Sunday, July 31, 2011

Alan Greenspan reinforces need for separating monetary policy from bank supervision and regulation

One of the critical decisions that governments have to make is whether to separate or combine monetary policy and bank supervision and regulation in the same regulatory body.

Prior to the credit crisis, the US combined these functions in the Federal Reserve while the UK kept them separate.  That neither structure prevented the crisis strongly suggests that both are fundamentally flawed.

Regular readers know that the fundamental flaw in both structures is the regulators' monopoly on all the useful, relevant information on the current asset and liability-level data at the banks.  As a result of this monopoly, market discipline cannot be applied to the banks as the markets are not able to perform their analytical function and instead must rely on the regulators performing this function.

Unfortunately, as documented by the Bank of England's Andrew Haldane and others, unlike market participants like competitors and credit and equity market analysts, regulators have difficulty translating this data into useful, actionable information.

This is why this blog has recommended the adoption of the FDR Framework.  Under this framework, the data is made available to the market participants.  They can turn it into useful information for the purposes of market discipline and also to help the regulators.

Assuming that the FDR Framework is adopted to cure the fundamental flaw in current bank supervision and regulation practices, the question then becomes should monetary policy and bank supervision and regulation be separated?

Individuals like Paul Volcker would argue that it should not be separated.  His argument is based on the idea that the regulator in charge of monetary policy is also the lender of last resort.  As the lender of last resort, there is a need for understanding the collateral that is pledged to the central bank.  As Walter Bagehot described in Lombard Street, central banks are only suppose to lend against good collateral.

Under the FDR Framework, central banks do not need to be responsible for bank supervision and regulation in order to receive the information necessary to determine the quality of the collateral.  Like all market participants, they will have access to it.  More importantly, the central banks will also see the valuation that the credit markets place on any individual asset that might be pledged as collateral.

Alan Greenspan makes the case for why they should be separated.  In a recent A-list blog posting on the Financial Times, Mr. Greenspan discussed why regulators should take more risk and allow banks to operate with lower capital requirements.

Regular readers know that I am not a big fan of higher capital requirements as capital is an easily manipulated accounting construct.  Higher capital requirements are not a replacement for ending the regulators' information monopoly and disclosing all the useful, relevant information in an appropriate, timely manner to market participants.

That said, the natural focus of bank supervision and regulation is financial stability.  If this regulator is doing its job right, it is working with the market's to take pre-emptive action (which is what market discipline is) to restrain individual bank's from taking excessive risk.

What happens if this regulator has to report to an individual who believes in gambling on financial stability with less frequent intervention and lower capital requirements?  The results when this occurred in the US under Chairman Greenspan was a financial crisis of epic proportions.

A response to some of the issues raised in Mr. Greenspan's post.
Since the devastating Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against virtually all the risks exposed by those extremely low probability events. But should they?
Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges... 
The choice by the Bush and Obama administrations to extend guarantees to the financial services industry was a choice to preserve the existing banks.  There was a clear alternative.  Let the existing banks fail and sell off their assets to new banking firms.
Any excess bank equity capital also would constitute a buffer that is not otherwise available to finance productivity-enhancing capital investment. 
The choice of funding buffers is one of the most important decisions that societies must make, whether by conscious policy or by default. If policymakers choose to buffer their populations against every conceivable risk, their standards of living would almost certainly decline.... 
Buffers are largely a luxury of rich nations...
Perhaps I am missing something, but did the lack of adequate buffers in the recent credit crisis result in the rich nations losing more money than they could afford to lose?  If not, then why is the US, Ireland, Portugal, Spain and Greece staring at default and austerity programs?
How much of its ongoing output should a society wish to devote to fending off once-in-50 or 100-year crises? How is such a decision reached, and by whom? 
In the 19th century, when caveat emptor ruled, such risk judgments were not separable from the overall price, interest rate and other capital-allocating decisions struck in the marketplace. 
Today, while the decisions of what risks to take remain predominantly with private decision-makers, the responses to the global financial and, of course, the Japanese earthquakes have been largely government scripted.
In the 21st century, when the FDR Framework, which combines the philosophy of disclosure with the principle of caveat emptor, is in place, governments will not have to script responses.  Investors understand that they are responsible for absorbing all losses and it will be expected that the government will step in and shut down any bank before taxpayers would suffer any losses.
In the immediate aftermath of such crises, it is very difficult to convince people that the recent wrenching events are not likely to recur any time soon, because, with a (very) low probability, they might. This is especially the case having just been through the brunt of a financial crisis that is likely to be judged the most virulent ever. 
Actually, it is impossible for the regulators to convince people that they know what they are doing now.  Everyone knows that they were in a position to identify and take steps to mitigate the financial crisis but failed to do so.

Without the fundamental change of ending their information monopoly, why should anyone believe that regulators can and will do their job better in the future?
In the wake of the Lehman bankruptcy in 2008, private markets and regulators are requiring much larger capital, ie buffers, to support the liabilities of financial institutions. Had banks and other financial entities maintained adequate equity capital-to-asset ratios before the 2008 crash, then by definition, no defaults or contagion would have occurred as the housing bubble deflated. A resulting recession, though possibly severe, would almost certainly not have been as prolonged or required bail-outs. 
Actually, had all the useful, relevant information been disclosed in an appropriate, timely manner to the markets, there would have been no reason to hold much larger capital buffers.  The market would have been able to exert market discipline and kept the risk within the capacity of the bank's capital base to absorb.
Bank managements, currently repairing their demonstrably flawed risk management paradigm, have been moving aggressively to build adequate capital to enable them to lend.
I wonder if the discussion by regulators to significantly increase capital requirements has any influence on management's decision to retain more capital?
... What is not conjectural, however, is that American policymakers, in recent years, faced with the choice to assist a major company or risk negative economic fallout, have regrettably almost always chosen to intervene. 
The choice to intervene is driven by the lack of data available to the market.

 If the market had the current asset and liability-level data for each financial firm, each participant could manage their exposure to every financial firm based on its risk profile.  Knowing that they might lose all of their exposure, each financial firm has an incentive not to take on greater exposure than it can afford to lose.  With disclosure, the risk of contagion is minimized.

Without disclosure, there is a strong incentive to intervene.
Failure to act would have evoked little praise, even if no problems subsequently arose; but scorn, and worse from Congress, if inaction was followed by severe economic repercussions. 
Regulatory policy, as a consequence, has become highly skewed towards maximising short-term bail-out assistance at a cost to long-term prosperity.
A problem that is easily solved with disclosure of all the current asset and liability-level data for each financial institution.

Saturday, July 30, 2011

Gambling with financial stability not limited to regulators

Between the US and European governments it is harder to tell which likes to gamble with financial stability more.

In the US, the Administration is talking about armageddon if the debt ceiling is not increased.  Not surprisingly, consumer and investor confidence is plummeting.

At the same time, just like it did for healthcare and financial reform legislation, rather than demonstrate any leadership by publicly defining exactly what it wants from Congress to address the problem, the Administration is leaving it up to the Democrats and Republicans in Congress to draft a bill acceptable to both parties.

