On Bank Systemic Risk, International Integration and Capital Requirement | Turner Discussion Paper
There has been much talk of systemic risk since the financial crisis hit. I see it more as a crisis of banking and banking confidence, and the debate on systemic risk is critical because it exists because of Government intervention and protections, implicit and explicit. The latest from Lord Turner of the FSA is a discussion paper, that reviews systemic risk and provides as good a discussion on that topic as I have seen.
What it particularly interesting is how the insights raise the prospect of penalising globally integrated banks over nationally independent organizations with higher capital requirements. Things just got more complex for decisions on integration.
DP09/4: Turner Review Conference Discussion Paper | FSA
3.18 In general terms, a firm is systemic when its collapse would impair the provision of credit and financial services to the market with significant negative consequences for the real economy. The factors which make firms systemically important fall into three categories (although firms may combine elements of these factors):
- systemic by size. This can be a function of the firm’s absolute size or in relation to a specific financial market or product in which a firm is particularly dominant. The channels through which systemic risks would crystallise as a result of the failure of such a firm include: losses to uninsured creditors and depositors through high bankruptcy costs and reduced recoveries; disruption to financial services (such as to payments, clearing and settlement, extension of credit); and losses to insured depositors because the DGS could not pay out sufficiently quickly or because the aggregate payout imposes unsustainable costs on those who fund the DGS. In addition and crucially, systemic risks can take a macroeconomic form, with the loss of credit extension capacity leading to, or exacerbating, a downturn in economic activity which then has consequences for the rest of the financial system.
- systemic by inter-connectedness. Links and inter-connections can include, inter alia, inter-bank lending, cross holdings of bank capital instruments, membership of payment systems, and being a significant counterparty in a crucial market. The channels through which such problems manifest themselves include:
- interbank exposures. The domino effect where the collapse of one firm leads to
major losses at others, and then in turn leads to their collapse. This can then
trigger a chain reaction;- the confidence channel. The collapse of a systemically important firm leads to a
crisis of confidence in financial markets. The confidence channel is particularly
important to the ‘systemic as a herd’ category (see below), given the perceptions
by the market that a number of firms are exposed to the same set of risks;- the asset margin spiral channel. Firms increasingly finance themselves through repo
and reverse repo arrangements. The haircuts charged on the collateral underlying
these contracts dictate the extent to which firms can leverage themselves. In a crisis,
both funding conditions and credit concerns will lead counterparties to increase
haircuts, triggering a deleveraging process. This will in turn be disruptive, through a
self-reinforcing spiral between lower market liquidity and funding liquidity.
- systemic as a herd. The market can perceive a group of firms as part of a common group (for example, because they have a similar business model, such as building societies in the UK and the savings and loans banks in the US), or common exposures to the same sector or type of instrument. A single firm in this group may not be systemic in its own right, but the group as a whole may be.
“Rally fuelled by cheap money brings a sense of foreboding” | ft.com
Gillian Tett voices her concerns here, based on background discussions with bankers. We are not out of the woods yet, despite the equity markets.
Rally fuelled by cheap money brings a sense of foreboding | FT
Yet, if you talk at length to traders – or senior bankers – it seems that few truly believe that fundamentals alone explain this pattern. Instead, the real trigger is the amount of money that central bankers have poured into the system that is frantically seeking a home, because most banks simply do not want to use that cash to make loans. Hence, the fact that the prices of almost all risk assets are rallying – even as non-risky assets such as Treasuries bounce too.
… …In the meantime, it is crystal clear that the longer that money remains ultra cheap, the more traders will have an incentive to gamble (particularly if they privately suspect that today’s boom will be short-lived and want to score big over the next year). Somehow all this feels horribly familiar; I just hope that my sense of foreboding turns out to be wrong.
Is the utility bank/ risky bank model workable?
Martin Wolf makes a persuasive argument that regulatory division between financial utilities and risk takers (casinos in his words) is impossible.
Why curbing finance is hard to do | FT Martin Wolf
First, the border between utility and casino banking is impossible to draw. For Mr Kay, the utility is the payment system and protection of deposits. This would leave all lending – including to households and businesses – inside the casino. For those in the US who hark back to the Glass-Steagall Act, the distinction is between commercial and riskier investment banking.
… …
Mr Kay’s distinction is clear, but problematic. If we followed him, all risk management would become unregulated. It is inconceivable that governments would, or could, leave them so. If we moved back to a Glass-Steagall distinction (itself never accepted in continental Europe), we would need to draw a line. But where? Why would lending to households and business be good, but securitising those loans bad? Why would hedging be good, but speculating bad and how might one draw the line between them?
