The FOMC announcement to hold the status quo on securities purchases resulted in a flatter yield curve.
While this surprising decision by the Fed helped a number of "risk-on" assets, it was a negative for banks. Bank shares rallied initially with equity indices, but sold off sharply later in the afternoon and the following day - creating a 2% underperformance gap (h/t George H).
red=S&P500; blue= bank index ETF
The yield curve slope benefits banks because they typically fund themselves through short-term instruments (mostly through deposits), while lending longer term. The higher the spread between the two, the greater the banks' net interest income (see story from May). The market is signaling reduced profitability and potentially weaker lending growth (discussed here). With higher capital requirements (under Dodd Frank, Basel III, Leverage Ratio rule, etc.), banks need to generate larger margins to achieve the same return on capital (ROC). If the curve is not steep enough, some loans no longer meet the ROC threshold.
But what about the lower mortgage rates improving demand for residential loans? Shouldn't that help banks originate more loans and sell them to the GSEs? Unfortunately the Fed's action resulted in just a 14bp decline in the 30y mortgage rate (see post). That's not nearly enough to stimulate demand. The FOMC's decision is therefore likely to be a net negative for US credit growth.
Ireland was the one country in the Eurozone "periphery" that seemed to be bucking the trend (see post). Many had hoped that the nation will be able to withstand the Eurozone recession due to its strong trade balance. Exports were really humming until global growth stalled last year (see post). Ireland's trade balance turned negative again and does not seem to be recovering. Furthermore, domestic demand is now weakening.
Source: Barclays Capital
As a result Ireland's GDP contracted and the nation followed the rest of the Eurozone into a recession - just over 3 years after the Great Recession.
Source: Barclays Capital
Given Ireland's high government debt to GDP ratio (Ireland ranks third in the Eurozone after Greece and Italy), this is bad news. The hope was that the government can manage down its leverage as the GDP grows, but that's not how things turned out.
Source: Tradingeconomics
Unlike most of the other Eurozone nations whose debt to GDP trajectory was much more gradual, Ireland's ratio shot up rapidly in a matter of 4 years. What makes Ireland somewhat unique in the Eurozone is that this debt spike is directly related to Ireland's bank bailout. The sad part is that Ireland's EU "friends" had a great deal to do with this. Here is why.
In the last couple of days the EU reached an agreement on dealing with failed banks.
The Express: - The European Union has today agreed to force investors and wealthy savers to share the costs of future bank failures, moving closer to drawing a line under years of taxpayer-funded bailouts that have prompted public outrage.
After seven hours of late-night talks, finance ministers from the bloc's 27 countries emerged with a blueprint to close or salvage banks in trouble.
The plan stipulates that shareholders, bondholders and depositors with more than 100,000 euros should share the burden of saving a bank.
If Ireland were allowed to implement anything resembling this provision during the financial crisis, its debt to GDP would never have reached anything close to the current levels.
During the financial crisis a great deal of the unsecured debt of Irish banks was held by the UK's and the Eurozone's banks. And neither the EU nor the ECB wanted to haircut these bonds. In order to "keep the peace" in the EU banking system, these bonds were not written down, forcing the Irish government to make the bondholders whole. It had no resources to do so and was forced to borrow tremendous amounts in order to cover these obligations. As losses on property portfolios inherited by the government mounted, so did the government debt (government guarantee had to cover increasingly larger losses). The austerity drive generated by this high government debt caused unemployment to spike and destroyed domestic demand. It may be a decade or longer before the nation fully recovers. Now that Ireland had paid the high price for covering its banks' obligations, the EU is about to implement the rules to force haircuts on unsecured creditors - something they refused to do for Ireland just a few years ago.
The next post will contain an email from a reader describing some of the ugly facts around the bailout of the Irish banking system.
The treasury curve has steepened materially over the past few weeks, driven by Bernanke's seemingly hawkish statements. One group of companies that will benefit from this adjustment is the banking sector.
In fact bank shares have been outperforming the broader market by a significant margin - over 6% in the past couple of months.
The reason is simple. Given the short end of the curve has not budged, banks will continue to pay next to nothing on deposits. But they can now charge much higher rates on new term loans they make. That spread increase (net interest income) will flow right into equity and juice up bank dividends. Bank shareholders and executives should thank Bernanke for this "gift".