Hello.  The public does not give credit for "passing" legislation.  The public gives credit for passing legislation that  does something positive for the US.

Take the financial reform legislation (also known as the Dodd-Frank Act).  The D and F actually stand for the grades that the public is assigning to this legislation.

Why are the grades so low?  It is obvious to the public that the legislation puts dramatically more responsibility into the hands of the regulators to prevent a future financial crisis.  The very same regulators that the public knows who had more than enough authority to prevent the last crisis and failed to do so.  Talk about gambling with financial stability.

It is equally obvious to the public that the legislation does not address the causes of the crisis.  Let us take for example the credit rating services.  The Dodd-Frank Act was suppose to reduce the financial system's reliance on the credit rating services.  The fact that the Administration is concerned over the potential for a downgrade and the impact this downgrade will have on the global economy is a sure sign that the Act did not achieve this goal.  Talk about gambling with financial stability.

Meanwhile, the governments in the Eurozone are hardly free of the gambling with financial stability addiction.  They keep trotting out the same solution to the bank solvency problem and its related sovereign debt crisis:  bailouts.

Unfortunately, the Eurozone governments just implemented the most recent bailout immediately after the regulators stress tested the banks and concluded that most banks were adequately capitalized and could absorb losses.  By implementing a bailout so soon after the regulators announcement, it calls into question the competency of the regulators.  Talk about gambling with financial stability.

On top of that, the latest bailout did not actually fix the Greek sovereign debt problem as it does not substantially reduce the amount of debt Greece owes.  This sets up the need for yet another bailout.  Talk about gambling with financial stability.

Despite all evidence to the contrary, your humble blogger continues to believe in Winston Churchill's observation that the US and, by extension, Europe always finds the right solution after trying everything else first.

If so, we must be rapidly approaching adoption of the FDR Framework.  As regular readers know, it is this framework that is the basis for financial stability and the restoration of investor and consumer confidence.

Friday, July 29, 2011

Has the limit been reached on bailouts?

Have we finally reached the limit on bailouts?  The Wall Street Journal's Richard Barley wrote an interesting column summarizing why Europe might have reached its limit as now France is coming under pressure.  The ongoing debt ceiling debate in Washington suggests that the US might have reached its limit too.

If we are finally approaching the limit, this means we must finally be nearing the end of the Bush-Paulson policy adopted at the start of the solvency crisis in 2007 of protecting banks from losses.  Instead, having had three years of exceptional earnings with which to recapitalize themselves, banks will now have to absorb the losses from their investment and lending decisions.
Is the euro-zone apple rotten to the core? 
Greece, Ireland and Portugal are on bailout lifelines. Cyprus, significantly exposed to Greece through its banks and hit by economic and political turmoil, may be next. Spain has called early elections as it battles with its budget deficit and, along with Italy, is under the market microscope. Repeated emergency summits and pledges to protect the euro have fallen flat. 
Cracks may now be emerging at the heart of the euro zone as government bond markets distinguish between French and German debt. French 10-year bonds, at 3.22%, now yield 0.68 percentage point more than German securities, far more than the 0.3-0.4 point gap seen for much of the year, and a level that has only been seen in the months following the collapse of Lehman....
But that doesn't mean there isn't cause for concern. France has vulnerabilities: Of the six triple-A-rated countries in the euro zone, it has the highest deficit, 7% of gross domestic product in 2010, and the second-highest debt, at 81.7% of GDP. 
The International Monetary Fund warned this week that France might have to take more measures to hit budget targets in 2012-2013. France is vulnerable to slowdowns in Spain and Italy, and its banks are exposed to debt in those countries. 
Other problems aren't directly of its making: the euro-zone crisis and the policy response to it. Each country that becomes affected simply reduces the number of options European government bond investors have, as well as increasing the strain on the strong countries that are on the hook to fund rescues.

Thursday, July 28, 2011

Solvency, US debt ceiling and European Solvency Crisis

It appears that it has become much more difficult for politicians to buy time in face of the solvency crisis that began in 2007.

Faced with a global solvency crisis, governments on both sides of the Atlantic chose to buy time through a combination of bailouts for the banks, socialization of some of the losses in the financial system and massive economic stimulus packages.

As a result of this decision, in the US there is a debate over whether to permanently end the role of US government debt as the risk-free asset off of which all other financial assets in the world are priced.  This debate takes the form of a partisan debate over whether to raise the US debt ceiling or not and, if the debt ceiling is raised, whether the additional debt should be paid for by the middle class or by the rich.

As a result of their kick the can down the road decision, European countries are facing a sovereign debt crisis of their own.

I am not going to debate whether buying time was a good decision or not.  What is much more important is the issue of what do you do to address the solvency problem with this very expensively purchased time.

From an economic perspective, it was used to pray for a miracle.  Paul Krugman summarized this miracle in his NY Times column as
Everything might still have been O.K. if other major economic players had stepped up their spending, filling the gap left by the housing plunge and the consumer pullback. But nobody did. In particular, cash-rich corporations see no reason to invest that cash in the face of weak consumer demand.
This blog has documented why this miracle was made even more unlikely by the strategies adopted by the governments.

For example, the central bankers pursued zero interest rate policies.  As Walter Bagehot pointed out a century ago, when interest rates drop below 2%, prudent individuals adjust their behavior (as previously discussed, there are three types of individuals - those who spend everything they earn, those who earn so much they cannot spend it all and those who are prudent and save for retirement).  In this case, faced with the loss of earnings on their savings that they need for retirement, prudent individuals cut back on current consumption to make up for the shortfall.

While zero interest rates make it cheaper for corporations to expand, the incremental benefit of lower financing costs in no way offsets the impact on their investment decision of the drop in demand for their product(s) corporations are currently experiencing.

The fact that central bankers are praying for the miracle of corporations to hire employees and invest with no demand in sight means that central bankers should at a minimum pursue policies that increase demand not reduce it.

From a regulatory perspective, the time purchased was used to increase the regulators' role in the financial system.  The Financial Stability Oversight Council's 2011 annual report describes this as:
The challenge of maintaining a stable financial system is exacerbated by the difficulty of
balancing the benefits of regulation against the costs of excessively restraining prudent risk
taking behavior. If we were to set the overall combination of margin, liquidity, and capital
requirements too high, we could handicap the ability of the financial system to support
economic growth. Further, financial activity would inevitably move more quickly to firms,
markets, and countries where the intensity of regulation is weaker. So we need to continue
to strive for a careful balance between the imperatives of creating a more stable system and
promoting a level of innovation and dynamism.
With all of these new powers, shouldn't the financial system be safer?

In Europe, the regulators recently ran stress tests that suggested that a de minimus amount of equity was needed to maintain the solvency of over 90 banks.  Why is it if the regulators are on top of everything that the European governments needed to step in subsequently with another bailout?  

Regular readers know that the bank solvency crisis has not been addressed.  If it had, disclosure under the FDR Framework would have been adopted and implemented.

