One of the factors contributing to treasury market's strong performance this year has been the Liquidity Coverage Ratio (LCR), a Basel III-based requirement for banks. These rules go into effect in 2015 and are phased in gradually through 2017 in the United States (the implementation period is longer in some countries). LCR requires that banks hold sufficient amounts of liquid assets to withstand a significant loss of funding sources (such as depositors withdrawing). This need for liquid assets has resulted in banks accumulating treasuries - which they've ramped up to record levels this year - and to a lesser extent GSE debt.
One would expect banks to buy treasury bills or short-term notes to meet their LCR requirement but that did not turn out to be the case. Lenders showed willingness to take rate risk and ended up focusing on 5- and 7-year paper.
Source: Deutsche Bank
It seems that the bulk of recent purchases have been placed into the so-called "Held-to-Maturity" (HTM) accounts as opposed to "Available for Sale". HTM accounts allow banks to avoid mark-to-market treatment, accruing the coupon and accreting/amortizing discount/premium. At current extraordinarily low cost of funds banks can generate a positive net interest income on these intermediate-term notes while "avoiding" rate risk using HTM accounts. Treasury bills on the other hand would have resulted in interest income that is below interest expense.
Source: Deutsche Bank
The question for fixed income investors is how much more will banks be forced to buy in order to comply with the LCR rules. According to DB, most US banks are nearly there.
DB: - Deutsche Bank’s bank analysts believe most banks have already added the highly liquid assets they would need for LCR, and the industry is about 80% to 90% there. Therefore, LCR-related bank demand for Treasuries could continue, although the majority of flows might have occurred.
The answer also depends on how quickly deposits continue to grow going forward because LCR requirements are partially based on the size and stability of deposit-based funding. Deposit growth in the US has remained fairly steady at around 7.5% per year. If this trend continues, we should see LCR-based demand for treasuries decline to more moderate levels in the near-term.
In addition to the pending Basel-based regulation on minimum leverage ratio (see post), US regulators are pushing to set the minimum supplementary Tier 1 leverage ratio for the eight "systemically important" US banks to 5%. Once again, this is expected to hit the repo market as well as other assets with low risk weights.
Source: Barclays Research
This action will achieve the following:
1. Disrupt the functioning of money markets by pushing larger banks out of secured deposits. Deposits collateralized by treasuries (reverse repo) is the only way many institutional palyers can place cash with banks without taking unsecured bank risk. Now these institutions will be forced take bank risk or buy treasury bills - which will likely go negative as a result.
2. Reduce liquidity in the treasury markets. As discussed earlier, treasury trading volumes follow repo volumes - and this is not a great outcome for either.
3. Increase fails and the overall volatility of the treasury markets by making it harder to borrow treasuries.
Barclays Research: - A significant reduction in repo
could reduce the ability of dealers to short securities without risk of being able to deliver,
raising the prospect of the fails charge being triggered. This should factor into how
aggressive they are at auction and actual auction pricing. Further, the possibility of
increased fails could mean greater volatility in rates around Treasury auctions.
4. Create similar headwinds as in #2 and #3 above in the MBS markets and potentially other markets that involve some form of securities lending.
Barclays Research: - Full effects likely to be more widespread. We believe the knock-on effects of these rule
changes are not likely to be limited to the Treasury and MBS markets. They would likely
filter through to other markets, including credit and equities, potentially reducing
liquidity and increasing volatility over time.
This regulation will certainly not reduce the risk of a systemic problem going forward - in fact it is likely to have the opposite effect. Banks will find other ways to make money, potentially by shifting to riskier assets. Ultimately it will be the end-users and market participants (mutual funds, ETFs, pensions, securities custodians, insurance firms, endowments, foundations, retail investors, etc.) who will feel the brunt of this regulation. Welcome to the world of "unintended consequences".
The debate around "too big to fail" of the US banking system is often infused with political rhetoric and media hype. Let's go through some Q&A on the subject and discuss the facts.
Q: Did large banks take disproportionate amounts of real-estate related risk vs. smaller banks prior to the crisis?
A: No. That's a myth. Smaller banks were much more exposed to real estate (see discussion).
