Perspective on Risk - Sept. 8, 2024
Covenant Wars; The Future Of Supervision; Capital; NAV Loans; Jackson Hole; Funding Failed Bank Resolution
The Covenant Wars
and the value of a good Chief Credit Officer
The New Rules of Debt Are Totally Cutthroat (Bloomberg)
… two things have happened over the past decade: Covenants grew weaker, as investors frustrated by the low interest rates prevailing in most of the market competed more fiercely than ever to lend to riskier companies that paid more in interest. And companies facing credit squeezes came up with a bag of tricks to get around some covenants, often by pitting one set of creditors against another.
In the covenant wars, companies that need cash but whose borrowing is constrained have been finding ways either to move assets out of the box and use them as backing for a new set of loans from new creditors, or to give new creditors a higher place in line than some or all of the old creditors.
J Crew’s “trap door”
J Crew devised a plan to “drop” the assets backing its debt into a different subsidiary — structuring the asset transfer as an intracompany “investment” by the parent into the new branch.
Double-Dipping
In what has become known as a double-dip transaction, a company creates a shell subsidiary. New creditors lend money to that shell, which loans the money to another part of the parent company. In return, the shell receives an intercompany note, akin to an IOU. That note can be counted as an asset and becomes the collateral for the loan from the new creditors.
At the same time, a different branch of the company issues a guarantee of repayment of the new unit’s debt. Together, these steps mean that the new unit’s creditors have $2 in claims for every dollar they have lent the company — which dilutes the recovery potential of the claims held by pre-existing creditors.
Up-tiering
A company whose loan agreements may prevent an asset transfer … can arrange for new borrowing if it convinces 51% of existing creditors to rewrite the rules that govern the entire loan in order to permit it. In return for providing that new debt, the favored creditors often can swap their existing loans for new notes that give them higher priority than other creditors in case of a default.
“For lenders, the assessment of risk related to traditional credit metrics — like liquidity and debt service coverage ratio — is often taking a back seat to the risk posed by capital structure vulnerabilities and the threat of this kind of liability management,” said Michael Handler, a partner in the restructuring practice at law firm King & Spalding.
The Future Of Supervision
Acting Comptroller of the Currency Michael Hsu Remarks
Supervisors are the guardians of trust in banking. This makes bank supervision one of the most important, rewarding, and under-appreciated jobs in finance.
I expected to hate this speech. I didn’t. I liked it. A lot.
He starts by running out the old analogies for what the job of a bank supervisor is: are they umpires (calling balls and strikes), cops (enforcing the law), auditors (checking for adherence to internal procedures and processes) or firefighters (saving the neighborhood from financial conflagrations).
I’ve always likened Fed supervision to the CIA (access to confidential information and sources required to identify threats to the financial system).
Hsu concludes (I think correctly):
In practice, supervisors do all these things and more; the trick for supervisors is knowing which role to play in a given situation.
He then goes on to describe the nature of supervision:1
Three things in particular stand out.
Supervision is a ground game. Supervision consists of regular interactions between supervisors and banks through examinations, monitoring, and ongoing dialogue. These activities give supervisors opportunities to develop independent and informed views of a bank’s strengths and weaknesses, its capabilities and vulnerabilities, and its financial condition. …
Supervision is a craft. In addition to being able to play a wide range of roles, effective supervision requires a special mix of skills, techniques, and experiences: curiosity, a nose for b.s., fluency with numbers (especially ratios), an ability to think critically, tolerance for tough conversations with bankers, situational awareness, good judgment, emotional intelligence, communications agility, and an unwavering commitment to public service. …
Supervision is asymmetric. Supervision usually enters the public consciousness only when something has gone wrong. … Effective supervision … is largely invisible to the public. When the banking system weathers notable events well, few give supervision a thought … When there is a headline-grabbing negative incident … supervisors understand they may be subject to intense criticism. This can cause them to become unnecessarily cautious, defensive, or to second-guess themselves. … This can result in supervisors seeking safety in closely adhering to preapproved checklists and processes rather than exercising judgment and discretion. … this can create significant obstacles to implementing risk-based supervision.