Friday, July 22, 2011

ECB set to select advisor to restore confidence in Irish banking system

A Reuters' article discussed how the ECB is in the process of selecting advisors to help it deal with both a restructuring of the Irish banking system and the management of its own exposure.

Ultimately, the solution to both of these issues goes under the broader heading of restoring confidence in the Irish banking system.  For example, with the restoration of confidence, private investors and depositors will provide the funds the Irish banks need to repay the ECB funding.

The question is what does it take to restore confidence in the Irish banking system?

Regular readers know that restoring confidence requires adoption and implementation of the FDR Framework.

The key to restoring confidence is making available to market participants all the useful, relevant information on the Irish banks in an appropriate, timely manner.  This information consists of the banks' current asset and liability-level data.

Market participants, knowing that they are responsible for any gains or losses on investments in these banks, will analyze this data to understand the risk/reward of an investment.  Confident in their analysis, market participants can then make a decision to invest.

Absent current asset and liability-level disclosure, any solution that the select advisor(s) propose will not work and is not worth the money spent for the advice.

This is not the first time your humble blogger has made this observation with respect to Ireland.  It is a matter of record that before Ireland spent a significant amount of money on a BlackRock Solution led stress test and bank restructuring your humble blogger said it would not restore confidence.  It is a matter of record that the exercise failed to restore confidence.
The European Central Bank is in the closing stages of appointing advisers to help it deal with Ireland's battered banking system and manage its own exposure to the heavily indebted country. 
The ECB asked potential advisers at the end of April to make proposals on how best to restructure Ireland's banking system, reduce banks' dependency on ECB funding and sell off their assets or alternatively transfer them to resolution funds....   
Only a handful of financial advisers were invited to pitch to the ECB, in part because institutions such as Barclays Capital, BlackRock Solutions and Boston Consulting Group might face a conflict after advising the Central Bank of Ireland in the run up to its stress tests. 
The conflict these firms face is their recommended solution failed to restore confidence.
The ECB could pick from the biggest debt restructuring houses like Rothschild -- which was the main adviser for the previous Irish government -- and Lazard. 
In November investment banks including Bank of America Merrill Lynch, JP Morgan, Goldman Sachs and UBS headed to Dublin to counsel the government and banks.
Aside from bank advisers, fixed income independent advisory firms like AGFE and Stormharbour have built specialist teams, as have alternative asset managers, such as BlackRock Solutions and PIMCO.
Other than adopting disclosure as recommended by your humble blogger, what these firms have to offer are variations of solutions that Barclays, BlackRock Solutions and Boston Consulting previously rejected as inferior to the failed stress test and bank restructuring they led.  The problems identified with these variations that made them inferior to the failed stress test and bank restructuring still exist.

More importantly, there is no reason to believe that the variations of the solutions that Barclays, BlackRock Solutions and Boston Consulting previously rejected will restore confidence.
The dependency of Irish and other periphery banks on the ECB is complicating the process of raising interest rates, and runs the risk of tarnishing the image of its lending operations.
Actually, what tarnishes the ECB's image is the activities it undertakes that are outside of its staff's highly regarded expertise in the conduct of monetary policy.  Examples of these activities outside the expertise of the ECB's staff include the ECB's attempts to restore confidence in the Irish national banking system or to bring transparency to the market for structured finance securities.

In attempting to restore confidence in the Irish banking system, the ECB is tarnishing its image.  It does this by appearing to practice Albert Einstein's definition of insanity:  doing the same thing over and over again and expecting different results.  The Irish have already tried investment banking, asset management and global management consulting firms and this has not worked to restore confidence.  Why would trying other firms from these industries as advisors produce a different result?

In attempting to bring transparency to the structured finance securities market, the ECB is permanently staining its image.  This blog has documented three significant problems with the ECB's solution.  Its proposed ABS data warehouse violates fair disclosure regulations.  It provides updated data on a frequency not satisfactory for timely rating changes or knowing what you own under Article 122a of the Capital Requirements Directive.  It features exactly the types of conflicts of interest in control of a data vendor that the European Union's Competition Committee does not want.  Each of these problems by itself should have caused the ECB to announce that it was withdrawing its proposal and going to rethink how it pursued this initiative.  Instead, the ECB has carried on as if these problems do not exist.
The decision to go to the private sector is evidence of the problems the ECB has encountered over the past two years in trying to come up with an in-house plan to wean weak banks off its liquidity support.     
It came close to launching a medium-term funding facility for Irish banks, which it hoped could have been a template for others, back in March, but eventually shelved the plans after hitting resistance from some of its own policymakers. 
The ECB is estimated to have bought around 15-20 billion euros of Irish government debt under its controversial bond buy programme. 
Irish banks are also borrowing almost a quarter of all the money it lends, leaving the ECB with over 100 billion euros worth of Irish collateral on its balance sheet. 
The Irish banking system has encountered the modern equivalent of a bank run.  Market participants do not know which banks are solvent and which are not. Because solvency is the issue, it is not surprising to see investors and depositors reducing their exposure to these banks.  As this occurs, the ECB is required to step up and cover the shortfall in funding at the banks.

It is not surprising that any in-house plan that did not involve disclosing all the current asset and liability-level data to market participants has failed.  Disclosing this data to a limited group of market participants in the Irish stress tests also failed. 
The proposal that the ECB's market operations and financial stability departments sent to potential advisers specified that the bank was looking for an independent assessment and a set of recommendations guided by the ECB's policy objective.
My firm could take on the assignment.
The winner of the main 3 million euro contract, which lasts until the end of 2011 but could be extended, will have to provide updates to the ECB before each EU/ECB/IMF mission to Dublin, meaning the first recommendations are likely to come around mid-October. 
Unlike the firms that assisted in running the latest Irish stress test and reorganization that failed to restore investor confidence, my firm would be willing to put some of its fee at risk that its solution will restore investor confidence.
Staff teams from this "troika" published the outcome of their latest quarterly review this week. 
The ECB's requirements include an assessment of how much capital Irish banks require for markets to perceive them as safe.
Why guess how much capital is needed for markets to perceive the Irish banks as safe when providing disclosure results in the markets telling everyone how much capital is required for the markets to think the Irish banks are safe?
It also wants opinions on liquidation prices and investor demand for various types of banks' assets, including potential proposals for the consultant to partner with private equity or distressed debt specialists to sell assets, and an assessment of the potential for selling securities backed by banks' assets.
Again, why guess when by providing disclosure to the markets the answer can be known?  Without the answer from the market, all the solutions the ECB is looking at are designed to maximize the looting of the Irish.

I look forward to advising the ECB and restoring confidence in the Irish banking system.

Latest European bailout buys time for implementing FDR Framework disclosure

European leaders unveiled their latest effort to address the sovereign debt and bank solvency crisis.  It is a fund to bailout countries and banks.

As regular readers know, bailouts do not address the underlying solvency issues of the countries or the banks, but rather buy time.  This time can be used to pray for a miracle or to actually address the underlying solvency problem.

Since I am an optimist, I will assume that the time will be used to address the underlying solvency problems.

