18 February 2012

Bank of England’s Wake-up Call

Now we are in the stage where even the so-called sophisticated institutional investors seem to become loud about their inability to understand and value banks’ assets and liabilities, assess their risks etc. Whatever the reason for this (I guess, institutional investors are being pressured to provide more liquidity to the markets as well as support banks in their efforts to raise additional capital), but as a result the significant players in the financial markets are calling central banks to do something about the opacity surrounding banks’ accounting practices and the regulatory frameworks. Thus, the December 2011 issue of the Financial Stability Report by Bank of England is pretty revealing in some sense, and worth a closer look.

As a side note, remember that when reading the reports by the IMF, by central banks, by financial supervisory authorities and the like, it’s always useful to pay attention to the factual information and understand the overall logic of the analysis, rather than get sleepy of the boring and politically correct way of presenting things, or focusing to the conclusions and executive summaries only. The later tend to be surprisingly moderate when compared to what the analysis should have revealed.

It’s the same with the Financial Stability Report concerned. The general tone of the report is that we are talking about some sort of normal process of monitoring the situation, identifying problems, issuing recommendations for solving the identified problems, and then following up how the recommendations have been implemented. This way the key messages and implications of the analysis remain to the background. Let’s bring them to the front.

Key Messages and Warnings

That’s what the UK’s central bank is basically implying between the lines (as I read it out):

* The accounting practices of banks are opaque. Regulators (as well as investors) have probably little if any idea about the true values of banks’ assets and liabilities. Despite of disclosing each quarter tens of pages with data and information, the transparency about the real situation is in many cases very low indeed.

WARNING 1: The practices of restructuring loans / forbearance have caught the attention of investors and regulators. Some banks may face materially higher provisions on loans that are being presented as performing but in fact are non-performing. Look closely at the interest-only loans, restructured loans and the like.

WARNING 2: More surprises are expected to come into the daylight about the banks’ creative funding structures and using assets as collaterals.

WARNING 3:  The valuations of complex financial instruments vary a lot across banks. The expectation to increased transparency here is likely to lead to some sort of surprises. One might expect that disclosing sufficient information is far too onerous, so that it’s ultimately easier / less costly to abandon the instruments.

* Basel Committee and regulators have done some terrible mistakes when designing and approving the Basel II / Basel III frameworks for the calculation of banks’ regulatory capital. They have allowed running a bank with almost no capital. The regulators have no clue about what the calculated regulatory capital ratios actually show (because there are tens if not hundreds of internal models within one single banking group only used for this purpose).

WARNING 4: Risk weights for calculating the risk-weighted assets are going to be revised (we do not know when and how exactly, but at some point this will happen); this will most probably turn the entire calculation of the regulatory capital upside down.

WARNING 5: Banks’ internal risk models will become under close scrutiny; expect more tests on a common hypothetical portfolio. Banks that are applying remarkably low risk weights for all or for some portfolios will probably have to increase them which in turn will automatically mean lower capital ratios.

WARNING 6: Investors are suggested to focus (and probably will focus) to the Basel III Leverage Ratio. The risk-sensitive ratios are simply not reliable.

WARNING 7: The situation in UK may be bad, but it’s even worse in Europe. For illustration, see Figure 1 below. (This warning may be a bit misleading though: UBS, Credit Suisse and Deutsche Bank are among the European banks with the lowest risk weighted assets when compared to total assets; thus the calculated average for Europe is probably not representative.) Note that while risk weights differ quite a lot across countries, the Tier 1 capital ratios are rather comparable. This is what has caught the attention of the investors, and what banks will have to explain.

* Banks’ shareholders have unrealistic expectations to the returns on equity.

WARNING 8: Banks’ ROE targets are far too optimistic / misleading accordingly. Furthermore, according to Bank of England, ROE is not an appropriate measure at all.

To summarise: all participants (incl. banks, investors, regulators) seem to have failed. Would it be realistic to assume that they are ever going to actually fix the situation, i.e. destroy their own reality?

A commented overview of the Bank of England’s story told in the Financial Stability Report provides further details and background information for those interested.

Bank of England’s Story (Commented)

Citations from the report are in italic. Stresses, and comments and explanations in brackets are my own; numerical data are from the report.

1. Macrofinancial environment

An escalation of sovereign risk concerns... …across the euro area… (Some problematic sovereigns “popped up” before the others, which does not mean that they are the only “scapegoats”; they just were not that good in masking the situation.) …and to a more limited extent elsewhere (The others like UK have their very own skeletons in the cupboard; yet now they have the opportunity to accuse euro crisis also in their own crap.)… …along with negative news on global economic growth… …led to sharp falls in risky asset prices and high volatility (No one wants to take risks into its own balance sheet; thus there is nobody for rip-off.).

Capital market functioning deteriorated… …as an increase in aversion to risk… …resulted in a reallocation of global risk capital… …affecting the financial system’s role in the management of risk (CDS contracts do not work as debt restructuring can occur without triggering them.)… …though payment and settlement services remained robust.