Q: Which "too big to fail" banks were directly bailed out by the US federal authorities during the 2008 crisis?
A: While hundreds of banks were forced to take TARP funds, only Citigroup received an explicit bailout to keep it afloat (one exception is Bank of America who received significant incremental assistance largely to support the acquisition of failed Merrill Lynch). Note that Bear Stearns, Merrill Lynch, Lehman, AIG, GM/GMAC, Chrysler, Fannie and Freddie were not banks and would not be subject to any "too big to fail" legislation. Neither was GE Capital and other corporations who relied on commercial paper funding and requited the Fed's support to keep them afloat. Wachovia may have become the second such large bank if it wasn't purchased by Wells. Failed foreign banks like UBS and RBS also would not be subject to any US too-big-to-fail laws.
Q: Why did Citi fail in 2008?
A: Citi ran into trouble because of a massive off-balance-sheet portfolio the firm funded with commercial paper. In late 2007, when the commercial paper market dried up, Citi was forced to take these assets onto its balance sheet. The bank was not sufficiently capitalized to absorb the losses resulting from these assets being written down.
Q: What were the assets Citi was "warehousing" off-balance-sheet?
A: A great deal of that portfolio were the "AAA" and other senior tranches of CDOs that Citi often helped originate (including mortgage related assets). Rating agencies were instrumental in helping banks like Citi structure these assets and keep them off balance sheet in CP conduits.
Q: Why did Citi (as well as many other banks) hold so much off-balance sheet?
A: Because they received a significantly more favorable capital treatment by doing so (the so-called "regulatory capital arbitrage" - see discussion from 2009).
Q: Did Citi break any state or federal laws by doing what it did?
A: No. All of this was perfectly legal and federal authorities were aware of these structures.
Q: Did derivatives positions play a major role in Citi's failure? Were other large US banks at risk of failure due to derivatives positions?
A: No. That's a myth. The bulk of structured credit positions (tranches) that brought down Citi were not derivatives (just to be clear, CDOs are not derivatives).
Q: What has been done since 2008 to make sure the Citi situation doesn't happen again?
A:
The US regulators now have the ability to take over and manage an orderly unwind of any large US chartered bank. Banks are required to create a "living will" to guide the regulators in the unwind process. The goal is to force losses on creditors in an orderly fashion without significant disruptions to the financial system and without utilizing taxpayer money.
Large banking institutions are now required to have more punitive capital ratios than smaller banks.
Capital loopholes related to off-balance-sheet positions have been closed.
Stress testing conducted by the Fed takes into account on- and off-balance sheet assets, forcing banks to maintain sufficient capital to be able to take a hit. US banks more than doubled the weighted average tier-1 common equity ratio since the crisis (see attached).
Q: Do large US banks have a funding advantage relative to small banks?
A: Not any longer. According to notes from the meeting of the Federal Advisory Council
and the Board of Governors (attached - h/t Colin Wiles @forteology), "studies point to a significant decrease in any funding advantage that large U.S. financial institutions may have had in the past relative to smaller financial institutions and also relative to nonfinancial institutions at comparable ratings levels. Increased capital and liquidity, in addition to meeting the demands of many regulatory bodies, has largely, if not entirely, eroded any cost-of-funding advantage that large banks may have had."
Q: What is the downside of breaking up banks like JPMorgan?
A: Large US corporations need large banks to provide credit and capital markets access/services (Boeing is not going to use Queens County Savings Bank or a broker like Sandler O'Neill - great institutions, but way too small). Without large US banks, US companies will turn to foreign banks and will be at the mercy of those institutions' capital availability and regulatory frameworks. Foreign banks will also begin dominating US capital markets primary activities (bond issuance, IPOs, debt syndications, etc.) And in an event of a credit crisis foreign banks (who are to some extent controlled by foreign governments) will give priority to their domestic corporations, putting US firms at risk.
Q: How large are US largest banks relative to the US total economic output? How does it compare to other countries?
A: See chart below:
So before jumping on the "too big to fail" bandwagon, get the facts.
This has been bugging me after some of your recent articles, but what prompted me to write was your post today Steve Hanke criticizes Basel III for the wrong reasons (see post). I think he might be right to some extent, but I believe both of you are wrong on the big picture. You implicitly assume that the problem is moving to Basel III: however, staying put on Basel I is not really an option. The problem is rather with the whole Basel project itself.
