provided below will make all too clear.
After 12 Years, FDIC Is Not Prepared To Liquidate A Non-Bank
We found that in the more than 12 years since the enactment of the DFA, the FDIC has not maintained a consistent focus on maturing the OLA program and has not fully established key elements to execute its OLA responsibilities.
The IG Fears The FDIC Cannot Resolve a SIFC
The FDIC’s Inspector General issued The FDIC’s Orderly Liquidation Authority.
Absent a consistent focus and fully established key elements for executing the OLA, the FDIC may not be able to readily meet the OLA requirements for every type of SIFC the FDIC might be required to resolve. If the FDIC were unable to resolve a SIFC, the banking sector and the stability of the U.S. and global financial systems could be severely affected.
If the FSOC is worth a damn they should be raising holy hell.
Aside: SVB & Signature Bank
Interestingly, this report does not tell us why ordinary liquidation authority was not used for SVB and Signature Bank.
In March 2023, two large regional banks, Silicon Valley Bank and Signature Bank, failed. … both failures represented a systemic risk to U.S. financial stability. However, the DFA specifically excludes IDIs, such as these two regional banks, from resolution under the OLA. Therefore, the failures were subject to FDIC resolution under the FDI Act, which was outside the scope of this evaluation report.
My Takeaways
Higher capital levels will not reduce bank failures; it will just immunize the deposit insurance fund from having to fund a systemic bank bailout letting them keep deposit insurance rates improperly low.
A better solution is Petrou’s enhancements to the PCA triggers combined with increasing the size of the deposit insurance fund (or my alternate proposal to require systemic banks to purchase ex-ante liquidity insurance from the Fed; see Perspective on Risk - May 19, 2023 (Bagehot is out of date)).
The FSOC need to get its act together.
Federal Reserve Material Loss Review of Silicon Valley Bank
Buried on the 12th level of hell, virtually impossible to find on the Federal reserve’s website, it the Fed’s OIG Material Loss Review of Silicon Valley Bank. I’ve written in the past about the Fed’s introspection on the SVB failure.1
This review reinforced a lot of what I previously thought, but also gave me a few new tidbits. It also refuses to place accountability.
Sensitivity To Market Risk
Usually, we talk about the failure to get the management or liquidity rating correct, but perhaps a bigger miss was the failure to get the “Sensitivity To Market Risk” subcomponent correct.
In Sept. 2021 the Fed rated this as ‘satisfactory.’ This despite the Board staff identifying the risk:
In June 2022, the Board’s surveillance team issued a special topic report discussing the high level of unrealized losses on the investment securities at many banks as a result of interest rate increases. The surveillance team identified SVBFG as one of the institutions with the highest levels of unrealized losses and with a large portion of investments in its HTM portfolio. The report cautioned that those institutions with a high level of unrealized losses and a large share of HTM investment securities may need to realize sizable losses when they sell investment securities in their HTM portfolios in case of liquidity needs, such as a large deposit outflow. As of June 2022, the Board’s surveillance team also placed SVBFG on the Systemwide holding company watch list with a high adverse change probability warning, indicating the likelihood of a downgrade to its supervisory rating in the near future.
There is no discussion of this disconnect; did the examiners see the special report? Were they aware of the change of status on the watchlist?
Our review of internal documents from CAMELS rating vetting meetings indicate that examiners met in October 2022 and again in November 2022 to discuss SVB. Specifically, examiners held a second meeting in November 2022 to discuss new information that became available after the first meeting in October. While examiners proposed maintaining a 2 rating on the CAMELS sensitivity to market risk component in October, they proposed downgrading it to 3 in November, noting the update given by the bank on declining net interest income due to rising interest rates.
Here is another critical issue: examiners focused on net interest income and not possible market value losses. Sensitivity to Market Risk is part of the CAMELS rating regime. For the Fed, it’s codified in SR 96-38,
The sensitivity to market risk component reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution's earnings or economic capital. When evaluating this component, consideration should be given to: management's ability to identify, measure, monitor, and control market risk; the institution's size; the nature and complexity of its activities; and the adequacy of its capital and earnings in relation to its level of market risk exposure.
For many institutions, the primary source of market risk arises from nontrading positions and their sensitivity to changes in interest rates. In some larger institutions, foreign operations can be a significant source of market risk. For some institutions, trading activities are a major source of market risk.
Market risk is rated based upon, but not limited to, an assessment of the following evaluation factors:
The sensitivity of the financial institution's earnings or the economic value of its capital to adverse changes in interest rates, foreign exchanges rates, commodity prices, or equity prices.
…
A rating of 2 indicates that market risk sensitivity is adequately controlled and that there is only moderate potential that the earnings performance or capital position will be adversely affected. Risk management practices are satisfactory for the size, sophistication, and market risk accepted by the institution. The level of earnings and capital provide adequate support for the degree of market risk taken by the institution.
A rating of 3 indicates that control of market risk sensitivity needs improvement or that there is significant potential that the earnings performance or capital position will be adversely affected. Risk management practices need to be improved given the size, sophistication, and level of market risk accepted by the institution. The level of earnings and capital may not adequately support the degree of market risk taken by the institution.
Clearly a blown subcomponent.
Bank Exams Tailored To Risk
The rapid growth of SVB is widely acknowledged as a risk factor that should have been considered. I’m really perplexed then by the need for the OIG to cite OCC guidance here. Could the Fed not find its own reference to this factor? If so, blame should be cast on those who write the guidance more than the examiners.