Concerns spilt over to banking systems… …despite stronger regulatory capital positions (As measured based on the Tier 1 capital ratio the quality of which is being questioned in the very same report.)… …and led to stresses in bank funding markets. ... Funding constraints led banks to reduce leverage… …affecting credit availability in the euro area… …and to some UK households (Private sector debt in UK is anyway above the alert level according to the recent Alert Mechanism Report by the European Commission, btw) ……raising concerns about future economic growth.

This sounds like an explanation of the situation, though biased towards stressing too much the sovereign risk concerns and too little the role of capital markets in building up these risks.

Let’s look to the next section:

2. Short-term risks to financial stability

UK banks have improved their capital positions… …and their funding structures. ... But they have significant refinancing needs (£140 billion of term funding is due to mature in 2012, mostly in the first half of the year; this is compared to euro-area banks that need to refinance over €600 billion of term debt in 2012, with the majority maturing in the first half of 2012.)… …and are vulnerable to exposures in the euro area (Reference to uncertainties related to the EFSF)in particular arising from banking sector linkages.

Institutions reliant on wholesale funding are more exposed… …including to asset price falls that could impair collateral values… …and lead to trading book losses. ...

 A flight to safety could cause sharp asset price movements (So, what’s the value of those assets?)… …propagated by complex and opaque financial instruments (References to leveraged exchange-traded funds, credit derivatives, CDS contracts)… …potentially threatening CCPs (CCP refers to the central counterparty that interpose itself in a trade, by becoming the buyer to every seller and the seller to every buyer) and payment systems.

This is followed by a discussion box, the aim of which is to show that the risks related to central counterparties are perfectly under control.

Banks could respond by paying more for term funding… …passing on the higher funding costs to lending rates (Expect higher lending margins.)… …shifting the composition of funding… …disposing of non-core and intra-financial system assets (Want to buy some crap? If not then some government sponsored entity may need to do it.)… …or reducing lending to the real economy (We actually would need to reduce the overall debt burden of the over indebted households, and adjust business models of the companies so that they would become less dependent on the short-term financing; so what’s the problem?).

Tighter credit conditions and weaker economic activity could expose credit risks (When banks cut back lending, they increase their own credit risks because there is less money in real economy.)… …that have to date been contained by forbearance (A reference to the often restructured non-performing loans that with high probability are not provisioned properly; a way for artificially bringing down arrears and loan losses)... …and could be amplified by weaker collateral values.

Household credit risks could be exposed by renewed declines in house prices (Plus considerable litigation risks arising from previous miss-selling)… …including where loans have benefited from forbearance… …and where households are sensitive to weaker growth or higher funding costs… …creating an adverse feedback loop (Here we are: the adverse feedback loop, the deadlock.).

That’s the storyline of the third section:

3. Medium-term risks to financial stability

Imbalances in the euro area underlie concerns over debt sustainability… …reflecting broader imbalances in the world economy……and adding to ‘scarring’ effects on investor behaviour (Investors are not willing to take risks., oops.).

Risk aversion could strengthen headwinds to banks’ profitability (Higher wholesale borrowing costs)… …adding to pressures on net interest margins from low risk-free rates… …and concerns over the sustainability of investment banking revenues (“Casino-banking” no more this profitable; less customers for charging every sorts of fees)… …reducing banks’ capacity to build capital and extend lending (Sounds threatening.)… …especially in light of return on equity targets that may be unrealistic (Investors are expecting higher ROE; this weakens banks’ incentives to boost their capital levels.).

Market confidence in the reliability of RWA (risk-weighted assets; calculated by banks that after having received the approval from their supervisor, use their own internal models for this purposes) calculations is ebbing (And understandably so)… …and RWA calculations can be opaque even to regulators (Despite that they have approved these opaque calculations by themselves)… …with evidence of material variation in capital requirements against similar risks.

Solvency concerns are accentuated by funding vulnerabilities… …such as reliance on opaque sources of borrowing (Collateral swaps, synthetic exchange-traded funds as a material source of funding, etc.).

Buyback’ risk is one example of an opaque funding vulnerability (Investors may ask banks to repurchase their own debt due to counterparty credit concerns, without reinvesting the proceeds. Banks do not have any legal obligations, but still an implicit commitment.)… …which depends on the behaviour of issuing banks in times of stress… …complicating the assessment of liquidity risk by banks and regulators.

These structural weaknesses highlight the role for stronger market discipline (Read: the disclosure of information by banks has been inadequate so far.)… …but important gaps in transparency remain… …in part due to lack of disclosures of regulatory reports.

That’s basically the story. Section 4 of the report already discusses the macroprudential policy (whatever this means), and Section 5 the outlook for the financial stability.

1 comment:

  1. Pointing out that UK net worth is negative and that our current economic behavior is unsustainable, it says that the economy must be rebalanced. Because our current consumption is unsustainable high and “the United Kingdom has been saving too little for some time”