First, the extent to which Hanke is right: you point out that US Banks are currently well capitalized so the compliance with Basel should be less of a problem. That might be true if one were just to compare current tier 1 ratios with the new Basel minimums (4.5% core tier 1 plus 2.5% buffer, etc) but there are 3 other considerations:-
There are going to be many new deductions which can quickly cause capital to evaporate, such as for pension deficits, deferred tax assets, and particularly important for US banks, mortgage servicing rights
Basel III is not just adjusting the numerator of the Cooke ratio, it is also going to massively inflate the denominator. The huge increases in RWAs in the trading book in particular, in both Basel 2.5 and III, will hit banks with any investment banking businesses very hard.
The 2 new liquidity metrics will require banks to hold more liquidity and will act as a constraint on new on-balance sheet lending. This could severely restrict maturity transformation.
Exercises on European banks 10-12% Tier 1 capital ratios at the end of 2010 or 2011 (and, yes, there are some), which superficially look like they should have no problem, end up with a deficit or barely enough capital when all this is taken into account.
You are also right to bemoan the complexity and micro-management of Basel III (and II), but that is attacking the symptom rather than the cause. This second-guessing of risk management down to desk and deal level is the inevitable consequence of global risk-based capital rules.
Basel I was implemented in the late 1980s to try and increase capital levels in banks throughout the major economies, and to create a more level playing field in international markets. In both these aims, it was in the short term very successful: capital levels did increase across the world economy.
However, Basel I was a short term fix; it is very crude and creates perverse incentives. As well as being too lenient on securitization that does not truly transfer risk, it incentivizes banks towards trashing the quality of their loan books. For example, all corporate loans attract a 100% risk weight (i.e. require $8 of capital for every $100 lent) , regardless of whether the loan is to Microsoft (AA+), or Dynegy (CC). So lending to high margin risky names creates a better return on capital.
The point that the critics often miss is that Basel I is broken. This is why we got Basel II: if we are to have risk based capital rules (and that is the big if), then we need to discriminate between credits. If we want to discriminate between credits, what alternatives are there? Well there are the Rating Agency ratings, or internal bank ratings and …. er….. that’s it. This is the point that the critics need to address: what else would you do? Sticking with Basel I is clearly not a safe option either.
The situation with straightforward lending is bad enough, but it gets much worse with more complex products, but this outcome was inevitable given the starting point. If we have risk-based capital rules, then the regulations will have to try to cover the risks in more and more detail, playing catch up with the banks and other institutions, which will always evolve and adapt faster than the rules can. With each iteration, they create ever greater market distortions.
And then there is the problem that these rules are applied globally, so institutions everywhere will adapt to the rules in the same way, which in a crisis will probably not be a good way.
These 2 issues (a) risk-based capital requirements and (b) global capital rules are the main problem. The Basel project seemed like a good idea in the mid 1980s but the monster that is the combination of Basel II, 2.5 and III is the logical result. Simpler, nationally grounded regulation which allows banks to compete and fail without threatening everybody’s taxes may seem like going backwards but maybe progress isn’t always such a good thing.
A recent post on the Cato Institute blog by Steve Hanke paints a grim picture of the impact from increasing bank capital ratio requirements on the US economy. He compares the current situation to the Basel I accord that supposedly lost George H. W. Bush his reelection by squeezing the money supply and causing a recession (in the early 90s). And the upcoming Basel III is going to do the same.
Cato Blog: - While the higher capital-asset ratios that are required by Basel III are intended to strengthen banks (and economies), these higher capital requirements destroy money. Under the Basel III regime, banks will have to increase their capital-asset ratios. They can do this by either boosting capital or shrinking assets. If banks shrink their assets, their deposit liabilities will decline. In consequence, money balances will be destroyed.
So, paradoxically, the drive to deleverage banks and shrink their balance sheets, in the name of making banks safer, destroys money balances. This, in turn, dents company liquidity and asset prices. It also reduces spending relative to where it would have been without higher capital-asset ratios.
