The use of foreign exchange (FX) swaps as a source of funding and as a hedging tool may increase the risk of financial and economic instability during periods of turmoil, according to a new Working Paper published by the International Monetary Fund (not official IMF policy).
Selected Excerpts from FX Swaps: Implications for Financial and Economic Stability (free pdf) Prepared by Bergljot B. Barkbu and Li Lian Ong1
The spillover of the liquidity crunch in international money markets into the FX swap market during the recent financial crisis has placed a spotlight on the latter’s potential impact on macro-financial stability. The increasing reliance on FX swaps for FX funding by some market participants and the sharp increase in cross-border transactions in this instrument gave rise to significant concerns when the market faltered during this tumultuous period. Specifically, the role of banks as key dealers and users of FX instruments—and their central importance for financial stability and economic activity—raised worrying questions in some countries about the possible impact of FX swaps on the health of the banking system and real economy.
Capital adequacy requirements under the Basel Accords hold implications for the application of capital charges when these instruments are held by banks, either for speculation purposes, to finance their FX needs and/or to hedge their open FX positions. FX swaps held by banks could also impact their liquidity positions, through margin calls by counterparties, even though they may be fully hedged for FX movements. Encouragingly, the accounting requirements under IFRS are aimed at improving the transparency of reporting by users of these instruments, by bringing them onto the balance sheets of the reporting entities.
During the recent crisis, central banks used FX swap facilities extensively to facilitate the rollover of FX swaps by the private sector during the crisis, in some cases, supported by swap lines with other central banks.
We conclude that the application of FX swaps is not infallible, despite their usefulness. That said, this paper is not intended as a critique of FX swaps, but rather, to examine the channels through which FX swaps could affect financial and economic stability, given their increasing popularity leading up to the crisis.
As recent events have shown, the use of this instrument could actually exacerbate risks to financial and economic stability during periods of turmoil. Thus, central banks, which typically use FX swaps as a monetary policy tool, and banks, which transact in this instrument for funding, hedging or speculative purposes, need to ensure that they have the necessary measures in place to address the stability problems that could arise from its use.
Technorati Tags: banking-system, central-banks, financial-regulation, FX swaps, money markets
There are some interesting tidbits in Moody’s latest quarterly report on the US banking system, notably that US banks are premature in reducing provisioning for bad loans, and the charge-off trend now shows that the erosion of commercial real estate surpasses that of residential real estate.
Although asset quality deterioration began with residential real estate, US banks are now experiencing deterioration in all asset categories, Moody’s notes. The following chart serves as a “heat map” for asset quality issues at rated US banks. It displays concentrations (size of bubble), non-performing levels (y-axis) and charge-offs (x-axis) for the major asset classes.
As can be seen from the chart, residential mortgages represent the highest concentration in aggregate for rated US banks, at 37% of total assets. This is followed by commercial and industrial loans at 24% and then commercial mortgages (non-owner occupied income producing, commercial construction, and residential construction) at 14%.
Although all asset classes are showing deterioration, construction loans, especially residential construction, are significant negative outliers. These asset classes do not represent a significant amount of overall rated US banks’ assets, but individual banks with significant concentrations in these assets have been severely impacted
“US banks have recognized approximately 40% of the loan charge-offs that will be realized from 2008 to 2010. Moody’s anticipates these losses will continue to make many US banks unprofitable in 2010.”
“The third quarter saw a surge in bad loans. There was also an increase in early-stage delinquencies, reversing a positive trend that existed in the first half of 2009. Despite these adverse developments, US banks reduced their loan loss reserve build in the quarter. A common explanation for this was a slowdown in the increase in the banks’ net charge-offs in the quarter.”
To reduce provisioning appears to be premature, in light of the continued formation of non-performers and the asset quality trends that we expect.
Other highlights:
- The negative outlook for the US banks is driven by steady deterioration in asset quality, despite what appears to be the beginnings of a macroeconomic recovery.
- US rated banks have already charged off $88 billion of loans in 2008 and $112 billion more during the first nine months of 2009, leaving $336 billion to reach our full estimate of $536 billion of loan charge-offs in 2008, 2009, and 2010 (net of purchase accounting marks). This sum will be equal to 9.7% of loans outstanding at December 31, 2007.
- Aggregate non-performers rose to 5.2% of loans at September 30, 2009 and 3Q09’s total annualized net charge-offs came to 3.3% of loans.
- The US banks’ allowances for loan losses stood at $183 billion as of September 30, 2009, which is equal to 3.6% of loans.
- The charge-off trend now shows that the erosion of commercial real estate surpasses that of residential real estate.
- A clear positive in the quarter was the continued improvement in capital ratios through equity raises and balance sheet reduction.
For details see US Banking Industry Fundamental Credit Conditions — 3Q09. (Premium)
Technorati Tags: banking-system, commercial-real-estate, defaults, residential real estate, U.S. banks
A new discussion paper from the Bank of England looks at the concept of increasing capital requirements on banks during market bubbles and reducing them in times of weak economic conditions when banks are typically reluctant to lend.