For European banks, the first step in doing this is to adopt and implement the disclosure requirements of the FDR Framework.  This means providing market participants with access to all the useful, relevant information in an appropriate, timely manner.  For banks, this information is current asset and liability-level data.

Market participants will then use this data to determine which banks are solvent and which are not.  This is done by comparing the market value of each bank's assets to the book value of its liabilities.  If the market value of its assets exceeds the book value of its liabilities, the bank is solvent.  Otherwise it is insolvent.

Perhaps more importantly, everyone knows how much capital is needed by the insolvent institutions to restore them to solvency.  The insolvent banks can either be recapitalized by the national government using funds from the bailout fund or closed.

Adopting disclosure under the FDR Framework and combining it with the bailout fund allows each country to restore solvency to its banking system independent of its sovereign debt situation.

Thursday, July 21, 2011

More on the European stress tests and its related data disclosure

The blog Bond Vigilantes ran an interesting post on the European stress tests and its related data disclosure.

This post puts an emphasis on what is required to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.
So the results of the bank stress tests are out. Do they add anything from an investor viewpoint? 
Well, despite the best efforts of the European banking Authority, we didn’t get the harmonised EU data we were hoping for. To say that there are inconsistencies in the data would be an understatement. 
Disclosure varies hugely bank by bank, especially in areas such as their Loan to Value ratios for real estate lending, and that’s before you start trying to factor in the differences in the way property valuations are performed or indexed in each country. Banks, and in particular the tax systems and legal systems in which they operate, are still national. We’re a long way from a harmonised, EU wide banking sector. 
There’s also no real information on banks’ liquidity positions. Assumed funding cost increases over the next two years are simply driven by the interest rate assumptions used, with little or no linkage to the banks’ actual and increasing costs of funding. It’s impossible to analyse what is happening to individual banks’ funding sources and costs. The EBA admits liquidity and funding is a critical issue but has backed away from making public its liquidity stress testing, presumably because they are concerned this might provoke further concerns. 
One of the most frustrating issues for investors is that the EBA doesn’t stress test the legal entities to which investors and market counterparties are exposed or potentially exposed. So the French mutual groups are tested on a consolidated basis, when in fact debt and equity investors are taking exposure to very specific legal entities within the group, such as CASA within the Credit Agricole group, whose risk profile will be very different to that of the consolidated group. 

EU highlights why only disclosure can be global standard (update)

As the negotiations over restructuring the debt of Greece heat up, Michel Barnier, the EU internal markets commissioner, laid out the rules for bank capital requirements.  While the required level of capital is important, what was more significant was the limit placed on national bank regulators preventing them from adopting and enforcing even higher capital requirements.

A Telegraph article by Harry Wilson suggests that the reason for this limit is that not all countries would be able to implement a higher capital standard.

One of the strengths of current asset and liability-level disclosure for banks is that it can be uniformly enforced regardless of the financial condition of the country the bank is headquartered in.
Banks will be forced to hold more capital of a higher quality as part of the package of reforms that will hand the EU sweeping powers to intervene in the financial system to prevent a future crisis....
Michel Barnier, EU internal markets commissioner, said regulations were a "tremendously important step forward in learning the lessons from the crisis"....
In line with the Basel III capital agreements, European banks will be required to maintain a core tier one capital ratio of 8pc, of which common equity will have to make up 4.5 percentage points of the total, up from two percentage points. In addition, banks will in good years be expected to set aside an undetermined additional store of capital as a "countercyclical buffer" and the largest banks will also face an additional surcharge. 
In what could prove to be contentious, national regulators are limited in their ability to impose extra capital requirements on their domestic banks, with the EU saying it wanted to prevent countries from "distorting" the market. 
"Financial stability can only be achieved by the EU acting together; not by each member state on its own," said the EU. 
"The apparent aim of the Commission is that, by creating uniform prudential standards, those jurisdictions that would struggle to impose higher standards will not be perceived as less safe, and capital requirements will not become a basis for inter-state competition," said Jeremy Jennings-Mares, a capital markets partner at law firm Morrison & Foerster. 
"It is frankly extraordinary that the UK has to fight in Europe to retain this discretion for national supervisors," said Ash Saluja, at law firm CMS Cameron McKenna. 
Senior British regulators, including Lord Turner, the chairman of the Financial Services Authority, have argued that higher capital requirements could be imposed in future. 
David Miles, a member of the Bank of England's Monetary Policy Committe, has said a capital ratio of 20pc could be appropriate.

Subsequent to the original post, Michel Barnier reversed course on not allowing national regulators to set higher capital standards.  According to a Reuters' article,
The UK will still be able to ring-fence its retail banks and impose extra capital limits on them under the European Union's proposed capital and liquidity rules, the bloc's financial services chief said. 
Michel Barnier, the EU's internal market commissioner, told the Financial Times on Friday he had split his proposal into two to give governments such as the UK and Spain more flexibility to impose additional demands on parts of their banking sector. 
The draft laws, unveiled on Wednesday, would make the EU the first jurisdiction to begin implementing the new global Basel III accord, which aims to make banks safer by making them hold more and better quality capital against unexpected losses.

The UK and other countries such as Sweden previously raised concerns that the draft EU laws would make it difficult for countries like Britain to tighten capital controls on banks beyond the levels which had been agreed internationally.

Some investors had also believed that Barnier's Capital Requirements Directive 4 would bar the UK's Independent Commission on Banking, chaired by John Vickers, from pursuing its bid to force banks to ring-fence their retail operations. 
"It seems (the Vickers Commission) may be proposing 10 percent for retail banks. That would be possible in my proposal. We think we have the flexibility we need," he told the FT. "We do think the (Vickers) proposals can be integrated into our framework." 
He also said that his proposal "foresees a much expanded use of the countercyclical buffers" that would allow countries like the UK to pile extra capital requirements on top of the 7 percent for "financial stability" reasons. 
"In the directive are all the issues relating to supervision where national flexibility is needed. There is flexibility for supervisors on the buffers," he said. 
Barnier added that he was confident that his proposal would eventually win the full support of the UK. "It becomes more credible if we have the UK on board, given the support of its financial sector," he said.

Wednesday, July 20, 2011

Asset managers reduce reliance on rating agencies

As predicted under the FDR Framework, a Reuters article describes how asset managers are using disclosure to reduce their reliance on rating agencies.

