14/7/2013: Banking Reforms : recent links

Some recent articles on Banks Reforms in the global and EU context:

"A viable alternative to Basel III prudential rules" by Stefano Micossi (9 June 2013) argues that Basel III "…proposed reforms will fail to correct flaws in the old system. The new rules are even more complicated, opaque and open to manipulation. What is needed is a radical shift to prudential rule based on a straight capital ratio."
Link: http://www.voxeu.org/article/viable-alternative-basel-iii-prudential-rules


And in a typically Bruegelesque fashion, "Basel III: Europe’s interest is to comply" by Nicolas Véron (5 March 2013) argues that since "the EU was once a champion of global financial regulatory convergence", then "the EU should drop its lacklustre inertia and pursue Basel III because, in the end, it’s in its interests to comply. EU policymakers ought to aim at enabling the adoption of a Capital Requirements Regulation that would be fully compliant with Basel III."
Link: http://www.voxeu.org/article/basel-iii-europe-s-interest-comply

His colleague, Daniel Gros is of a view that diversification is a good thing, but diversification not i regulatory space. In his "EZ banking union with a sovereign virus" (14 June 2013) he argues that: "The doom-loop between banks and the national governments played a dominant role in the Eurozone crisis for Ireland and Cyprus. A Eurozone banking union is usually viewed as the solution. This column argues that the doom-loop cannot be undone as long as banks hold oversized amounts of their government’s debt. A simple solution would be to apply the general rule that banks are prohibited from holding more than a quarter of their capital in government bonds of any single sovereign." Here's the problem, however, in both Cyprus and Ireland sovereign bonds holdings of own governments were not a problem. In Cyprus the problem was holding of Greek Government bonds, and in Ireland, the contagion mechanism was from inter-bank lending and banks' own bonds issuance to the sovereign via a blanket 2008 Guarantee.
Link: http://www.voxeu.org/article/ez-banking-union-sovereign-virus


"Implementation of Basel III in the US will bring back the regulatory arbitrage problems under Basel I" by Takeo Hoshi (23 December 2012) says that "rejigging financial regulation is in vogue. But, in the world of international finance, how well do different regulatory systems join up?" In the US context, the author "argues that the US Dodd Frank Act and Basel III are, in part, incompatible and that harmonising them may lead to unintended consequences. The US ought to tread carefully here but should also try hard to maintain the spirit of better financial regulation."
Link: http://www.voxeu.org/article/implementation-basel-iii-us-will-bring-back-regulatory-arbitrage-problems-under-basel-i


There's a huge amount of opinion published on Voxeu.org on bank regulation: http://www.voxeu.org/debates/banking-reform-do-we-know-what-has-be-done


ZeroHedge classic: http://www.zerohedge.com/node/475643 "The Secret Sauce Of Iceland's Success Story: Debt Liquidation?" argues that "That Iceland is so far the only success story in the continent of Europe, which continues sliding into an ever deeper depressionary black hole, as a result of the complete destruction of its financial sector and its subsequent rise from the ashes, is by known to most. …As it turns out, perhaps the biggest jolt to Icelandic economic growth is what we said was the correct prescription for resolving not only the US but global growth malaise that struck in 2008: debt liquidation."


Irish Times covers the outright bizarre and sublimely ironic day-dreaming that is going on in Ireland's highest policy circles. The latests instalment is transformation of the IFSC into a sort of "We've screwed up so comprehensively, we can sell this as competence" story: http://www.irishtimes.com/business/sectors/financial-services/ifsc-faces-radical-rethink-as-effects-of-crash-become-clear-1.1460832?page=2

Pearls of wisdom: "Ryan’s paper makes eight proposals, including “relaunching the IFSC brand” along product lines – global asset finance, a global servicing platform and a global listing platform." All of which have been already in place for years to various success. "The document recommends the creation of a JobsHub to allow firms seeking staff to “find people quickly and cost effectively”." Other things: setting up IFSC as a centre for 'bad banks' on foot of 'experience already present in NAMA'. This is the logic of converting Dublin Bay into a global toxic refuse dump for the UK and European waste disposal, because we 'already have considerable expertise' at the Poolbeg waste facilities. And last, but not least: converting IFSC into "global centre of excellence for property"… Even the Irish Times could not have escaped the obvious irony present in this idea.


Last, but not least, Bloomberg report on Michel Barnier balmy ideas on 'Bank-Crisis' plans for the EU: http://www.bloomberg.com/news/2013-07-09/eu-steels-for-battle-over-bank-resolution-plans-led-by-germany.html from July 9. "The European Union’s executive arm proposed procedures for handling failing banks with a 55 billion-euro ($70 billion) backstop, setting up a showdown with Germany over control of taxpayers’ cash." Good summery of current play on this.