The other way to increase a bank’s capital-asset ratio is by raising new capital. This, too, destroys money. When an investor purchases newly-issued bank equity, the investor exchanges funds from a bank account for new shares. This reduces deposit liabilities in the banking system and wipes out money.
Theoretically that's correct. However, US banks have been well capitalized for some time now (see this post from almost a year ago). Therefore Basel III by itself is not going to force significant capital increases by US banks. This of course is not the case in Europe (see discussion) and elsewhere (for example in South Korea the impact will be significant).
The data in the US suggests that unlike in the early 90s, money supply continues to grow unabated. Most US banks are operating as though they are already under Basel III, even if the rules haven't been fully implemented. Therefore if there was an impact on broad money stock, we would have already seen it.
As discussed here numerous times, the issue with Basel III is the ridiculous complexity and numerous idiotic rules in which a small group of bureaucrats with little understanding of US credit markets decide what banks should and should not hold (see discussion here and here). This, combined with the somewhat arbitrary Volcker Rule will have unintended consequences (see discussion). Professor Hanke is therefore correct to criticize Basel III, but he is doing it for the wrong reasons. In the US it is not about bank capitalization these days as it is about terrible regulation.
As discussed before (see post) Basel III implementation carries significant costs. In the US the implementation has its unique problems (discussed here). The approach hits securitization particularly hard, making ABS (short maturity credit card and auto loan paper) tougher for banks to hold - yet encourages banks to hold more sovereign debt (less capital required to hold Italian bonds than a pool of auto loans for example). Also small businesses that are not rated will have a tougher time obtaining loans because such loans will require more capital. In fact a portion of small business lending will shift to non-bank entities such as mezz funds who will charge higher rates. To add to the fiscal cliff worries, US bank regulators were going to impose Basel III rules at the start of 2013. Luckily that deadline has been pushed back, as concerns grow about this new set of rules.
WSJ: - While taxpayers wonder if Washington is going to throw them off a cliff of scheduled tax hikes, another potential economic calamity has been postponed. On Friday, bank regulators announced that they will not impose complicated new rules on New Year's Day. Let's hope they don't impose them on any other days.
The Federal Reserve, Federal Deposit Insurance Corporation and Comptroller of the Currency issued a joint release saying they will no longer require U.S. banks to follow the so-called Basel III capital rules by January 1. Created by a college of global bureaucrats who enjoy meeting in Switzerland, the new rules are brought to you by the same people who encouraged banks to load up on mortgage risk before the panic of 2008.
Their new rules encourage banks to load up on sovereign debt. This makes perfect bureaucratic sense, since the world's governments have proven to be hands-down the issuers with the most dishonest accounting.
The US is not the only country concerned about Basel III. The impact on the US is actually expected to be smaller on a relative basis than on a number of other nations' economies. Asian nations will see the largest impact, particularly South Korea. In Europe, Switzerland ("CHF" in chart below) will be impacted the most, in part due to Credit Suisse (see discussion).
Peak Impact of Basel III on GDP (source: Barclays Capital)
In the US the issue is not as much the higher capital requirements (US banks are already well capitalized) as it is with the rules themselves - which artificially penalize some risks but not others. The WSJ article summarized the situation with Basel III quite well (it would be interesting to find out who on the WSJ staff actually wrote this story):
WSJ: - The FDIC's own Director Thomas Hoenig sees in Basel III the same complicated system for judging risk that failed in Basel II "but with more complexity." Using theoretical models that have failed in practice, the rules assign "risk-weights" to different assets, divined by an almost endless series of calculations. For the largest banks with the resources to spend on regulatory arbitrage [see discussion], this is an opportunity to get risky assets officially designated as safe.
But the cost of this complexity, and the burden it will place on small banks in particular, is no doubt a big reason why the feds have taken a step back from the regulatory cliff. In their Friday note, the bank overseers said they were moving back the deadline "in light of the volume of comments received and the wide range of views expressed during the comment period."
Certainly a wide range of negative views have been expressed, including by the Bank of England's Andrew Haldane and Vasileios Madouros. Their research shows that Basel's intricate models were hardly of any use in predicting which giant banks would fail during the crisis. This should surprise no one. The essential function of the Basel Committee is to strike political compromises among global regulators, who have rarely been confused with the best and brightest minds in finance.
