Perspective on Risk - Sept. 3, 2024

CRE; Liquidity; Brokered Deposits; Accounting; Banks Behaving Badly; Risk Management Primers; Repo Concerns; MMMF Reform; Cyber; Crypto; Model Validation

I always found the last weeks of August and early September to be the most consequential time for financial stability problems. When there were issues, they often had something happening behind the scenes at the end of August, when the head traders were on vacation, or when the policymakers intended to have some particular plan of action begin after Labor Day (and hence us staff had to work through the dog-days of August). It could be some rumbles in the FX market, or perhaps the groundwork for the actions taken with Fannie and Freddie.

There’s not much on the radar that could be of that nature this year that I can see. The Yen’s strength as the Japanese raise policy rates to around 1.5% while the US is about to begin cutting could be one factor. The politics of protectionism with China’s continuing current account surpluses could be another, but nothing seems to be imminent or dramatic. Hope I’m right.

Commercial Real Estate

Some small banks have portfolios with concentrations in CRE, but are not as exposed to office properties. Large banks have the office exposures, but have lower overall levels of CRE concentration.

Determinants of Recent CRE Distress: Implications for the Banking Sector (Fed Board)

Rising interest rates and structural shifts in the demand for space have strained CRE markets and prompted concern about contagion to the largest CRE debt holder: banks. We use confidential loan-level data on bank CRE portfolios to examine banks’ exposure to at-risk CRE loans. We investigate (1) what loan characteristics are associated with delinquency and (2) to what extent the portfolio composition of major CRE lenders determines their exposure to losses.

Higher LTVs, larger property sizes, and greater local remote work tendencies are all associated with increased delinquency risk, particularly for office loans. We use several machine learning algorithms to demonstrate that variation in exposure to these risk factors can account for most of the performance disparity across different types of CRE lenders. The headline result is that small banks’ comparatively modest delinquency rates mostly reflect observable portfolio characteristics—predominantly their low holdings of large-sized office loans—rather than unobserved factors like extension or modification tendencies.

Which Banks Are Most Vulnerable To The Commercial Real Estate Doom Loop? (Forbes)

Liquidity

A Helpful Federal Reserve Board Statement on Bank Liquidity (BPI)

Jefferies-Led Bank Group Sweetens Terms on Loan for Label Maker (Bloomberg)

Brokered Deposits

The FDIC wants to change the rules for categorizing brokered deposits, expanding the definition of what qualifies. This has some banks mad.

Banks that heavily rely on deposits that are reclassified as brokered could face significant liquidity challenges. Banks might be forced to offload these deposits quickly, especially if they are undercapitalized or nearing regulatory capital thresholds. This could lead to a liquidity crisis for some banks, particularly smaller or community banks that have fewer alternatives for raising funds

Deposits classified as brokered typically also result in higher deposit insurance assessments.

I don’t have much sympathy for the industry here. Brokered deposits have historically been associated with higher costs to the FDIC and a higher likelihood of bank failures.¹

Accounting

Accountancy firms fight back against audit reforms (FT)

A new rule agreed by the US audit regulator, the Public Company Accounting Oversight Board, will force each of the biggest firms to establish a body to oversee quality control, and to make sure at least one person on it comes from outside the firm. The rule is part of a broader revamp of quality control standards that the industry wrote itself decades ago and which are only now being updated by the PCAOB, some 20 years after the agency was created following the Enron scandal.

… six large audit firms that, along with the industry’s trade group, have appealed to the Securities and Exchange Commission to nix the rule. … The PCAOB countered this month with a 28-page defence of the standard, urging the SEC to approve and, in a few spots, barely concealing its exasperation.

I have little patience for the big accounting firms here; they’ve had more than their share of failures.

Behaving Badly

Citi was cited by the Fed and OCC in 2020 with:

significant ongoing deficiencies in implementation and execution by Citigroup with respect to various areas of risk management and internal controls, including for data quality management and regulatory reporting, compliance risk management, capital planning, and liquidity risk management.