Regular readers know that this blog has recommended that disclosure is the key ingredient for replacing rating agencies in financial regulations.  If there is disclosure, market participants can do their own homework and not rely on the rating agencies.
Some of the world's largest asset managers are cutting ties to credit rating agencies, potentially signalling the beginning of the end of their grip on global financial markets. 
Managers responsible for billions of euros of fixed income investments are reviewing relationships with the likes of Fitch Ratings, Standard & Poor's and Moody's Investors Service, whose calls on Portugal, Ireland and the United States have roiled central banks desperate to avert a collapse of the Euro zone. 
Fund firms contacted by Reuters said rating agency research tended to be backward-looking and superficial, and often encouraged the kind of speculation that has recently dragged down Italy, one of the world's largest government bond issuers. 
"We have cancelled our subscriptions to two of them and they haven't left us alone since. It has been very irritating," the head of sovereign debt investment at one large European bond investor told Reuters on condition of anonymity. 
"It would be naive to blame the agencies for everything that went wrong during the financial crisis but anyone who relies on a third party to form their investment opinions is headed for trouble ... clients pay us to make those decisions, it would be completely wrong of us to abdicate that responsibility." 
Investors say they have steadily reduced reliance on external research providers ever since rating agencies slapped high ratings on complex structured financial investment products such as collateralised debt obligations (CDOs) which later turned out to be far riskier than initially assessed. 
A broad push for development of proprietary research teams shows credit ratings agencies have never fully regained the trust of some of their most important buy-side clients, some of whom are still counting the costs of belated warnings of a change in the risk profile of debt issuers...
"Ultimately, we believe that the research which we produce 'in-house' is more detailed, more forward looking and timelier than that of the agencies," Garrett Walsh, head of credit research, Europe and Asia at Pioneer Investments told Reuters. 
Pre-crisis, Pimco, the world's largest bond investor, used to limit its own internal ratings to private corporations. In 2008 it extended this to Western sovereign credits and now runs its own internal ratings system for all issuers of debt. 
"We will compare our rating to the external ratings but we try to make our decision independent of what the major rating agencies are saying and that has certainly accelerated," Andrew Bosomworth, head of portfolio management in Germany at Pimco, told Reuters. 
"We know what's inside what we rate," he added. 
Daniel Noonan, a New York-based spokesman at Fitch said his company advised investors to use its ratings and commentary alongside a range of inputs when making investment decisions. 
"We think over-reliance on any single input, including a credit rating, is unwise. We continue to see strong demand for our opinions and products, and as a result our business is growing," he said. 
"Investors are undoubtedly doing more of their own research, which we think is appropriate. However, they still need benchmarks to support their research efforts," added Michael Privitera, a member of S&P's Valuation and Risk Strategies team. 
While credit rating agencies may be losing influence on the investment decisions of the world's largest asset managers, sudden ratings calls can still trigger massive sell-offs from passively-managed funds which track an index whose composition is shaped by the ratings given by the credit agencies. 
When a country's debt is downgraded below investment grade it is pushed out of an index, forcing passive investors to sell their holdings and crystallize hefty losses that could shrink when the immediate rush for the exit subsides.... 
Some investors say credit default swap prices -- the cost of insuring debt against default -- are a much better measure of risk than credit ratings....
"Our approach seems to have quite a high correlation to 5-year CDS index which is a decent measure of value in bond markets and a much greater correlation than rating agencies have. In general markets tend to move ahead of rating agencies," BlackRock's Ewen Cameron Watt said.

Tuesday, July 19, 2011

European stress tests confirm FDR Framework

Bloomberg ran an article confirming yet another prediction under the FDR Framework.  In particular, the article confirms the prediction that market participants will analyze the most recently disclosed data and use the results of this analysis to exert market discipline.

In this particular case, market participants analyzed the European stress tests and their related data disclosure and are now requiring specific banks to raise more capital.
Deutsche Bank AG (DBK), Royal Bank of Scotland Group Plc (RBS), Societe Generale SA and UniCredit SpA (UCG) may face pressure from investors to boost capital after scraping through Europe’s banking stress tests. 
Deutsche Bank, Germany’s largest bank, had a core Tier 1 capital ratio of 6.5 percent under the test’s adverse scenario. While that surpassed the 5 percent fail rate, it ranked eighth among the 12 German banks that participated and 57th overall among the 90 banks tested. Edinburgh-based RBS had a ratio of 6.3 percent, Societe Generale of Paris 6.6 percent and Milan- based UniCredit 6.7 percent...
“Since the stress tests did not include any sovereign debt failure, some view them as not being stringent enough,” said Espen Furnes, an Oslo-based fund manager at Storebrand Asset Management, which oversees $74 billion. “If we see sovereign defaults, many of the large banks like Deutsche, SocGen and RBS will need new capital. These banks should strengthen their capital base to curb investor worries.”
Deutsche Bank, Societe Generale (GLE) and UniCredit said their capital ratios would have been higher had regulators recognized all the steps they were taking to increase reserves...
JPMorgan Cazenove analysts led by Kian Abouhossein said in a note after the test that as many as 20 banks may need to raise as much as 80 billion euros of additional capital to help allay investor concern over a Greek default. 
“The EBA tests give a lot of transparency and it looks like some of the banks, even if they did pass the 5 percent capital ratio minimum level, will likely need to boost their capital to regain market confidence and investors’ trust,” said Jonathan Fayman, a fund manager at BlueBay Asset Management Plc in London, which oversees about $43 billion....
Deutsche Bank said on July 15 that the stress tests failed to reflect the bank’s plans to reduce risk-weighted assets and retain earnings, as well as the “sound economic environment” in Germany. The company plans to reach a target for a core Tier 1 ratio above 8 percent by 2013 under Basel III rules. A spokesman declined further comment. 
By reducing risk-weighted assets, a bank can bolster its capital ratio. 
“I don’t expect Deutsche Bank to make a capital increase,” said Konrad Becker, a Munich-based analyst at Merck Finck & Co. “You have to look at the reason for the 6.5 percent ratio and it is not because of sovereign risk. It is mainly because of risk-weighted assets linked to derivatives and other assets.” 
Chief Executive Officer Josef Ackermann, 63, told reporters in Cernobbio, Italy, in April that the company is “well capitalized.” The Frankfurt-based bank raised 10.2 billion euros last October in its biggest-ever share sale to finance a bid for a controlling stake in Deutsche Postbank AG and meet stricter capital rules for banks. 
Societe Generale, led by CEO Frederic Oudea, 48, would have had a core Tier 1 ratio of 7.5 percent under the adverse scenario had the tests taken into account its first-quarter results, an option to pay dividends in shares, the annual capital increase reserved to employees and the reduction of capital allocated to risky assets, according to a statement on July 15. The bank reiterated that the ratio will climb to at least 9 percent in 2013 under Basel III. Spokeswoman Laetitia Maurel declined to comment. 
Berenberg Bank analysts including Nick Anderson said in a note yesterday that the EBA’s methodology was “relatively harsh” on RBS as it assumed a static balance sheet after 2010, ignoring the bank’s plans to sell holdings including its insurance unit to reduce assets by a further 10 percent by the end of 2012. 
RBS spokesman Michael Strachan declined to comment. The bank, run by Stephen Hester, 50, since November 2008, required a government rescue after piling up the most losses of any European bank during the financial crisis, according to data compiled by Bloomberg. 
“The bottom line is that the role of capital in a bank is not properly understood, putting pressure on banks to hold more capital rather than less in the future,” the Berenberg analysts said in the note. “The debate is now in the hands of politicians, the media and the markets, all now armed with stress test data.” ...
“The stress tests conducted showed that although only eight banks failed, several of the larger European banks are thinly capitalized,” said Furnes at Storebrand Asset Management.