29/6/2013: Banks-Sovereign Contagion: It's Getting Worse in Europe

Two revealing charts from Ioan Smith @moved_average (h/t to @russian_market ): Government bonds volumes held by Italian and Spanish banks:

Combined:

• Italy EUR404bn (26% of 2013 GDP) up on EUR177bn at the end of 2008
• Spain EUR303bn (29% of 2013 GDP) up on EUR107bn at the end of 2008

Now, recall that over the last few years:

• European authorities and nation states have pushed for banks to 'play a greater role' in 'supporting recovery' - euphemism for forcing or incentivising (or both) banks to buy more Government debt to fund fiscal deficits (gross effect: increase holdings of Government by the banks, making banks even more too-big/important-to-fail); 
• European authorities and nation states have pushed for separating the banks-sovereign contagion links, primarily by loading more contingent liabilities in the case of insolvency on investors, lenders and depositors (gross effect: attempting to decrease potential call on sovereigns from the defaulting banks);
• European authorities and nation states have continued to treat Government bonds as zero risk-weighted 'safe' assets, while pushing for banks to hold more capital (the twin effect is the direct incentive for banks to increase, not decrease, their direct links to the states via bond holdings).

The net result: the contagion risk conduit is now bigger than ever, while the customer/investor security in the banking system is now weaker than ever. If someone wanted to purposefully design a system to destroy the European banking, they couldn't have dreamt up a better one than that...

8/6/2013: Shortages of Safe Assets & Banks Recaps - troubled waters of Basel III

Here's an interesting view on European banks: http://www.voxeu.org/article/urgent-need-recapitalise-europe-s-banks . The core point is here:

Chart: Market-to-book value of European banks:

Quote: " On average, the market-to-book value of European banks now is about 0.50 (see Figure 1). This indicates that accountants’ estimates of bank capital are far too rosy, and that banks have substantial hidden losses on their books."

But there's more. "Until now, Europe’s banking sector has been kept afloat by implicit state guarantees of virtually all liabilities. …in 2012 these guarantees provided banks in Europe with an annual average funding advantage amounting to 0.3% of total assets. …An annual funding advantage of 0.3% of assets can be capitalised to be equivalent to 2% of total assets, on the assumption of a discount rate of 15% commensurate with banks’ uncertain earnings prospects. Given total banking assets of €33 trillion in the Eurozone, we are talking about an implicit guarantee of about €650 billion."

In short, through the crisis, European banking system was pumped with implicit supports to the tune of EUR2.6 trillion.

More than that. EBA is delaying stress tests into 2014, so we won't even in theory be able to know what is going on in the banks. Except, one has to doubt that the theory is a good instrument for the reality, as EBA has managed to bungle all stress tests it carried out to-date. In other words, EBA is acting de facto to increase implied supports as it delays and evades recognition of losses.


Look at the following paper: http://www.cpb.nl/en/publication/private-value-too-big-fail-guarantees (alternative link via ssrn: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2271326) which concluded that: "over the period 1-1-2008 until 15-6-2012" for only 151 European banks, "the size of the funding advantage' granted by various state supports "is large and fluctuates substantially over time. For most countries it rises from 0.1% of GDP in the first half of 2008 to more than 1% of GDP mid 2011. Our results are comparable to findings in previous studies. We find that larger banks enjoy on average higher rating uplifts, but the effect of size does not increase anymore for banks with total assets above 1,000 billion Euro compared to banks with assets between 250 and 1,000 billion Euro. In addition, a higher sovereign rating of a bank‟s home country leads on average to a higher rating uplift for that bank."

In other words, remove the protectionist supports and the system will crumble.

Note, the paper also cites the case of Ireland. "When we take a closer look at the funding advantages of banks from Spain, Italy, and Portugal in Figure 7, we see that the advantages enjoyed by banks are relatively small in these countries. This can be explained by the smaller rating uplifts that the banks from these countries enjoy. The fact that rating uplifts are relatively small in these countries is likely to be related to lower sovereign creditworthiness. The banking sector in, for example, Spain is not necessarily smaller when compared to GDP than the banking sector in France and Germany. So this is unlikely to explain the results we find. In Ireland, funding advantages are relatively large compared to the other three countries. The funding advantage enjoyed by Irish banks is somewhat higher than the advantage enjoyed by French and German banks."