But there are headwinds appearing on the horizon for the banking sector that may negate some of these gains. Here are a few examples:
1. A portion of bank revenue has been generated from mortgage refinancing in the past couple of years. But that game is over (see post) and the refi fee revenue will no longer be there. We'll let our friends who analyze bank shares quantify that number, but it can't be immaterial.
2. With rates rising, loan demand in the corporate sector may in fact decline. We are already seeing evidence of that.
On top of reducing origination fees and asset growth for banks, this trend could easily result in slower economic growth, which has been quite fragile to begin with.
3. Treasury and agency securities make up about 10% of bank assets. Even though not all of these securities will get marked to market, the recent bond correction can't be good for the old P&L. Customer flows in fixed income departments of banks will also decline materially.
4. New regulatory pressures could create tremendous headwinds for the larger banks and could even result in dividends being shut off for years to come as banks are forced to build up capital.
Bloomberg: - U.S. regulators are considering doubling a minimum capital requirement for the largest banks, which could force some of them to halt dividend payments.
The standard would increase the amount of capital the lenders must hold to 6 percent of total assets, regardless of their risk, according to four people with knowledge of the talks. That’s twice the level set by global banking supervisors.
For those who think banks haven't been lending enough, just wait till such rules go into effect. We will see an outright credit contraction in the US.
Given these headwinds in the banking sector, one should be careful jumping on the bank shares bandwagon. There may be some nasty earnings surprises along the way. And with banks under pressure, those who are predicting the US GDP to grow at 2.5% or higher should go back to the drawing board.
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.
US regional banks have over-reserved for loan losses during 2009-2010 period, expecting a wave of defaults. Default rates however have been lower than projected and banks have been releasing these reserves into earnings in the past couple of years. According to Credit Suisse, that trend is expected to continue.
CS: - US Regional
Bank reserve levels have declined by 38% from the peak levels of 1Q10. However, we
think reserve levels may still decline by 11% to the trough, which we estimate will form in
3Q14.
Ratio of loss reserves to loans (Source: CS)
As banks release reserves for existing loans (not to be confused with reserves at the Fed), the amount of loans they have on the books continues to grow. At some point (in 3Q14 according to CS), the absolute levels of reserves will begin to grow again. For now however the release in reserves is offsetting generally weaker than expected core revenues.
CS: - We remain cautious on the industry as we forecast core revenues to miss expectations over the next 12 months. While our net interest income forecasts trend
below consensus expectations, our long-term EPS forecasts are only modestly below
expectations as we have larger reserve releases than consensus in our models. Reserve
reductions are low quality drivers of earnings; however, they still support higher capital
payout ratios through the annual CCAR (capital stress test) process, and also imply a
faster capital growth rate.
Declining interest income and fees are the reasons for this caution on core revenues. CS is also concerned about a recession next year, driven mostly by the US fiscal cliff (see discussion). So far however (particularly while releasing these loss reserves) regional banks have materially outperformed the overall banking sector and have continued to perform in line with the broader market.
A Bloomberg article this morning discussed an increase in balance sheets of Eurozone's banks. It basically made it sound as though the ECB had been encouraging banks to take on more risk via the LTRO program.
Bloomberg: - European banks pledged last year to cut more than $1.2 trillion of assets to help them weather the sovereign-debt crisis. Since then they’ve grown only fatter.
Lenders in the euro area increased assets by 7 percent to 34.4 trillion euros ($45 trillion) in the year ended July 31, according to data compiled by the European Central Bank. BNP Paribas SA (BNP), Banco Santander (SAN) SA, and UniCredit (UCG) SpA, the biggest banks in France, Spain and Italy, all expanded their balance sheets in the 12 months through the end of June.
They have Mario Draghi to thank. The ECB president’s decision nine months ago to provide more than 1 trillion euros of three-year loans [3y LTRO] to banks eased the pressure to sell assets at depressed prices. The infusion, designed to encourage firms to lend, succeeded in averting a short-term credit crunch by reducing their reliance on markets for funding. It also may be making European lenders dependent on more central-bank aid.
Draghi is making the Eurozone banks grow "fatter". Please just stick to reporting the news. This is misleading and portions of this article are just wrong. The LTRO program provided financing relief to a heavily strained banking system and created a near permanent dependence on central bank funding. But it had little to do with risk taking by euro area lenders.