Office of the Comptroller of the Currency guidance notes the following:
Uncontrolled, rapid, or significant growth can be a sign of risk management weaknesses and can increase a bank’s risk exposure, stretch the expertise of bank management, and strain the bank’s resources, which, in turn, can lead to numerous and sometimes sudden bank failures as sectoral economic conditions change.7
Now there is considerable references to Bank Exams Tailored to Risk (BETR) which drives or influences the supervisory resources planned for a firm. This for the Fed is codified in SR 19-9. So I went down the rabbit hole to see if I could find rapid asset growth in the metrics. SR 19-9 references SR letter 15-16, "Enhancements to the Federal Reserve System's Surveillance Program" that discusses enhancements to certain models (SABR). Digging deeper, there is a lot of blather on now writeups should be completed, but no details on the model.2
Consensus & Accountability
I’ve discussed before the culture of vetting of findings, and the back and forth between numerous parties (exam team, Board staff, system committees) that results in a lack of timeliness and sometimes a bias towards inaction. That’s more clearly evident in this report.
FRB San Francisco and the Board RBS section considered downgrading the CAMELS management component to 3 with the issuance of a memorandum of understanding (MOU) on the IT findings.
The section consulted with the Board and learned that because SVBFG had total consolidated assets over $50 billion, the MOU would require review by the Board’s Legal Division.
According to a February 2021 communication, Board staff from RBS and LFBO Supervision discussed whether findings from an IT examination warranted a downgrade of the CAMELS management component.
After discussing with CDFPI officials, the Board and FRB San Francisco decided to monitor the bank’s progress in addressing the examination findings through continuous monitoring and not issue an enforcement action or downgrade the CAMELS management component.
Despite examiners’ earlier attempt to downgrade the CAMELS management component to 3, this component remained 2.
The OIG doesn’t tell us who over road the examiners here.
In September 2021, LFBO Supervision began its 2021 supervisory cycle to assess SVB and SVBFG against the large bank supervisory expectations.
FRB San Francisco examiners identified several supervisory issues, proposed a downgrade of the CAMELS liquidity component rating, and discussed whether to downgrade SVB’s CAMELS management component rating and SVBFG’s LFI governance and controls rating during the System LFBO vetting.
However, Board S&R, the LFBO MG, and the LFBO DST decided to defer issuing the ratings for the 2021 cycle by 6 months and conduct additional reviews to better assess the root causes of the issues and to have sufficient evidence to support downgraded ratings. According to interviewees, LFBO Supervision felt that it needed additional evidence to downgrade the ratings that the RBO examination team assigned to SVB just 4 months prior in May 2021.
Another Take
The Bank Reg Blog wrote up their findings on the OIG report in Vibes-Based Supervision. They highlight the political caution that the Board exhibited.
… something the OIG report effectively glosses over is that the EGRRCPA changes to the thresholds for the application of enhanced prudential standards did not need to result in changes to (a) the composition of the RBO portfolio (i.e., grouping all $10 billion - $100 billion banks in the same category) or (b) the banks to which the BETR approach applied. These were choices made by the Federal Reserve Board and the Board alone.
Why, then, if not required by statute, were these choices made? The OIG report says those are the vibes the Board intuited from the EGRRCPA:
A Board official stated that the message the Board took from EGRRCPA becoming law in 2018 was to reduce the regulatory and supervisory burden; the intensity for firms below the $100 billion threshold was to be much lower than for those firms above $100 billion.
Similarly, later in the report an unidentified interviewee expresses fears of being on the wrong side of a “tug of war” with the industry, should supervisors have been perceived to be too aggressive in expecting SVB to be prepared to transition to enhanced prudential standards.
One interviewee stated that the System would try to prepare firms for the transition but felt it was placing requirements on those firms prematurely, noting a constant “tug of war” between industry and supervisors
I feel that the OIG report goes too far in pointing the finger at the EGRRCPA to the extent it does. At the end of the day, whatever the vibes the Board was getting from Congress or big scary trade associations or whoever, the construction of supervisory portfolios and the intensity of supervision of banks within these portfolios were choices very much within the Board’s discretion, even after the EGRRCPA.
Risk Premia Moves/Normalizing
TIPs Yield
TIPs now have a positive real and rising yield.
10 Year Treasury Real Yield
10 year Treasury now is offering a positive real yield.
Term Premia
The ACM Term Premia continues to move higher, though well below long-term peaks.
Equity Premia
Equity Risk Premia, on both a nominal and real basis, are low and falling.
Remember The Mozambique Tuna Fraud?
Looks like UBS settled the legacy CS lawsuit: Mozambique Bonds Rally After Settlement on Tuna Debt Scandal
The settlement announced on Sunday resolved a case between the Swiss bank and Mozambique that began a decade ago, when Credit Suisse first financed a new coastal patrol force and tuna fishing fleet for Mozambique. The African nation alleged the Swiss bank ignored red flags and the corruption of its own bankers in deals struck as part of $2 billion worth of bond deals.
Masters Degree in Systemic Risk
Thought I’d do some advertising for the Yale folks. Master’s Degree in Systemic Risk. One-year in residence program. Curriculum looks good. Looks like they’ve got Tim teaching.
Or perhaps this is more relevant: Degree in magic to be offered at University of Exeter
It’s worth noting that the Fed’s OIG has issued another report The Board Can Enhance the Effectiveness of Certain Aspects of Its Model Risk Management Processes for the SR/HC-SABR and BETR Models that finds the Fed doesn’t follow its own model validation guidance:
Many of the SR/HC-SABR and BETR models in use have not undergone Committee on Supervisory Model Oversight (COSMO) review and System Model Validation (SMV) group validation, in part because of COSMO’s resource constraints. In addition, S&R can enhance model risk management by developing a comprehensive model inventory of top-tier supervisory models (TTSMs), including the SR/HC-SABR and BETR models, that aligns with the guidance outlined in Supervision and Regulation Letter 11-7: Supervisory Guidance on Model Risk Management (SR Letter 11-7). F