I disagree. It is hard but not impossible. From inside a bank it is abundantly clear where the distinction lies, so there has to be a way to draw up the rules. Personal mortgages funded dollar for dollar directly against retail deposits for example with no securitization vehicle in between would be a good place to begin. The inevitable argument would be that without access to alternative securitization activities that consumer credit would be more expensive. Well recent experience would suggest stability over extreme discounts would be a good thing. There could be two types of mortgage offerred by utility and by risk banks. This would be a fascinating comparison.
At the other end of the division Mr Wolf draws we have clear investment banking activities funding large corporates with obscure investment vehicles.
The difficulty would lie in the middle range of products as to whether they are utility or casino. The rule would be best served to keep them in the casino until they can be shown as deserving to be in utility. No amount of debate will solve this – it would require draconian regulation driven by speaking to regular bankers, not investment bankers.
Finally the drive from consumers towards utility or riskier banking products would be the ultimate measure. Bearing in mind that the offerors of the risky products would have no government backing, this would be reflected in the price and the nature of collateral they would require. The final piece of this puzzle is the extent to which the utility offering banks have deposit insurance, and government assistance. They should in my view have deposit insurance to a limited dollar value, but should not be government owned.
It is a journey worth beginning, and should not be written off lightly as this Wolf piece does – the future stability of consumer economy depends on it.
Bank of Canada joins other Central Banks is calling for caution
In the regular Monetary Policy Report the Bank of Canada keeps their focus on a low interest rate environment right through 2010.
On inflation the view is mixed …
The main upside risks to inflation relate to the possibility of a stronger-than anticipated recovery in the global economy. A stronger global recovery would be transmitted to Canada via trade, financial, confidence, and commodity price channels. There is also the risk that Canadian domestic demand could be more robust and have a more sustained momentum than projected.
On the downside, a stronger-than-assumed Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as a significant further drag on growth and put additional downward pressure on inflation. Another important downside risk is that the global recovery could be even more protracted than projected if self-sustaining growth in private demand, which will be required for a solid recovery, takes longer than expected to materialize.
Worldwide consumer demand rejuvenation is not assumed in the near term …
Vigorous and coordinated fiscal and monetary policy stimulus in the G-20 economies, including a wide range of measures to support the fl ow of credit, have been sustaining aggregate demand, but evidence of self-sustaining private demand remains modest. Necessary adjustments on both the real and financial sides of the global economy are under way, and will involve a significant and protracted rotation of global demand, as well as deleveraging by U.S. and European banks, households, and firms.
Canadian consumer confidence is very real estate focussed due to affordability.
On capacity …
After reviewing all the indicators of capacity pressures and taking into account the weakness in potential output associated with the ongoing restructuring in the Canadian economy, the Bank judges that the economy was operating about 3 1/2 per cent below its production capacity in the third quarter of 2009, in line with the July projection.
This chart is worrisome though, begins to sow seeds of doubt. Consumer credit is growing but business credit is lagging. Consumers are increasing mortgage debt but not purchasing ‘things’ – (sound familiar – 2007?)
On money supply enormous growth, but suggestions the money is being parked – i.e. low velocity of money suggesting low prospect of near term inflation.
The monetary aggregates have continued to grow strongly. In the three months to August, the narrow aggregate M1+ grew at an annual rate of 18.2 per cent, while M2++ grew by 7.0 per cent. It is diffi cult to assess the implications of monetary expansion for economic activity, since the demand for money is likely to be abnormally high in an environment of very low interest rates and tight credit conditions. The continued robust growth in narrow money reflects the desire of both households and firms to keep money in liquid assets until it is clear that the economic recovery is taking hold. Consistent with our base-case projection, the growth in money balances is expected to gradually decline over time.
On GDP – this is a very clear depiction that consumer spending has been replaced by government spending, and that won’t change consequently until 2011. The other factor also noted here is that currency shifts and changes in imports/ exports will be the real next thing that determines each country’s economy
On consumer confidence 2 …
In the wake of a short, severe recession, and with residual economic uncertainty, the personal savings rate remains elevated over the projection horizon.
Monetary Policy Report Oct 2009 mpr221009.pdf
A succint comparison of exiting 1980 recession, and 2009 recession
I thought this a particularly succinct view of the next 10 years view prospects for banks and their business planning.