It looks like the Fed conducted a follow-up exam in 2023 that found:

Citigroup’s progress in executing its plan to enhance its data quality management program … or toward the implementation of appropriate compensating controls has not been adequate.

Now we have a little insight to the findings.

Citi breached a rule meant to keep banks safe, made liquidity reporting errors (Reuters)

Citigroup (C.N), opens new tab repeatedly breached a U.S. Federal Reserve rule that limits intercompany transactions, leading to errors in its internal liquidity reporting, according to a Citi document from December seen by Reuters

Regulation W, opens new tab was put in place by the Federal Reserve more than two decades ago. It aims to prevent depository institutions from incurring losses from their related entities, known as affiliates.

The press tends to write about this as a compliance issue, protecting insured depositors from losses at affiliates, but these days a more common focus will be around crisis and resolution planning.

I have a soft spot for Reg. W as one of my jobs at the Fed was running a unit that did the initial reviews of Reg W. It is also one of the first things you get under control if you are about to come under Fed supervision. Poor Reg. W compliance is a sign that your accounting controls need strengthening.

A Couple Of Risk Management Primers

Basic for some of you, probably enlightening to others.

Risk Management

How Pod Shops Really Manage Risk (Odd Lots)

Tracy (14:20):
Ooh, that’s a good word. Orthogonal.

It’s two things. It's risk limits and it's about how frequently your book turns over. So at a deep value fund, the goal might be, in theory, to have more than a year long average hold period. In practice, it'll be often shorter than that, you know, nine months or whatever as bad ideas cycle out or whatever. But at a multi-manager, those numbers can be anywhere from 10 to 15 to even higher, meaning the entire book turns over 10 to 15 times in a year.

So the first is constraints. So step one is dollar neutrality, I'm long as many dollars as I'm short. That's a simple limit. One level higher is beta neutrality. Relative to the overall market, am I long or short on a beta-adjusted basis? The third level is factor neutrality. I'm balanced against all of these, if you maybe simplify it just slightly, the sub-components of beta. So instead of like ‘Hey, I have a beta to the market,’ I actually have a beta to the basket of size large companies, I have a beta to the basket of companies with momentum

… you add up those exposures on each side and you are limited essentially by the percent of your bets in a book in aggregate that are betting basically on factor type bets as compared to the percentage of your bets that are betting on the remainder term, the non-factor component of any stock.

The other framework of how do you size positions … is there are tools that are called optimizers that basically look at the expected return that each portfolio manager thinks they have in their book of stocks and tries to solve for the optimal balance of the expected return against the volatility of those stocks and the volatility of the factor bets in the book ...

The essential reality is that in order for this entire model to work, you have to have a great deal of diversification across idiosyncratic bets, meaning the non-factor bets.

That then leads to this question of like, what factors exist inside the residual term

… some places will have nothing in terms of tooling and they'll just have a risk team that kind of looks at books and helps people understand their risks on a sort of shorter cycle … They'll get a report on their risks or they'll check in, etc., etc. And then at the far end you have funds that have full software platforms that hand …

… there's sort of a spectrum of people's technology and factor awareness risk systems, but at the sort of platonic ideal of that, that, you know, exists in various forms. There's sort of a CIO level, there's a CIO and risk team level, there's the PM level, there's even an analyst level that sort of is monitoring each level of that.

there is leverage and the leverage you're putting on is not leverage against beta. That's the distinction that I think people often elide, is that when you think of like LTCM, or maybe forgetting even LTCM, but any fund that takes very high leverage on a beta, a directional bet, that's beta on a factor.

And so if you're neutral against those factors, the residual return remains cross-sectionally normally distributed. So there's obviously a lot of detail under the hood, but the basic answer is that you're trying to find a type of return and a diversified source type of return that doesn't have that risk in a blowup. So you're kind of levering alpha.

Derivatives & Asset Management

A Frank Fabozzi paper!