After the Ferbruary post on the flaws of Basel III regulation (see discussion) we got a number of emails pointing to the importance of uniform global banking rules. "By criticizing Basel III you support these banksters" was one of the comments. Of course the wrongs of banking could be set right by new rules - even if they are a messy modification of an earlier set of regulations that got large banks (like Citi) into trouble to begin with (see discussion from 2009).
But many professionals in the financial services industry continue to support Basel III, in part because it benefits them. Most people don't fully appreciate how much business the major international accounting/consulting firms for example get from engagements to implement new capital rules at banks. That's why it's no surprise that many advocates of (and experts on) this "enhanced" regulation just happen to be consultants from the Big 4 and other large accounting firms. Nothing wrong with consulting, but there is a bit of a conflict here.
Clearly some of the new rules are important - particularly those dealing with adequate liquidity. But the prescriptive methods used to solve every possible concern dealing with capital and liquidity will push financial organizations to focus on the "letter of the law" instead of the "spirit of the law". And loopholes will inevitably arise (as they did with Basel I) creating more systemic risks.
Some of the problems with Basel III are laid out in this excerpt from a well written article on Bloomberg Brief. The implementation issues emerging from the new regulatory framework are troubling indeed.
Karen Shaw Petrou (Federal
Financial Analytics): -
... Basel Committee
rewrote its capital book in 2010 and, for
good measure, added needed global
liquidity standards.
Two years later, though, and each
of these axiomatic standards remains
unimplemented in almost every major
banking center. Some have suggested
that, with just a bit more gumption, the
Basel rules will jump national borders to
conquer risk. But, like it or not – and I
don’t much like it – Basel can’t work.
...
The global capital and liquidity standards
codified as Basel III have important
weaknesses of their own – most
important among them undue complexity
resulting from a hopeless effort to
address every nuance in each major
banking market under each applicable
accounting scheme in all circumstances.
But, even if Basel were better, it couldn’t
be consistently implemented in comparable
fashion across borders no matter
how well meaning the national regulator.
The reasons for this are statutory and
structural. First, many nations – the U.S.
is a prime case – have laws that override
key tenets of Basel III. For example,
the U.S. bans reliance on credit ratings,
which means that its risk judgments are
substantively different from those that
underpin Basel III. The European Union
is considering a law that side-steps
implementation of the Basel leverage
ratio – a critical reform meant to prevent
all the risk-weighting games still shockingly
evident across the globe. And,
even where law permits imposition of
Basel’s key provisions, it often doesn’t
let supervisors actually enforce tough
capital rules – mooting the point.
And, even if there weren’t these
statutory barriers to Basel III, profound
structural ones bar comparable crossborder
capital and liquidity standards.
One of the most important here is the
U.S. commitment to community banks,
for which Basel is in many ways inappropriate.
Even if one carved out community
banks, the U.S. still has 34 bank
holding companies with assets over $50
billion, a sharply different and more diverse
banking system than found almost
everywhere else.
Even more significant, the U.S. now
has a combination package of statutory
and structural barriers to Basel III. The
Dodd-Frank Act created an “orderly liquidation
authority” (OLA), a new law that
will end too big to fail by barring taxpayer
support for large banks. In sharp
contrast, the European Union and many
other nations have banks that are not
only backed by too big to fail, but also
“too big to save” expectations by virtue
of national reliance on only a very few,
very large banks.
Published Basel III-based capital measures are exposing European banks who will need to raise the most amounts of capital to meet the latest regulatory capital requirements (see attached Basel III handbook). There is also an expectation from investors, analysts, and some regulators that these banks will need to meet the minimum Basel III based Tier 1 ratio of 8% before the year-end.
But when it comes to European banks, it's not only the Eurozone periphery institutions that are in a race to improve their capital ratios.
It turns out that some Swiss institutions, particularly Credit Suisse (CS) will look undercapitalized once Basel III becomes official.
Common Equity Tier 1 capital under Basel III
Responding to recent comments from the Swiss National Bank, CS announced an aggressive capital raising program.