Figure 7: funding advantage per country (Spain, Ireland*, Italy, and Portugal) (*note that the figure for Ireland is drawn on a different scale)

Now, when you just thought that the resolution path (as suggested by the article linked above) is well-known: assess, expose, recap, things are getting slightly out of hand. BIS has warned that simply pumping more capital into banks might be a wrong thing to do. Here's the BIS paper: http://www.bis.org/publ/cgfs49.pdf.

In the nutshell, BIS is saying that core tools for dealing with banks insolvency so far are… possibly… making these banks less safe, not more. The problem is that under Basel III, safety of bank capital is determined by safety of underlying assets held as capital (so far - fine). These 'safe' assets are… err… Government bonds and Government-guaranteed commercial paper (e.g. MBS). The idea is that 1) these assets are more secure, thus provide better cushion in the case of distress, and 2) these assets can be sold (are liquid) easily to cover any losses.

Problem is: there is a shortage of 'safe' assets as defined by Basel. The shortages are riven by 1) higher demand for these assets, 2) smaller number of 'safe' (highly-rated) sovereigns, 3) reduced issuance by highly-rated sovereigns ('austerity') and 4) central banks and non-banking financial institutions (e.g pensions funds) hoovering up these assets. BIS is not worried about the shortages of safe assets, but here are some links on this:

• from the Economist: http://www.economist.com/blogs/freeexchange/2013/02/safe-asset-shortage
• and from BIS own researchers: http://www.bis.org/events/conf120621/gourinchas_paper.pdf
• from Bruegel: http://www.bruegel.org/nc/blog/detail/article/1023-blogs-review-the-safe-asset-shortage/
• from FT Alphaville: http://ftalphaville.ft.com/tag/shortage-of-safe-assets/ with a chart:

In turn, shortages of safe assets, even if nascent, can drive ups emend for riskier assets and thus increase riskier assets allocations by the financial intermediaries (think insurance and pensions funds on drugs).

Here's a very interesting discussion of what can happen next from @simonefoxman: http://qz.com/88585/new-fears-of-financial-interconnectedness-highlight-the-delusion-of-bank-capital/?oref=dbamerica

"And therein lies the risk. The assets don’t change hands permanently: It’s just one institution lending junk bonds to another and borrowing higher-quality ones in return. So a default on one side could translate into problems for the other. In such cases, the “high-quality capital” is only as reliable as the low-quality capital it was exchanged for. Moreover, if assets on either end of such a deal are mispriced, it could have knock-on effects across the financial system.

As a result, warns the BIS, the financial system is becoming more interconnected—and thus more susceptible to system-wide problems of the kind we saw in the financial crisis a few years ago."

Once again, Basel III might be off the target by a mile when it comes to improving quality of risk buffers in the banks… Just as with liquidity buffers: http://trueeconomics.blogspot.ie/2013/05/352013-basel-25-can-lead-to-increased.html

3/5/2013: Basel 2.5 can lead to increased liquidity & contagion risks

Banca d'Italia research paper No. 159, "Basel 2.5: potential benefits and unintended consequences" (April 2013) by Giovanni Pepe looks at the Basel III framework from the risk-weighting perspective. Under previous Basel rules, since 1996, "…the Basel risk-weighting regime has been based on the distinction between the trading and the
banking book. For a long time credit items have been weighted less strictly if held in the trading book, on the assumption that they are easy to hedge or sell."

Alas, the assumption of lower liquidity risks associated with assets held on trading book proved to be rather faulty. "The Great Financial Crisis made evident that banks declared a trading intent on positions that proved difficult or impossible to sell quickly. The Basel 2.5 package was developed in 2009 to better align trading and banking books’ capital treatments." Yet, the question remains as to whether the Basel 2.5 response is adequate to properly realign risk pricing for liquidity risk, relating to assets held on trading book.

"Working on a number of hypothetical portfolios [the study shows] that the new rules fell short of reaching their target and instead merely reversed the incentives. A model bank can now achieve a material capital saving by allocating its credit securities to the banking book [as opposed to the trading book], irrespective of its real intention or capability of holding them until maturity. The advantage of doing so is particularly pronounced when the incremental investment increases the concentration profile of the trading book, as usually happens for exposures towards banks’ home government. Moreover, in these cases trading book requirements are exposed to powerful cliff-edge
effects triggered by rating changes."

In the nutshell, Basel 2.5 fails to get the poor quality assets risks properly priced and instead created incentives for the banks to shift such assets to the different section of the balance sheet. The impact of this is to superficially inflate values of sovereign debt (by reducing risk-weighted capital requirements on these assets). Added effect of this is that Basel 2.5 inadvertently increases the risk of sovereign-bank-sovereign contagion cycle.

The paper is available at: http://www.bancaditalia.it/pubblicazioni/econo/quest_ecofin_2/qef159/QEF_159.pdf