Monday, July 18, 2011

Real value of European stress tests lies in disclosure

A David Enrich article in the Wall Street Journal discussed how the European Banking Authority saw the real value of the stress tests lying in disclosure.

As previously discussed, the disclosure did not go far enough.

The WSJ article makes the case for why current asset and liability-level disclosure is needed by focusing on loans that banks have made to countries experience sovereign debt problems.  Without knowing how the individual loans are performing or are collateralized, market participants are left to make worse case assumptions about the value of the loans given the sovereign debt problems.
Europe's banks are sitting on vast quantities of loans to individuals and businesses in cash-strapped Southern European countries, highlighting how plain-vanilla loans, not just government debt, pose potential risks to the Continent's troubled banking system. 
The holdings are detailed in disclosures Europe's largest banks made as part of the European Union "stress tests," whose results were announced Friday...
But officials with the European Banking Authority, the regulator that conducted the tests, argue that the real value of the exercise is the mountains of data—about 3,200 pieces—each bank was required to reveal about its balance sheet. That includes detailed, country-by-country breakdowns of the types of loans and securities on their books. 
During Europe's 15-month financial crisis, investor and analyst fears have centered largely on banks' holdings of sovereign debt issued by governments in financially shaky countries such as Greece, Ireland and Portugal. If those countries were to default, it could saddle banks and other holders of their bonds with big losses. 
But Friday's test results shed light on another potential problem for Europe's banks: huge piles of residential mortgages, small-business loans, corporate debt and commercial real-estate loans to institutions and individuals from ailing countries. As those economies struggle, the odds of rising defaults grow. 
Banks tend to be holding far greater quantities of those commercial and retail loans than they are of sovereign debt, according to a Wall Street Journal analysis of disclosures accompanying the stress tests. 
This year's stress tests represent the first time there has been a uniform way to measure this exposure. Until now, banks have disclosed their portfolios of loans to customers in troubled countries on a piecemeal basis. That made it virtually impossible to aggregate data across the industry or to compare different institutions. 
"The country-by-country exposure [data] is better than any data we've seen before," said Alastair Ryan, a London-based banking analyst with UBS AG. "It's giving me more things to be fearful of," Mr. Ryan added, referring to the disclosures of some banks' large holdings of loans to customers in troubled countries...
The stress-test figures actually understate some banks' holdings of loans in certain troubled countries. That is because the European Banking Authority required banks to disclose their loan holdings in countries only if they represent more than 5% of the bank's total loan exposures. 
As a result, some banks opted not to disclose details of their loan portfolios. 

Sunday, July 17, 2011

In protecting their information monopoly, Eurozone regulators make crisis worse

The Telegraph ran an article on the European Banking Authority and the stress tests that confirms everything your humble blogger has said about regulators gambling with financial market stability by protecting their monopoly on all the useful, relevant information on banks' current asset and liability-level data.
Andrea Enria, chairman of the EBA and other officials of the London-based organisation, fielded questions from analysts angered at what were quickly described as an "inadequate" set of tests. 
Mr Enria is understood to have outlined the difficulties the EBA faced in conducting the stress tests on the 91 European banks that took part. He was asked why just nine banks failed, requiring total new capital of €2.5bn (£2.2bn). 
The EBA was clear in methodology papers it released on Friday that it had faced great difficulties getting different national regulators and banks to provide accurate data. 
Describing the process as "constrained", the EBA admitted that figures given by the banks in some cases "materially" changed after being challenged. "It is clear the EBA is telling us it was unable to perform the type of tests it wanted to and considering the difficulties it faced it didn't do a half bad job," said one market professional. 
The previous two paragraphs need to be re-read as they document financial regulators directly contributing to financial market instability by not making the data available so that the risk of the banks they are supervising could be analyzed.

As a result of the national regulators' efforts, the ability of the market to accurately distinguish between solvent and insolvent banks is compromised.
Criticism of the tests was largely on the loss assumptions it used for banks' sovereign exposures. 
For instance, the EBA required banks only to take a 15pc loss on holdings of Greek government debt, even though the bonds are currently trading in the market at about half their face value. 
"There may be doubts over the credibility of the EBA's ability to conduct a thorough stress test since it appears to have avoided tackling the thorny issue of banks' exposures to sovereign debt," said Syed Kamall, a Conservative MEP and a member of the economic and monetary affairs committee. 
"The exposure of banks to sovereign debt is the giant elephant in the room and ignoring this issue could undermine the credibility of these tests," he added. 
However, the EBA's document makes it clear that it wants national regulators to force the banks to prepare for the eventuality of a severe worsening in the crisis, even a sovereign default. 
"A further deterioration in the sovereign crisis might raise significant challenges, both on the valuation of banks' holdings of sovereign debt and through sharp changes in investors' risk appetite," it said. 
It also warned that "funding pressures" could "further affect market confidence in these banks" if not dealt with quickly. 
This blog has documented these "funding pressures" as the on-going run on the bank for both deposits and inter-bank loans.
... Tomorrow is the first chance for investors to give their view on the tests. Many observers are expecting a volatile trading session as the markets assess the findings of the exercise.

Bailouts are for buying time, disclosure is for restoring functioning capital markets

The Telegraph ran a column asking the question of whether more bailouts is really the right solution for the European sovereign debt crisis.

This is a trick question because everyone knows that all bailouts do is buy time.  By themselves, bailouts do not solve any problems.

For example, putting more capital into large US banks did not cause the losses on their toxic security holdings or second mortgages to go away - that was achieved through suspension of mark-to-market accounting and adoption of extend and pretend regulatory forbearance.  In theory, bankers could have realized their losses using the bailout capital.  In practice, bankers preferred to return the bailout funds and resume paying themselves large bonuses even though the losses still remain on their bank balance sheets.

The real question is how is that time purchased by the bailout going to be used to cure the underlying intertwined problems of sovereign debt and bank solvency.

Your humble blogger has proposed using that time to implement disclosure under the FDR Framework to restore functioning capital markets.
In the light of the deepening eurozone crisis and concerns over the implications of the EU bank stress tests, many commentators are now saying that the EU sovereign debt bailout fund needs to be perhaps five times as big, and that governments must declare themselves willing to recapitalise any insolvent or capital-inadequate banks as soon as next week. 
Really? You really think that the lesson of the past four years, since the financial crisis began in mid-2007, has been that governments have just not been sufficiently willing to stand behind the banks? That the problem with the eurozone is that governments that aren’t broke haven’t been willing to lend enough to those that are? That the poor impoverished bondholders in banks and sovereign debt have just been exposed to totally unreasonable levels of credit risk? 
... But surely anyone can see now that this has been a Failed Strategy  Surely anyone can see that the answer, from here, just can’t be for governments to become even more committed to their banking sectors, and bank bondholders even more shielded from any risk of loss? Surely anyone can see that the answer can’t be to move banking sector losses from poorer governments’ balance sheets onto richer governments’? Someone has to be left that isn’t broke! 
... This is a Failed Strategy. I understand perfectly well the political attractions of Denial, that governments in 2007 and 2008 wanted to pretend that nothing was really wrong, that it was all evil speculators or irrationally pessimistic markets, and if they could just bluff it out then the markets would understand that they’d got it wrong. Even if markets had been wrong (and they do get these things wrong sometimes), I wouldn’t have agreed that the government should pursue Denial – were governments truly in a position of such omniscience that they could declare, arrogantly, that the markets were wrong? And was the cost – the destruction of Private Capitalism, a system in which capital was allocated through private banks with depositors and bondholders subject to risk of loss - really worth it? In practice the government’s strategy was immoral – involving bailing out the richest 20 percent of the population (those with large deposits, those with large pension pots invested in the banking sector) at the expense of taxing the poor. 
Since I regarded the strategy as arrogant, destructive of our economic order (Private Capitalism) and immoral, I would have objected to it even if it had “worked” in its own terms.  But it didn’t.  Surely – surely – it’s time to try something else?