Barclays Capital: - Credit Suisse acknowledged this challenge on 18 July when it announced a new set of
capital enhancing measures in response to pressure from the Swiss National Bank. As of
March 2012, Credit Suisse had a fully-loaded Basel III CET1 [Common Equity Tier 1 ] ratio of just 5.3%, among the
weakest in Europe. In its 2012 Financial Stability Report published on 14 June 2012, the
Swiss National Bank highlighted the weaker capital position of the Swiss banks relative to
international peers, and that of Credit Suisse in particular. The SNB recommended that both
CS and UBS increase their loss-absorbing capital buffers, which in the case of Credit Suisse
had to be done in a ‘substantial’ manner and ‘during the course of the current year’.
Reacting to these pressures, Credit Suisse announced last week a set of immediate capital
measures for up to SFR8.7bn, expected to boost the bank’s fully-loaded Basel III CET1 ratio
by 1.5pp and additional measures totalling SFR6.6bn to be implemented by the end of 2012,
when the bank’s Basel III CET1 ratio will increase to 8.6% (fully-loaded). Although anecdotal
so far, the SNB move indicates that, in practice, the Basel III transition period will be much
shorter than scheduled. In our opinion, the focus regarding capital is shifting from the
strength of reported ratios to the weakness of ‘fully-loaded’ ratios.
This year banks have been boosting capital ratios by improving core equity capital (in many cases via retained earnings but in some instances issuing equity) as well as reducing Risk Weighted Assets (RWA) - roughly in equal amounts. Credit Suisse's goal of catching up to its peers in terms of Basel III based capitalization this year will be difficult. Shutting down capital intensive businesses (that will involve significant layoffs), selling assets (which will cut into earnings) and possibly issuing more equity (diluting existing investors) does not bode well for the share price. That's one of the key reasons CS shares just hit a 20-year low.
Credit Suisse share price
UBS and some other banks are struggling with this issue as well.
Basel III will clearly improve bank capitalization, but some institutions will end up with significantly lower share valuations as a result of trying to meet their target capital ratios.
Structured correctly, a reduction in a bank's Risk Weighted Assets for certain corporate credits may still be possible, even under the new bank regulation.
David McKibbin (Scute Consulting) provides a case study. A more detailed write-up can be found here.
David McKibbin: With many bank credit risk mitigation techniques now being questioned by regulators and more and more corporate funding transactions coming back on balance sheet, new and effective solutions are required. Banks need to reduce RWA's, which must better reflect effective due diligence and ongoing risk.
The attached case study is aimed at the European IFRS market.
A Sober Look post from a couple of years ago discusses the issues associated with using rolling historical period Value at Risk (VAR). The approach has a highly pro-cyclical impact on bank capital. During periods of low volatility and generally high profitability for financial institutions, the historical VAR method allows firms to lower their capital usage. During periods of crisis and therefore high volatility, VAR forces banks to allocate higher capital for the same positions. As an example, for the same dollar equivalent position in a diversified portfolio of US equities, a bank would have to allocate 3 times as much capital in 2009 as it did in 2007. Yet in 2009 these equities were no "riskier" than they were in 2007 - in fact one might argue that the inverse is true.
Basel III attempts to correct this approach. The new paradigm for market risk capital is expected to more than double the current capital requirements (that's partially why EU banks will need to raise so much more capital). A large portion of this regulatory capital increase comes from SVAR - the "stressed value at risk". SVAR still uses the standard 99% confidence interval (one-tailed), 10-day holding period, and at least one year worth of data, but requires it to be "calibrated" to a stress period (such as 2008).
This is certainly an improvement on the existing methodology and should reduce the pro-cyclical nature of the approach. But since the Basel Committee did not specify the stress period, and in fact requires that banks consider multiple stress periods, the measurement is still open to interpretation. One for example could see a case where regional supervisors would choose different stress periods for the same asset classes. That would mean that the same asset held in two different jurisdictions could potentially require different capital requirements.