The view from New York | Buttonwood/ Economist
The bearish view came from Josh Rosner of Graham-Fisher. Mr Rosner was one of the first analysts to spot the potential havoc caused by the interaction between subprime mortgages and structured products like CDOs. He thinks the economy will not rebound as it did in the 1980s. Demographic trends are not as favourable (the baby boomers were entering their prime earning period in the 1980s; now they are retiring); while credit card use was about to explode (now it is contracting). He argues that small businesses, a key source of job creation are still being denied credit; one problem is that small businessmen can no longer afford to use their houses as collateral.
Mervy King calls for banks’ break up per “The Great Unwinding” post in Feb
It is with some relish I see Mervyn King agreeing with me from last February.
King calls for break-up of banks | FT – Oct 2009
Mervyn King, governor of the Bank of England, called on Tuesday night for banks to be split into separate utility companies and risky ventures, saying it was “a delusion” to think tougher regulation would prevent future financial crises.
The Great Unwinding | part 1 of 3: 2009 – 2012 | The Bankwatch – Feb 2009
This will effectively split the financial community into two distinct sets:
- financial utilities – significant operating restrictions in light of implicit and explicit government guarantees underpinning the business
- risk takers – not clearly defined as yet – will be dependent on regulation applicability
I expect my commission cheque is in the mail.
Full Text of King speech at in Edinburgh on 20 October 2009: speech406 pdf
Edit: King provides attribution to John Kay here written Sept 09.
Bank retail operations have not recovered despite profits
In this piece at the NY Times, Krugman points out the obvious that despite profits, Banks’ retail operations have not recovered. The large profits we are hearing about are all centred in the Investment Banking units.
I would add that it will take more than a turnaround in consumer confidence and reduction in unemployment. It will also take time to work through the de-leveraging impacts of consumer desire to reduce debts and save more for future crises while this one is firmly in peoples minds. For everyone who is still working they know of someone who is not, and that memory takes time to erase.
But there’s an even bigger problem: while the wheeler-dealer side of the financial industry, a k a trading operations, is highly profitable again, the part of banking that really matters — lending, which fuels investment and job creation — is not. Key banks remain financially weak, and their weakness is hurting the economy as a whole.
RBS pays out 10% of equity to investment bankers
In the banking business I think we all understand the point and motivational benefit of bonuses, however this story from a Bank that is almost a Government Department (70% government owned) takes insanity to a new level, if you are a taxpayer.
The sheer size of the bonus pool of £4 billion is astounding. That represents just under 10% of the banks equity!
I mention the government ownership because while we are used to investment bankers paying out such bonuses, one would have thought that their government overseers would have insisted on that £4 billion being used to boost capital, or repay Government assistance.
Nice work if you can get it.
Royal Bank of Scotland to give huge bonuses The Times
The average employee in its high-risk investment banking arm is likely to take home £240,000, with the top 20 staff in line for payments of between £1m and £5m.
Relevance to Bankwatch:
On a slightly more serious note, when I predicted the arrival of financial utilities in financial services, I did not expect such a hands off approach from government. Surely it will be a matter of time only.
Canadian Electronic Commerce Protection Act and lobbyists efforts {Geist}
Michael Geist provides a gallant service following and analyzing the legal developments in the Canadian Parliament relative to internet, privacy, DRM. His current focus is the ECPA that is having its Commons review completed Monday.
Electronic Commerce Protection Act (C-27) (Posts on Michael Geist site re this topic)
The ECPA is basically intended to be an anti-spam bill. This should include opt-in only relative to advertising. It has become mired in the minutiae of cookies, tracking, email address collection and such things. The opposition Liberals appear to be taking the opportunity to side with the lobbyists from the advertising world to create exclusions.
I have little faith in such legislation. The future will be in self protection, and online tools that assist. The comments in the latest post on copyright lobbyists are well worth the read.
US deficit reaches world record levels, and rising
US deficit is now in Botswana and Russia territory in terms of record levels relative to GDP. The argument that this is not inflationary sounds to me like pushing water uphill.
$1.4 Trillion Deficit Complicates Stimulus Plans
WASHINGTON — The Obama administration said Friday that the federal budget deficit for the fiscal year that just ended was $1.4 trillion, nearly a trillion dollars greater than the year before and the largest shortfall relative to the size of the economy since 1945.
http://www.nytimes.com/2009/10/17/us/17deficit.html?_r=1&th&emc=th