Let's take a look at some of the key components of the Eurozone banking system's assets.The largest portion of the balance sheets are corporate loans, particularly loans to non-financial corporations. As the chart below shows, growth in corporate loans came to a grinding halt after the financial crisis. Certainly over the past year, lending to corporations declined. So corporate credit clearly did not increase balance sheets in the Eurozone.
Source: ECB
The situation with corporate bonds is similar, as banks have not bought more corporate debt. In fact banks have reduced corporate bond holdings during the past spring/summer.
Now let's take a look at residential/consumer lending. Mortgage loan balances are roughly flat from last year,
... while consumer credit (such as credit cards) has been declining for some time now.
So what actually drove this increase in assets discussed above? A large part of it was due to accelerated purchases of sovereign debt.
Bloomberg: - Banks across Europe bolstered capital instead of selling assets and curbing lending. They did it by retaining profit and swapping debt with other securities, such as subordinated debt, considered to have better loss-absorbing qualities, the European Banking Authority said in July.
Some lenders used the ECB’s loans to purchase sovereign bonds. Under current Basel Committee on Banking Supervision rules, banks don’t have to hold any capital against government debt because it’s considered risk-free.
Basel rules require banks to maintain varying amounts of capital against assets depending on their riskiness. They allow the largest firms to use their own models to calculate how much capital they need. By adjusting the criteria or swapping assets for ones considered less risky, lenders can reduce their risk- weighted assets, even as total assets increase.
Swapping corporate and consumer debt for government paper due to better capital treatment was clearly one of the incentives - particularly as government bond yields in the periphery rose (the "crowding out" effect). But it wasn't just the fact that funds were made available by the ECB that spurred this bond buying. It was the periphery governments who "encouraged" banks to purchase their paper (see discussion). And some governments even provided guarantees on banks' own paper to be used as collateral in order to give banks more "buying power" (see this discussion). That's why banks' holdings of sovereign debt in the Eurozone are now at record levels.
Bloomberg's assertion that banks somehow did not want to keep their "promise" to reduce assets due to Draghi's program is nonsense. Draghi's 3y LTRO obviously provided the opportunity for banks to purchase more sovereign debt and lock in the spread differential between bond yields and the ECB's 1% financing for 3 years. But banks would certainly not have loaded up on all this government debt on their own - the additional exposure made the share prices more volatile. It was the governments who pressured their nations' banks into participating in their bond auctions - since very few others would "show up". Italy and Spain clearly did not care if banks' balance sheets would increase as a result. And it was done at the expense of lending to the "real economy", pushing the Eurozone into its current recession.
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.
Staying with the topic of periphery banks, here is a comparison of loan to deposit ratios for various nations' banking sectors. This is an indication of severe liquidity constraints that periphery banks have been experiencing. Much of that is driven by capital flows out of the Eurozone periphery.
Here is an interesting chart from the Fed. It shows bank (all US chartered banks) charge-off rates for 3 different asset classes: commercial/industrial (corporate) loans, commercial real estate loans, and residential real estate loans. Charge-offs for all three spiked during the last recession. But the previous two recessions were quite different.
The "Gulf War-I" recession caused an increase in corporate and commercial real estate loans charge-offs, while residential loans remained relatively intact. The "Dot-com bust" recession however only hit the corporate loan asset class (Worldcom, Enron, Mirant, etc.). Real estate loans charge-offs remained immaterial.
What's interesting is that on a relative basis the largest dollar losses during this past recession came from residential loans followed by commercial property loans, with corporate loans producing the least amount of dollar losses. There isn't a sufficient data for a conclusive result, but one could postulate that risk appetite (looser lending standards) and ratings biases were driven by how assets behaved in earlier recessions. And the better the asset class performed in previous economic shocks, the more comfortable the lenders/investors became with the product. Risk managers and regulators in effect "fight the last war".
As an example of that effect consider the fact that sovereign debt did quite well during 08-09 and became the darling of European banks. Clearly these banks held sovereign debt before the 08 crisis, but the holdings increased considerably during 2009 and 2010. Just as with mortgage loans prior to the crisis (using securitization), both the regulators and the rating agencies made holding sovereign debt easy for banks.