The broader issue here is that VAR, even if it's now SVAR, is still the preferred regulatory approach to capital requirements. Risk practitioners in the financial services industry (both on the "buy" and the "sell" side) have long preferred to apply stress testing/scenarios when analyzing risk for internal purposes. SVAR would not have captured the risks at many financial institutions going into 2008. Since regulatory capital requirements drove performance, in many instances internal stress scenarios were ignored. The gap between what should be a superior approach to measuring risk and what the BIS bureaucrats are using to determine capital requirements has not been closed. Aaron Brown at AQR put it well when he said:
"People have tried to change VAR in lots of ways to explore the tail, but VAR is really for the center risk. In the tails you don't have enough data, so you don't know if something is one in a million, one in ten thousand or one in a hundred. But auditors and regulators want precise tools for exploring the regions that you can't explore with precise tools. They want to take a protractor into the jungle – it just doesn't work."
In addition to SVAR, the market risk framework under Basel III will also add capital charges from the incremental-risk charge (counterparty credit), a new asset securitization charge, and the so-called comprehensive-risk measure (more on these new rules later.) Risk "management" departments at banks will now grow more bloated (and probably even less effective), just to keep up with all this.
There is no shortage of ill-conceived regulation descending on the global financial industry. In some instances the new regulation will not only add little to improve the safety of the financial system but could actually destabilize it. One of Basel III rules for example is sure to create some potentially severe "unintended consequences".
As a bit of background, back in 2007, Citigroup was forced to take onto their balance sheet a significant amount of assets from "CP conduits" because the firm provided commercial paper (CP) "backstops" to these entities. The entities were funding themselves with asset-backed commercial paper while Citigroup effectively guaranteed that it will step in to finance the assets in case the entities could not roll their CP. And that is indeed what happened. All of a sudden Citi was saddled with large amounts of "AAA" CDO paper and other securities that weren't on their balance sheet before, even though Citi always had exposure to them. Citi was in fact financing this paper off balance sheet via their CP backstop commitment because it allowed the bank to reduce regulatory capital requirements and achieve higher returns on capital. In 2008 that action ultimately brought down the firm, with the US government forced to take a large stake in the company and providing it unprecedented financial support. RBS (taken over by the UK government) and Wachovia (taken over by Wells Fargo) both met with similar fate.
Instead of attempting to address this specific issue the
Basel III architects decided to use a blunt instrument. They put in place a simple rule stating that any unfunded contractual commitment to a financial institution must be treated as a fully funded commitment for the purposes of regulatory capital. It sounded great to many ivory tower bureaucrats, but few have realized the implications, particularly for the US. In the US the usage of revolving facilities is quite common both within and outside the financial industry. With this new rule banks will have to "put aside" the same amount of capital as they would for a fully funded loan. Therefore banks would have to charge the same interest on the undrawn amount as they would on the amount actually lent out. It's a bit like having to pay interest on your full credit card limit rather than just on the amount you borrow.
Consider a money market mutual fund for example. Often a large mutual fund would have a credit line with a bank for which it pays an unfunded commitment fee. Under the new rules funds would have to pay the full rate as though they have taken out a loan. That would be prohibitively expensive for a fund, making revolving facilities a thing of the past. Now imagine that a fund finds itself with large unexpected redemptions. Normally it would simply draw on the revolving facility to fund the redemptions and pay back the loan when its holdings of short term paper mature. Under the new regime it may be forced to sell the paper in the market at a great discount (secondary commercial paper does not trade well) and create losses for investors. A money market fund "breaking the buck" for example will panic other investors, generating more redemptions and so on. It is not at all clear how such a rule is making the financial system more stable.
Even beyond the problem of providing revolving facilities to mutual funds, Basle III will have significant implications for the corporate sector as well.
Journal of Global Finance: But the dilemma that all corporate treasurers face is in anticipating which particular financial services they will wind up paying more for—or earning less from. The Basel Committee of the Bank for International Settlements’ new rules will require all banks —including the 23 that International Paper does business with—to more than triple their core Tier 1 capital from 2% of risk-weighted assets to a minimum of 7% by 2019. Made up of common equity and disclosed reserves—or retained earnings—core Tier 1 is “the most expensive” type of capital that a bank holds, explains Peter Neu, a partner and managing director at Boston Consulting Group in Frankfurt....
...rather than rejoice at rules that are intended to reduce overall risk in the global financial system, senior managers of banks around the globe that are starting to comply with Basel III are quick to identify a litany of brutal impact points for their corporate clients, ranging from a drop in already-low interest rates on deposits to dramatic increases in interest rates on loans.