He then goes on to discuss the evolution of supervision:
… changes in banks and banking have compelled bank supervisors to adapt to remain effective. Three changes in particular are worth highlighting:
Effective supervision requires a more nimble “team-of-teams” approach. In general, supervision has long consisted of bank-specific teams led by an examiner-in-charge or equivalent. These teams are sometimes referred to as on-site teams, vertical teams, or supervisory teams. The 2008 financial crisis highlighted deficiencies in relying primarily on the on-site team model to supervise global systemically important banks (GSIB). . A mix of teams working together … [for] instance, so-called horizontal teams, with expertise in particular areas such as liquidity or market or cyber risk, might monitor, benchmark, and assess a cohort of banks … complement the vertical teams.
Supervision must be as adept at covering nonfinancial risks as financial risks. Trust and confidence in banks and banking are not just about ensuring financial resilience. … What’s different now is that the stakes for each of these are higher, bank-nonbank interdependencies have increased, and the pace of change has accelerated significantly. Particularly challenging is the proliferation of bank partnerships and arrangements with nonbank third parties, who in turn often partner and rely on fourth parties, and so on. The provision of banking services increasingly resembles global manufacturing supply chains, with their efficiencies and vulnerabilities.
Supervision must contend with more large banks. There must be a commensurate evolution and strengthening of supervision and regulation. … In addition, we must ensure that our supervision and regulation of non-GSIB large banks are not under-calibrated. Given last spring’s banking turmoil and the projected growth of large banks, the time may be ripe for the U.S. banking agencies to consider a framework for formally identifying domestic systemically important banks (DSIB).
I’m happy to say that this is the exact approach we tried to take at the NY Fed back around 2000 when we reorganized thee function into a Relationship and Risk structure.
He also comes out forcefully for tailoring and prioritizing, something that was getting lost post-SVB in favor of a return to “check-the-box” supervision:
The problem with check-the-box supervision is that there are a lot of boxes to check, and each box is given equal weight. This ensures comprehensiveness, but artificially limits our ability to focus supervisory attention where it is needed most. Risk-based supervision takes a different approach by de-emphasizing the checklist
In many ways, the greatest challenge for risk-based supervision lies with what is not prioritized. In theory, supervisory teams should not be responsible for incidents or bank weaknesses in deprioritized areas. In practice, however, supervisors are often expected to know everything about every bank. This expectation rewards check-the-box supervision over risk-based supervision.
Kudos Director Hsu.
Capital
The Amount & Nature Of Capital
Thomas Jordan gave an exit interview to NZZ in "It's not a joke. You are challenged every day and have to expect that the situation will change suddenly" - the farewell interview with the outgoing head of the National Bank. Much of this discussion is on Swiss monetary policy.
Bloomberg has a partial summary of the banking-related highlights in UBS Should Increase Capital Levels, Central Bank Chief Tells NZZ
This got the headlines:
Improvements are required in terms of resolvability, and adjustments are needed on the capital side. (Swiss National Bank President Thomas Jordan)
An old friend and Fed colleague Stefan Walter is taking over for Jordan soon.
IMO, the more insightful comments from the Bloomberg piece were:
Jordan highlighted three elements must be ensured:
An accurate valuation of capital;
An adequate distribution of capital between the parent company and subsidiaries so that in a crisis the necessary decisions can be made at group level without causing capital bottlenecks in the parent company;
Convertible capital can be converted legally without any problems.
All are at least as critical as the overall capital level.
The original NZZ interview has some other interesting tidbits.
I’ve always told many of you that central banks frequently feel constrained by the letter of the law when dealing with crisis’s. Jordan states:
The National Bank must abide by its legal framework and cannot simply do anything. As much as we regret that we no longer have two large banks in Switzerland, the National Bank was not allowed to take over Credit Suisse. If we had done so, we would rightly have been accused of exceeding our authority.