The problem markets/asset classes for the next crisis may therefore be those that did well during the recent economic shocks. There are a few that come to mind, but that's a topic for another discussion.
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.
As capital becomes more scarce for banking institutions in the Eurozone and balance sheets become constrained, the tightening of credit to the "real economy" accelerates. The lending standards that banks impose to provide credit to companies are becoming considerably stricter.
FT: A European Central Bank survey on Wednesday showed the eurozone debt crisis has triggered a severe credit squeeze across the region with banks imposing significantly harsher loan terms on businesses and consumers. Demand for mortgages and loans to fund corporate investment was also falling sharply, the survey showed.
But not all the Eurozone nations are impacted in the same manner. One would think that the differences in lending standards is defined by the divide between the "core" and the "periphery" nations. But that's not exactly the case. The divide is between nations with stronger banking institutions and the weaker ones. French financial institutions, in spite of being part of the Eurozone core, have been weakened dramatically by the crisis and are therefore tightening loan terms. Germany on the other hand is not impacted while Italy is in bad shape. The chart below shows how lending standards depend on nations' banking system strength.
Source: JPMorgan Economic Research
There is a reason the ECB is going all out to provide funding with unprecedented
terms/amounts to the banking system - they are trying to
arrest these tightening lending conditions. The liquidity should help, but the damage has already been done to the Eurozone's corporations and consequently to jobs and the area's economic growth.
Last night's eurozone downgrade news from Standard and Poors was largely expected. Going forward however these downgrades may impact bank capital requirements for banks who hold sovereign debt. In particular for banks who use the Basle II standard model, the downgrades may increase risk weights for some sovereign bonds. A 100% risk weight means that a $100 holding (for minimum of 8% capital ratio) will require $8 in capital, while a 50% risk weight would require $4 in capital, and so on.
BIS (January 2001):
The standardised approach is conceptually the same as the present Accord, but is more risk
sensitive. The bank allocates a risk-weight to each of its assets and off-balance-sheet
positions and produces a sum of risk-weighted asset values. A risk weight of 100% means
that an exposure is included in the calculation of risk weighted assets at its full value, which
translates into a capital charge equal to 8% of that value. Similarly, a risk weight of 20%
results in a capital charge of 1.6% (i.e. one-fifth of 8%).
Individual risk weights currently depend on the broad category of borrower (i.e. sovereigns,
banks or corporates). Under the new Accord, the risk weights are to be refined by reference
to a rating provided by an external credit assessment institution (such as a rating agency)
that meets strict standards. For example, for corporate lending, the existing Accord provides
only one risk weight category of 100% but the new Accord will provide four categories (20%,
50%, 100% and 150%).
Basle II risk weights are determined using ratings - larger banks generate internal ratings while smaller banks tend to apply the "standard model". Most regulators however expect to see some consistency between rating agency scores and ratings generated by internal models. Under these rules, the risk weights would change as follows:
Spain and Slovenia bond holdings may get adjusted from zero risk weight to 20%. Where in the past no capital was required to hold these bonds, now 1.6% capital charge would be applied. Spanish bonds in particular may have an impact as they are widely held by EU banks (not just eurozone).
Italy bond holdings may get adjusted from 20% risk weight to 50%. This could cause a material increase in capital requirements across the eurozone as well. Capital charge would increase from 1.6% to 4%.
Cyprus and Portugal bond holdings may get adjusted from 50% risk weight to 100%. This is the biggest capital adjustment (4% to 8%) as the ratings move from "investment grade" to "junk". Fortunately Portugal's bonds do not constitute a substantial portion of EU bank sovereign bond holdings.
There should be no impact from the France downgrade because those bonds would still have a zero risk weight (as is the case with US treasuries). Also it is important to note that these capital changes may or may not take place immediately. Each nation's regulator may have a different interpretation of the rules when dealing with a downgrade by a single agency and not the others. But this move by S&P makes further downgrades by other rating agencies far more impactful because banks applying these capital rules would no longer be able to ignore them.
As European banks face a wall of maturing debt and no buyers, they are using a tool provided by the ECB to borrow on an unsecured basis. There really is no other choice for many institutions.