Even undrawn lines of credit will become more expensive and difficult to maintain. Banks will be required to treat 10% of short-term lines and 5% of long-term ones as if they were already drawn, according to Neu. The most that clients will be able to borrow from those lines will be 90% and 95% of their outstanding balances, respectively. “You cannot use this cash for other purposes. ...
The new rules will impact numerous business activities - from bank owned lease companies to trade finance.
Journal of Global Finance: In trade finance, where the liquidity ratio under Basel III would imply a fivefold increase in interest rates, some corporate treasurers are considering taking their business to insurance companies that issue surety bonds covering trade transactions. They are even looking at ways to serve as their own guarantors.
The bewildered public and some ignorant politicians continue to play the blame game for the slow economic growth and anemic hiring in the US. But at least a part of the answer can be found in the uncertainty associated with and the unintended consequences of the new regulation meant to cure all ills of the financial industry. Applying blunt instruments from Basel Switzerland to the US financial and corporate sector will damage numerous successful practices that served US commerce well for decades.
In their effort to remove proprietary trading from bank holding companies and increase capital requirements, regulators are destroying liquidity in the US corporate bond market. If you make markets (offer to buy and sell) in any product that has limited liquidity, you must run inventory. Baseball cards, antiques, or bonds - it's the same process. However between Basel III and the Volcker rule, the ability to maintain inventory is being undermined.
Barclays Capital: Increased regulation is a primary cause of this shift in dealer behaviour, in our view, in
particular Basel III and the Volcker rule. Basel III significantly increases the risk-weighted
assets associated with dealer balance sheets, thus making holding inventory more costly.
Several banks have cited this change when noting material decreases in their fixed income
balance sheets. For example, Credit Suisse announced that it plans to nearly halve the Basel
III risk-weighted assets in its fixed income division over the next three years. Uncertainty
about the implications of the limitations on proprietary trading included in the Volcker rule
have also led dealers to reduce inventories. While the rule-writing process on that front is
still ongoing, absent some substantial unexpected changes, the trend will likely continue
towards reduced capital devoted to market making.
The dealers have started pulling back on inventory ahead of new regulatory framework The chart below shows the levels of dealer inventory of corporate bonds, both High Yield (HY) and Investment Grade (IG) vs. mutual fund holdings.
Mutual funds tend to be "buy and hold" investors. Therefore price discovery in the corporate bond market comes from transactions facilitated by dealers or dealer quotes. As dealer inventories drop, transaction volumes decline and bid/ask spreads get wider. In other words if you can't add bonds to you inventory or have no bonds in your inventory to sell, you will have to find the other side of the trade before you can transact. If you don't have the other side of the trade ready (and usually market makers don't), you will make markets wide enough to compensate you for the risk of finding the other side later to unload your position.
Another troubling "unintended consequence" of the upcoming regulation is increasing concentrations. Dealers will only make markets in the largest, most liquid names because the smaller names would not justify the capital usage in the new regulatory framework. The next two charts show the transaction volumes for HY and IG bonds sorted from highest to lowest. The most liquid few issues account for the bulk of the volume.
Investment Grade
High Yield
Barclays Capital: As dealers shrink their corporate bond holdings and mutual funds demand higher liquidity, we
see an increased risk of volumes becoming even more concentrated than they are currently.
Indeed, in the first three quarters of 2011, of the nearly 628 tickers in the U.S. Corporate Index,
the 37 most liquid credits accounted for 50% of the volume; only 10% of the volume was in
the bottom 412 tickers (Figure 16). The volume concentration is even more pronounced in
high yield – 50% of the volume in the first three quarters of 2011 was in 46 tickers (out of
1,140), with the bottom 821 tickers accounting for only 10%
Who cares, you might ask. It's the medium-size businesses who are going to get hurt. Because liquidity in their bonds is going to dry up, investors will become concerned that they would not be able to sell these bonds when they need to do so. Therefore they will demand an increasingly higher yield to purchase such bonds (liquidity premium). And the medium size business - who tend to create a great deal of new jobs - will be the ones paying significantly more to borrow money.