Intricacies of Implementing Derivatives: Insights from Asset Management Experts, Part 1

This paper embarks on a comprehensive exploration of the application of derivatives in asset management, addressing a notable gap in the literature that often skims over real-world applications and the challenges of implementing derivative strategies. Through a collection of detailed illustrations/mini-cases prepared by practitioners, the practical intricacies, challenges, and issues encountered by asset managers when integrating derivatives into their strategies are described. Each case is contributed by seasoned asset managers, offering a blend of theoretical knowledge and practical expertise.

• The series begins with an examination of asset allocation decisions—a critical determinant of performance—showcasing how futures can be utilized in a top-down strategy by Scott Hixon of Invesco.

• Robert Harlow from T. Rowe Price demonstrates hedging techniques using stock index futures and put options, while

• Vineer Bhansali of LongTail Alpha LLC addresses tail risk hedging with options.

• Shaojun Zhang presents liquidity management strategies for active equity fund managers using index futures, and the team from Allspring Global Investments explains cash equitization with futures.

• Foreign currency derivatives for managing currency risk in equity portfolios by the team of Redouane Elkamhi, Jacky S.H. Lee, and Marco Salerno, and

• U.S. Treasury futures for adjusting bond portfolio interest rate risk by Adam Kobor.

• Alexander Rudin from State Street Global Advisors elaborates on developing effective hedging strategies, from simple equity portfolio cases to complex scenarios like high-yield bond portfolios and cross-border equity portfolios, highlighting when it might be beneficial to avoid hedging.

• In the final application, Alexander Rudin, Rahul Sathyajit, and Shubham Upadhyay illustrate the speculative use of derivatives in a commodities portfolio, offering insights into proprietary trading strategies.

Repo Markets

Let’s Start In London

There is an interesting set of developments occurring behind the scenes, driven by the Bank of England. The global repo market is navigating the complex challenges of withdrawing liquidity from the financial system. ²

Over the past year, the BoE has steadily reduced its balance sheet, marking a significant departure from the era of quantitative easing (QE). This liquidity drain has forced banks to increasingly rely on the BoE's short-term repo (STR) facility, which provides cash in exchange for government bonds. The STR facility has seen unprecedented demand, with banks borrowing over £30 billion, a dramatic rise from just £700 million at the start of the year.

The surge in STR usage has sparked debate among market analysts about whether the central bank's balance sheet reduction is happening too quickly, potentially outpacing the market's ability to adapt.

However, this surge in short-term borrowing has raised alarms within the central bank. Vicky Saporta, the BoE's Executive Director for Markets, has voiced concerns about the sustainability of this trend, urging financial institutions to shift toward longer-term repo solutions.

The market's heavy reliance on short-term repos is not without risks. As liquidity becomes scarcer, the potential for market disruptions increases, and we need to ensure that the tools we have in place are robust enough to manage these challenges.

The BoE's Indexed Long-Term Repo (ILTR) facility, designed to offer more stable funding, has seen limited uptake, prompting a review of its effectiveness and attractiveness to market participants.

The Bank is also introducing the Contingent Non-Bank Financial Institution (NBFI) Repo Facility, a new vehicle aimed at providing liquidity to insurance companies, pension funds, and other non-banks during periods of severe market dysfunction. This is not something the Fed has explicitly put in place in the US yet, though it mimics many of the emergency facilities the Fed has used.

The US Has A Different Set Of Issues

In the US there is a transition that is ongoing from Libor to SOFR. Among other aspects, Libor was an unsecured benchmark whereas SOFR is a secured benchmark.

In July, the repo market exhibited some unexplained volatility. One market participant, Concoda, has noted a perplexing dislocation in repo rate benchmarks since July 2024. Specifically, while the Federal Reserve's triparty repo measure (TGCR) remained stable, the OFR's triparty rate (TPR) fell significantly, suggesting that a major cash lender was willing to lend at rates below the Fed's risk-free repo rate, which is unusual and concerning.³

The US is also implementing the Uncleared Margin Rules (UMR) that have forced buy-side firms to engage more actively with triparty agents, leading to a shift in how collateral is managed across the financial system.

Keep watching this space.