Saturday, July 16, 2011

European Banking Authority deserves our thanks

I would like to take this opportunity to thank the European Banking Authority for reminding governments and financial regulators around the world about what restores confidence in the capital markets.

It is not regulators disclosing the results of stress tests.

Rather, it is disclosure of all the useful, relevant information in an appropriate, timely manner so that market participants can analyze this data and adjust the pricing and amount of their exposures based on risk.

While the disclosure of data that accompanied the stress tests fails to meet either the "all the useful, relevant information" or "in an appropriate, timely manner" criteria, it was dramatically better than the black hole of opacity that previously existed.

As reported in an article in the Telegraph,
... [T]he EBA and the European Union are under the impression that their power to pass and fail banks will translate directly into making them better at what they do. 
The fallacy of this approach is ... obvious... 
Namely that the regulators are setting themselves up for losing their credibility if the results of the stress tests can be discredited.  It is a no win situation for regulators.

Your humble blogger has repeatedly recommended that regulators should disclose the data and then survey market participants to see what the market participants think.  The regulators should then compare what market participants think and see if and why this differs from what the regulators' own analysis shows.
Take one of the more pertinent “stressed” assumptions the European authorities have used to test the 90 banks in the latest tests. 
Greek bonds are currently trading in the market at half their face value, yet the EBA seriously asks sophisticated investors to believe that they have properly tested the banks by applying a “haircut” of just 15pc to Greek debt. 
Or look at the €2.5bn (£2.2bn) of new capital the EBA says the eight banks that failed the tests will have to raise. 
Analysts at Credit Suisse, just three hours and 25 minutes after the EBA announced its results, have concluded that the actual amount needed would be more like €45bn and that 14 banks should have failed.  
The following part of the article is a description of the FDR Framework in action.  The EBA has provided disclosure and market participants are responding by analyzing this disclosure with the intent of adjusting the price and amount of their exposure to different European banks based on the riskiness of the individual banks.
As you read this, across the City and in financial centres around the world, groups of analysts at investment banks, hedge funds, pension funds, large companies and a host of other institutions are examining in detail the EBA numbers and conducting their own stress tests.  
They are likely to conclude that many European banks are in far worse shape than the authorities would like to believe. 
“Pass” or “fail”, the money men will make up their own minds about which banks are solid and which are not. 
Under their control are the purse strings every bank, large or small, requires to keep their doors open. 
Lose the faith of the funding markets and your days are numbered – as Lehman Brothers and Royal Bank of Scotland can attest. 
Some banks and their regulators may like to believe ... that the authorities’ stamp of approval is all they need to stay on the road. The financial markets are likely to take a different view. 
This week the markets will deliver their verdict on what they think the stress tests meant. They may, like Mr Enria, believe they were “rigorous”, “robust” and all those other fine words he used to describe them. 
More likely, Monday could see the beginning of a process that will deliver a much more real and painful test of the European banking system, one that will prove far more testing than anything the EBA chose, or was allowed, to inflict. 

Friday, July 15, 2011

Why the 2009 US stress tests worked

This blog has frequently observed that the reason why the US stress tests worked in 2009 was because the 19 banks that were tested were then backed by a pledge to inject as much capital as necessary by the US government.

Today, a Wall Street Journal article independently confirmed that it was the pledge to inject capital by the US that accounts for why the 2009 US stress tests were successful.
On Feb. 10, 2009, Treasury Secretary Timothy Geithner outlined the new administration's plan to subject 19 large U.S. banks to government-administered "stress tests" to see how much more capital they would need to fill the hole in the event of another severe recession or collapse of housing prices. 
The speech flopped. The Dow Jones Industrial Average lost nearly 400 points while he was speaking. The very phrase "stress test," though common in financial circles, conjured up images of Citigroup Inc. collapsing on a treadmill. The left derided stress tests as a poor substitute for nationalizing banks, the right as a precursor to nationalization, financial pundits as a whitewash or worse. 
Yet by most retrospective accounts, the stress tests worked better than hoped. Despite sniping that the worst-case scenario used wasn't bad enough, the tests were credible enough to help markets distinguish between weak and strong U.S. banks and to bolster investor confidence in the stability of the U.S. banking system. 
"The U.S. stress tests were a key driver of the recovery from the financial crisis both because they made bank balance sheets more transparent but also because they forced banks to recapitalize, with some government help," says Frederic Mishkin, a Columbia Graduate School of Business economist and former Federal Reserve governor... 
When results were disclosed in May 2009, after much speculation and back and forth between banks and regulators, 10 banks were told to raise $75 billion in new capital. The U.S. government had said taxpayers would provide capital from the Troubled Asset Relief Program unless banks could raise money from markets; all but one raised the money privately. 
Regular stress tests are now among the tools the Federal Reserve and other bank regulators are using to try to prevent a repeat of the financial crisis...
"The U.S. stress tests succeeded because they forced banks to raise a lot of capital," says Anil Kashyap, an economist at the University of Chicago Booth School of Business, noting the U.S. government's willingness to provide a "backstop"' source of capital if needed. 
"The last European test failed because it did not mandate recapitalization. Whether this one succeeds will hinge on whether they are honest about the capital shortages and include a backstop that will force the banks to raise capital one way or another."

Analysts begin the process of analyzing disclosure included with European stress tests

A UK Guardian blog on the release of the European stress test results documents the observation that analysts are interested in and fully capable of changing raw data into information.

3:20 pm

But Sony Kapoor, MD of Re-Define, an economic think tank, says the unprecedented level of detail contained in the stress tests will be a "real punch" that'll lead to a roller coaster few days.

"The EBA has done everyone a big favour by shining the light of transparency on opaque risks in the European banking system."
"The next few days are likely to deliver a roller coaster ride as the new information contained in the stress tests is digested and everyone waits for EU policy makers to make up their mind on Greece."
"The bank-sovereign links that the stress tests reveal means that the pressure to sort out the Euro crisis and put in place a good bank resolution framework will increase sharply."
5:00 pm data is released

5.24pm: FT Alphaville is updating the capital shortfalls as we speak [and making them available to all market participants.]

The run on European banks picks up steam

As predicted several months ago under the FDR Framework and subsequently chronicled, as confidence in European banks and European sovereign debt evaporates, the European banks are experiencing a bank run.