Joseph Cotterill at FT/Alphaville pointed out that the ECB has loosened collateral requirements so much that it now includes private bonds:
... we said the ECB’s decision in September to accept unlisted bank bonds — i.e., bonds that the banks could have issued purely to themselves solely in order to pledge them as collateral for central bank funding — was “potentially very significant”.
The process is quite simple. The ECB can't lend on an unsecured basis, but they can take a private (unlisted) bond as collateral. A bank can issue an unsecured bond to its own subsidiary and then pledge it as collateral to borrow from the ECB. In effect it becomes unsecured funding form the ECB.
Backdoor unsecured funding from the ECB
Originally the ECB had a strict limit on how much "related party" unsecured debt they can accept as collateral (usually only 5%). But with the credit markets frozen in the eurozone and bank bonds maturing, the ECB had to relax these rules. We pointed out last week that the ECB has little choice in the matter:
Sober Look: Going forward either the ECB expands their definition of eligible
collateral further (as they have already done) or the eurozone
governments, the ECB, or the IMF would need to provide unsecured
financing...
That is indeed what seems to have happened. James Mackintosh (FT) describes how the ECB created a few "exceptions" to the 5% rule:
The ECB quietly increased the list of collateral it would accept by more than a third at the start of the year. Almost all the 10,599 debt instruments it added were from banks – and more than 8,000 of them from French banks. Furthermore, French banks also dominate the list of newly eligible instruments created since the rules were announced.
The problem is not close to being solved, but this loophole will allow the ECB to keep banks from failing - something the eurozone could not withstand at this juncture.
This chart gives an overview by country of how much capital banks of the euro-zone nations would need to raise to get to 9% capital ratios.
With Greece a lost cause, the number from Spain looks particularly troubling, especially given the economic/market backdrop. It will be next to impossible to raise EUR26 bn of equity capital for Spanish banks from private sources in the near future. Spanish banks will attempt to sell equity at the same time as other euro-zone institutions will be trying to access the capital markets.
In a recent post called The perverse impact of Value at Risk, we focused on the problem of banking institutions using market based models to set aside capital. For example the same dollar position in the S&P500 (or most other asset classes) during 2007 would have a third of the current (2009) capital requirements (because 2006-07 market volatility was so much lower).
This issue is actually not unique to trading positions. Loan loss reserves follow the same pattern. Banking institutions use historical default experience to assign loss reserves to loan portfolios, but this data tends to be cyclical. Therefore the reserves would drop during a prolonged economic expansion. Instead, however, banks should be doing the opposite - increasing reserves during good times to be able to draw on them during times of economic stress.
The US Treasury finally woke up to this problem and issued a statement yesterday with guidelines to reform bank capital requirements. They focused among other things on what they call "procyclicality of the regulatory capital and accounting regimes". During times of growth, capital requirements drop, promoting extension of more credit and increasing the ability to take larger risks. That in turn feeds growth of credit and liquidity in the system, creating what's called a "positive feedback loop". An example of that would be placing a speaker next to a microphone and connecting the two - creating the unbearable noise and potentially frying the speaker. This is how credit bubbles get built.
Of course this also works in the opposite direction. A "negative perturbation" in the system causes capital requirements to go up and liquidity and credit availability to get sucked out of the markets, forcing capital requirements to increase even more, and so on (violently deflating the bubble). Engineers would call this procyclicality an "unstable equilibrium".
From the US Treasury:
Certain aspects of accounting standards also have procyclical tendencies. For example, during good times, loan loss reserves tend to decline because recent historical losses are low.
... The capital rules should rely less on procyclical Value-at-Risk (VaR) models, point-in-time internal rating systems, and non-stressed risk parameters. A movement toward greater use of longer-horizon, through-the-cycle risk estimates should result in higher capital requirements in the early phases of the credit cycle and more uniform capital requirements throughout the cycle.
...in determining their loan loss reserves, banking firms also should be required to be more forward-looking and consider factors that would cause loan losses to differ from recent historical experience.
The Treasury proposes some creative solutions to even out bank capital requirements or even push them to become "anticyclical" (moving toward a "stable equilibrium"). Some examples include linking capital and loss reserves to economic indicators - the stronger the economy, the more incremental capital (above the minimums required) the banks should reserve. Banks can also issue debt that converts to equity in an economic downturn, effectively recapitalizing the bank.
It's a well thought out proposal - definitely worth a read.