MMMF Reform Leading To Shifts In Allocations

Money-Market Assets Rise to New Record With System Awash in Cash (Bloomberg)

In a breakdown for the period to Aug. 14, government funds — which invest primarily in securities such as Treasury bills, repurchase agreements and agency debt — saw assets rise to $5.04 trillion, reflecting a $30.3 billion increase.

Prime funds, which tend to invest in higher-risk assets such as commercial paper, saw assets fall to $1.05 trillion, a $1.04 billion decline. On the institutional side, cash has left prime money-market funds, an indication investors are starting to shift their allocations ahead of the Securities and Exchange Commission’s latest set of regulations, which are slated to take effect later this year.

Cyber Breaches

Managing Cyber Risk: Breach Risk Trends in Public Companies (Harvard)

In the two years to January 2024, almost 700 cyber incidents were reported among Russell 3000 companies in the U.S., impacting more than 10% of the firms. One-third of those involved the compromise of a supplier or other third party, and the study also identified substantial third-party aggregate risk concentration across Russell 3000 firms.

One-third of reported incidents among Russell 3000 firms involved a supplier or other third-party relationship, and incidents that impacted a large number of individuals were more likely to have a third-party as the root cause.

Aggregate risk exposure across the index is high, with more than 90% of Russell 3000 firms utilizing certain third-party technologies, and more than 1,000 different unique supplier/technology pairings each being utilized by more than 10% of constituent companies.

FinTech & Crypto

ClearBank Wins License Allowing Fintech to Expand Across Europe (Bloomberg)

ClearBank Ltd. said it received a banking license allowing the fintech to offer real-time clearing and settlement services to clients across Europe, marking the UK company’s first step toward global expansion.

The European Central Bank authorized the permit, under the supervision of De Nederlandsche Bank, ClearBank said in a statement Friday. The license allows the financial-technology firm to offer European clients with euro accounts, foreign-exchange services, embedded banking and access to major European payment rails, and funds will be protected by the central bank’s deposit-guarantee rules.

Pig Butchering

We first discussed pig butchering in Perspective on Risk - June 15, 2024 when discussing Evolve.

Former CEO of failed bank sentenced to prison (DOJ)

According to court documents, Shan Hanes, 53, of Elkhart pleaded guilty to one count of embezzlement by a bank officer.

While the CEO of Heartland Tri-State Bank (HTSB) in Elkhart, Kansas, Hanes initiated 11 outgoing wire transfers between May 2023 and July 2023 totaling $47.1 million of Heartland’s funds to a cryptocurrency wallet in a cryptocurrency scheme referred to as “pig butchering.” The funds were transferred to multiple cryptocurrency accounts controlled by unidentified third parties during the time HTSB was insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC absorbed the $47.1 million loss. Hanes’ fraudulent actions caused HTSB to fail and the bank investors to lose $9 million.

Model Validation

The Three Types of Backtests

Backtesting stands as a cornerstone technique in the development of systematic investment strategies, but its successful use is often compromised by methodological pitfalls and common biases. These shortcomings can lead to false discoveries and strategies that fail to perform out-of-sample.

This article provides practitioners with guidance on adopting more reliable backtesting techniques by reviewing the three principal types of backtests (walk-forward testing, the resampling method, and Monte Carlo simulations), detailing their unique challenges and benefits. Additionally, it discusses methods to enhance the quality of simulations and presents approaches to Sharpe ratio calculations which mitigate the negative consequences of running multiple trials. Thus, it aims to equip practitioners with the necessary tools to generate more accurate and dependable investment strategies.

1. Regulating Brokered Deposits (UponFurtherAnalysis)

Brokered Deposits Rule Threatens to Upend Bank Balance Sheets (Bank Director)

2. ‘No one length fits all’ – haircuts in the repo market (Bank Underground)

Does the Bank of England have a plumbing problem? (Alphaville)

BOE Wants Banks to Use Long-Term Repos Amid Liquidity Drain (Bloomberg)

Banks Borrow Over £30 Billion From BOE Repo Amid Liquidity Shift (Bloomberg)

3. The Repo Market Dislocation: Part I (Concoda)

The Repo Market Dislocation: Part II (Concoda)