In discussing Credit Suisse:
The problem was that Credit Suisse had too little collateral available or had not prepared enough. A bank must be able to legally hand over assets that it wants to provide as collateral to the SNB as ownership or pledge so that we can realize them in the event of bankruptcy. If the bank has already used these assets elsewhere or cannot transfer the collateral, the SNB is not allowed to provide liquidity.
Knowing what is encumbered and what is available to pledge is an important, if frequently neglected, practice.
A central financial stability question that arises in supervisory circles is “Are the Swiss banks too large for their economy to effectively backstop?” Jordan stays on the party line:
I believe that Switzerland should have an interest in being a leading financial centre. … If we want to remain an internationally important financial centre, we must also accept the risk posed by systemically important, globally active banks. We must find solutions that, on the one hand, enable the development of important banks in Switzerland and, on the other hand, limit the associated risks for the taxpayer.
Capital Rules
US to Propose Bank Capital Rule Revisions as Soon as This Month (Bloomberg)
The revisions, which run up to 450 pages, may be unveiled as soon as Sept. 19 …
They invented LLMs just in time. 450 pages. Wow. Ridiculous.
The original plan had called for an overall 16% hike in the capital that banks must hold as a cushion against financial shocks. But the Fed later floated a dramatically weaker version of the plan to other regulators, which alarmed some agency officials at the time and led to robust negotiations. The weaker version, which served as the initial draft of the September changes, suggested an increase as low as 5%.
All this sturm-und-drang for a measly 5%.
NAV Loans
Private Equity’s Favorite Borrowing Tool Sparks Fresh Scrutiny
The Prudential Regulation Authority has asked banks to provide more information about their offering of net-asset-value loans to buyout funds
NAV loans are a type of debt that allows fund managers to borrow against a pool of companies they own, making them a controversial form of financing because they let private equity managers layer more leverage onto their funds. That’s because the borrowing comes on top of loans taken out by many managers when they first acquire a company.
In its June financial stability review, [the Bank of England] said such “leverage on leverage” could “expose lenders to risks at the portfolio company level, at the fund level, and at end-investor level.”
Commenting on exposure management,
“Very few firms carry out routine, bespoke and comprehensive stress testing for aggregate sponsor related exposures,” [Rebecca Jackson, a PRA official] said. “We found that hardly any banks do it well in this context.”
Good on the PRA. Presume the Fed has already done the same. Ex-ante coordination is a bit weak, but ex-post note sharing should be productive. The kind of thing we might have tried to coordinate under the Senior Supervisors Group rubric in the past.
Jackson Hole
Financial Markets and the Transmission of Monetary Policy
I like to look for the financial stability-related papers that are presented at the dude ranch in Wyoming. From the Jackson Hole symposium, there was a panel on the title topic with Kashyap, Mosser and Swanson presenting. Here are the remarks and handout from Kashyap, and Swanson’s handout. There is no presentation or remarks from my former colleague Mosser on the site. The key recommendations from his presentation (excerpted and reformatted by me) are:
I expect that sometime in the near future a major central bank will decide it needs to embark on a purchase program. With that in mind, I offer a couple of high-level suggestions about how to set up purchase facilities.
My first recommendation is that the internal central bank processes for deciding when to commence and cease purchases should be clarified. In the case of the UK, where a formal Financial Policy Committee (FPC) exists, the existing arrangements seem adequate. … For many other central banks, including the Federal Reserve and ECB, there is not a formal FPC equivalent.
The other suggestion is that after the PFC is formed it should quickly begin a public consultation on how the purchase facility will be structured. There are a myriad of details that need to be worked out, including the range of counterparties who can participate, the range of assets that are eligible, pricing rules and quantity limits, to name just a few. … Starting the discussions now, during peacetime, of what will surely be a complex set of issues is very important.