Just like in 2007, the leading edge of this bank run is interbank lending.  Just like in 2007, the lack of disclosure of current asset and liability-level data makes it impossible for banks to determine which of their competitors is solvent and which are not solvent.  As a result, banks stop lending to each other.

The Financial Times ran an article that shows that interbank lending bank runs are spreading across Europe.
Europe’s debt crisis has stoked tension in its interbank lending markets as some financial institutions find it harder to raise money ahead of bank stress tests due on Friday
UniCredit and Intesa Sanpaolo, Italy’s two biggest commercial banks, have been asked to pay higher premiums for lending, according to brokers, as the crisis has hit Italian government bonds amid growing fears of contagion. 
One broker said: “Lending is now very name specific. Banks will only lend to high-quality banks or names. Italian banks, in particular, have had difficulties this week. They can only access the markets if they pay big premiums. Other banks will not lend to them unless they pay up.” 
David Owen, chief European financial economist at Jefferies, said: “This eurozone crisis is a banking crisis as much as anything. Confidence among the banks has been undermined by Italy’s problems and there is a fear the stress tests will reveal problems.” 
The key measure of credit risk for short-term bank lending has jumped sharply since the start of the month. The spread between the risk-free cost to lend overnight in euros measured by Eonia and the cost to lend for three months measured by Euribor has jumped to 29 basis points from 20bp on June 30, a rise of 45 per cent... 
The jitters have caused problems for banks’ longer-term borrowing too. In the past six weeks, European banks have sold $19.1bn of senior unsecured debt – less than a third of the average $68.2bn they sold in the past five years during this period, according to data from Dealogic. 
Senior unsecured bonds form the biggest chunk of any bank’s financing efforts. But even sales of covered bonds, the loan-backed deals popular with investors who consider them ultra-safe, have slowed. Banks have sold $27.7bn in the past six weeks, compared with an average of $42.6bn for this period. 

Thursday, July 14, 2011

More clarity needed on bank exposures

A Wall Street Journal Heard on the Street column called for investors receiving more clarity on US bank exposures to both financial institutions in and sovereign debt from Portugal, Ireland, Italy Greece, Spain and the US.

The column explicitly observes that without this disclosure, investors are going to assume the worse and require a higher rate of return to compensate for risk (as reflected in a lower stock price).
Banks are the last place to be in a financial storm. So it's up to big bank CEOs to assure investors their firms won't be swamped by crises brewing on both sides of the Atlantic....
But to be meaningful, they need to go beyond the usual generalities related to risk exposures...
Mr. Dimon previously has tried to put a figure on a European calamity. Writing in his annual letter to shareholders, he said in a worst-case scenario involving the so-called Piigs—Portugal, Ireland, Italy, Greece and Spain—J.P. Morgan "could lose approximately $3 billion, after tax." 
That figure needs updating. But Mr. Dimon shouldn't stop there. 
Any European banking problems likely will hurt Germany and France, where J.P. Morgan at the end of 2010 had total exposure of about $300 billion. J.P. Morgan should factor that into any update, as well as give more timely country exposure disclosures; it does so only annually. 
Citigroup and Bank of America, which report results Friday and Tuesday, respectively, provide quarterly updates. Yet they, too, need to put more flesh on their risk bones, especially Citi. 
The bank didn't report any sizable Piigs exposure at the end of the first quarter, while total exposure to France and Germany was $163 billion. But it did have the highest level of foreign government-bond holdings relative to its tangible common equity, at 139%. J.P. Morgan's was 91% and BofA was at 36%. 
And the banks shouldn't stop at Europe. The U.S. is a potential danger, too, with Moody's on Wednesday placing the country's top-notch rating on review for possible downgrade. 
Bank of America at the end of the first quarter had the largest holding of Treasurys relative to tangible equity, at 83%, with Citigroup following at 52% and J.P. Morgan at 29%. Those exposures should be manageable because it is unlikely government bonds would suffer more than temporary losses in a default over the debt-ceiling standoff. 
Again, though, investors need more information. 
Banks may be wary of getting too specific, ... But if investors are left in the dark, bank stocks will pay the price.

European bank run continues

The Irish Times ran an article on Europe's on-going bank run.

The bank run is a predictable reaction given the lack of disclosure.  When market participants do not know who is solvent and who is insolvent, it makes sense for them to withdraw their funds and find alternative investments to bank deposits or sovereign debt securities.
A Europe-wide test of the safety of its banks risks becoming a sideshow as long as politicians struggle to contain the continent's debt crisis and the detrimental impact on day-to-day funding for lenders. 
Bankers say rapidly rising funding costs are a far bigger headache than Friday's release of the results of the annual probe by the European Union's banking watchdog, which is running the rule over 91 banks to see if they have sufficient capital. 
"The collapse of market confidence in sovereign debt affects banks more than any regulatory stress test," said an investment banker who advises financial institutions. 
"This is the markets stress-testing the system, which is far more dangerous than any simulation by a regulator." 
Lack of clarity about how Europe plans to tackle the risk that countries such as Greece will default under a huge debt burden has sent bond yields soaring, dramatically raising the cost for banks when issuing new bonds. 
The drop in bond values also means banks may need to write down any portfolios of sovereign bonds they hold. Bank shares have been losing ground as a result. 
Depositor funding - from clients who put their money in a current or a savings account - is also under pressure, with withdrawals seen in countries such as Ireland and Greece and a fight for deposits in Spain and elsewhere squeezing margins. 
And other funding channels - such as the covered bond market, commercial paper, or asset-backed securities - are also starting to look increasingly shaky. 
"Look at what's happening in Italy. The rates are going up 30 to 40 basis points a day. 
That's going to translate into a higher cost of funding," said a second investment banker, whose clients are also financial institutions....
European finance ministers have acknowledged for the first time that some form of Greek default may be needed to cut Athens's debt, but investors fear that could ripple through Europe's banking system. 
European banks have raised about €43 billion since their resilience against economic headwinds was tested last year, and this year will show the need for more capital. 
This year isn't expected to throw up any surprises, either in terms of the numbers or the likely test failures. 
A survey by Morgan Stanley in April estimated that fewer than 10 banks would fail the test, and that €30 to €40 billion of capital would be raised in the run-up to or after the exercise. 
Unlisted banks in Spain and Germany and a batch of banks that are already raising new funds are the most likely to fail this year's tests, analysts at Nomura have said. 
"These are well identified today; there are some cajas in Spain, there are couple of regional banks. It's a very well-known sample of banks," the second banker said. 
Nomura identified Spain's Bankinter and Sabadell, Italy's Banco Popolare; Greece's Piraeus and ATEbank; Cyprus-based Marfin Popular and Bank of Cyprus; and Bank of Ireland and Allied Irish Banks as vulnerable. 
The EBA is also conducting a liquidity assessment, but its results will not be published. It is conducted in parallel with the stress test, and is used to inform supervisors about areas of funding vulnerability. 
Given the uncertainty, the two bankers were telling their clients to hunker down.