The OddLots crew interviewed Kashyap in A New Way for the Fed to Fight a Market Crisis (OddLots)
Anil Kashyap … presented a paper at the conference proposing a separate tool within the Fed that can handle balance sheet operations for financial stability. We discussed his proposal along with broader questions about the transmission of monetary policy.
… asset purchases for financial stability should only be deployed when a lending facility won't work. … So the thing that's weird about asset purchases is you're finally admitting, ‘Okay, the lending facility isn't enough.’
Don Kohn’s Reflections
Do is a hero to many of us in the financial stability community. As VC of the Board of Governors, he “got it” and was often a wise voice of council in a crisis.
Don Kohn’s reflections on Jackson Hole 2024 (Brookings)
Powell’s speech was more forceful and forward leaning on the easing side than many expected, myself included. It was a complete pivot from ‘whatever it takes’ on inflation to ‘whatever it takes’ on the labor market, and seemingly no worry that they might not make that last mile to 2% inflation. It was all about easing policy to support the labor market. And there were no cautionary words about the pace of easing—other than it would depend on incoming data. Notably absent were references to ‘gradual’ and ‘measured’ rate cuts
It seems mostly the monetary policy aspects caught his attention, not the financial stability work.
Funding Failed Bank Resolution
An interesting bit of inside-baseball for those of us interested in the technicalities of bank resolution. Steve Kelly writes How the FDIC Sourced Crisis-Time Fed Funding Through the Failed Banks of 2023 (Yale)2
Two things were particularly “unprecedented” about this funding mechanism.
As Vice Chair Hill noted, the FDIC did not immediately pay back the Fed upon the closing of the Silicon Valley Bank (SVB) and Signature Bank bridge banks or of First Republic Bank. The FDIC instead sold many of the assets collateralizing the Fed loans, swapping an FDIC corporate guarantee for the collateralization and keeping the Fed loans outstanding.
Second, and not discussed by Hill or elsewhere, the bridge banks’ extensive new discount window borrowings included uncollateralized borrowing. The FDIC made this “naked” borrowing possible by providing its corporate guarantee—backed by the full faith and credit of the United States—to the Fed as security.
Steve focuses on the fact that the FDIC did not follow normal procedure by repaying the Fed from the proceeds of asset sales.
I was interested in this for different reasons.
First, the primary way the FDIC is supposed to obtain backup liquidity is through a line it has with the US Treasury, not with the Federal Reserve. Steve perhaps correctly points out that this may have been done to avoid pressuring the debt ceiling. Still, it is a skirting of normal-way operations.
Second, I don’t believe that the Federal Reserve has ever in the past accepted an FDIC guarantee on assets in lieu of collateral. Yes, during the GFC the FDIC was involved in explicitly taking credit risk on assets allowing the Fed to maintain a super-senior position to meet its “well-secured” obligations, but this was not a guarantee given to the Fed. So this is something new.
Kelly shows that the FDIC guarantee was needed for SVB to continue to obtain Fed funding as the collateral was substantially under water (and hence not well-secured):
FDIC Chair Martin Gruenberg … revealed that SVBB’s discount window borrowing appeared to have little margin and SBB’s appeared to be substantially underwater. The SVBB borrowings of $126.5 from the discount window were against collateral with book value of $152.2 billion and fair value of $127.5 billion—a haircut of less than 1%. SBB’s outstanding $53.6 billion of discount window borrowing at the time of failure was backed by collateral with a book value of $65.3 and fair value of just $42.3 billion—a “haircut” of negative 27%.
Kelly raises the interesting question of whether the FDIC needed to borrow from the Fed given its ability to guarantee repayment of funds - wouldn’t the private sector be willing to take the guarantee rather than have it done somewhat opaquely through the Fed?
I’ve reformatted a bit for emphasis and clarity.
One nit: the article refers to “the Banking Crisis of 2023” - I still dispute whether this rose to the level of a crisis.