Excerpts from The role of macroprudential policy (free pdf download)
This discussion paper examines whether it would be practical to dampen cyclical overexuberance through a regime of capital surcharges on top of prevailing microprudential capital ratios. These surcharges could be applied to headline capital requirements or at a more disaggregated level (through so-called ‘risk weights’ on particular types of exposure). The sectoral approach might allow policy to be better targeted at pockets of emerging exuberance, but would also entail greater complexity. The appropriate level of disaggregation for setting capital surcharges would need to be considered carefully.
Increasing capital requirements in a credit boom would generate greater systemic self-insurance for the system as a whole and, at the margin, act as a restraint on overly exuberant lending.
Crucially, this mechanism could also operate in reverse: lowering capital requirements in a bust might provide an incentive for banks to lend and reduce the likelihood of a collective contraction of credit exacerbating the downturn and increasing banks’ losses.
Separately from seeking to address changes in risks through the credit cycle, capital surcharges could also be set across firms so as broadly to reflect their individual contribution to systemic risk. For example, as the FSA have discussed, surcharges could be levied based on factors such as banks’ size, connectivity and complexity. This would lower the probability of those institutions failing and so provide some extra systemic insurance. It would also provide incentives for those firms to alter their balance sheet structure to lower the systemic impact of their failure.
A big practical question is whether a macroprudential regime with aims of the kind described above could be made operational. Capital surcharges would need to be calibrated. That would ultimately require judgement, drawing on analysis, market intelligence and modelling. This discussion paper summarises, by way of illustration, a few of the indicators, quantitative and qualitative, that with further work could become useful inputs. They would largely be about the macroeconomy, and the financial system as a whole and the interaction between them.
It seems unlikely that macroprudential instruments could be set wholly according to fixed rules. Judgement may be needed to make robust policy choices. That would call for assessments of the resilience of the system, credit conditions, sectoral indebtedness and systemic spillovers — all of which vary over time and according to circumstances. All available evidence would need to be weighed, and policymakers would themselves need to adapt as they learn about the effects of their instruments on behaviour.
But it would be important that constraints were placed on a macroprudential regime to ensure transparency, accountability and some predictability. That would call for clarity around the objectives of macroprudential policy, the framework for decision-making, and the policy decisions themselves. It also suggests the need for robust accountability mechanisms. Such a macroprudential regime of ‘constrained discretion’ would share some similarities with macroeconomic policy frameworks.
Another important issue would be the degree of international co-operation. To be wholly effective, a macroprudential regime might require significant international co-ordination. But, even in its absence, appropriate macroprudential instruments might still be able to strengthen the resilience of the domestic banking sector.
Technorati Tags: banking-system, banks, financial-regulation
But a BIS paper suggests that some of the main crisis-affected economies will return to their pre-crisis level of GDP by the second half of 2010.
Excerpted from Financial Crises and Economic Activity by Stephen G Cecchetti, Marion Kohler and Christian Upper
Financial crises are more frequent than most people think, and they lead to losses that are much larger than one would hope. On average, there have been between three and four systemic banking crises per year for the past quarter century. Not all of these have had visible real costs, but most have. In the restricted sample of 40 financial crises that we study, fully one fourth resulted in cumulative output losses of more than 25 per cent of pre-crisis GDP. And one third of the crisis-related contractions lasted for three years or more.
Banking crises are also quite diverse. In fact, those that we study appear to be practically unique in their evolution. In an important sense, the average crisis does not exist. In 16 cases, countries had a positive shift in the level and in 6 cases countries had a negative shift in both the level and the trend.
Nevertheless, by directing a battery of statistical tools at the historical data, we are able to use the variation across crises to learn a number of things that can provide insights into the likely progression of the current crisis. We find that when a banking crisis is accompanied by a currency crisis, it is nearly six quarters longer, and the trough in output is (on average) 6 percentage points lower. And when it comes along with a sovereign debt default, the financial crisis is less severe – one and a half years shorter and 6 percentage points of precrisis GDP less deep.
Furthermore, we show that if the crisis is preceded by low growth – possibly because it is induced by a recession – it tends to be more severe. For each percentage point that GDP growth is lower, the contraction is longer by one quarter and the trough in activity is 1 percentage point lower.
We find that many systemic banking crises have had lasting negative effects on the level of GDP. And even in those cases in which trend growth was higher after the crisis than it had been before, making up for the output loss resulting from the crisis itself took years.
By altering attitudes towards risk, as well as increasing the level of government debt and the size of central banks’ balance sheets, systemic crises have the potential to raise real and nominal interest rates and consequently depress investment and lower the productive capacity of the economy in the long run. We looked for evidence of these effects and found that a number of crises had lasting, negative impacts on GDP. In some countries this was a result of an immediate, crisis-induced drop in the level of real output combined with a permanent decline in trend growth. In other cases, we find that the growth trend increased following the crisis but that the immediate drop was severe enough that it took years for the economy to make up for the crisis-related output loss.
Finally, we were able to find a robust statistical model that can explain a large share of variation in contraction length across past crises. This model predicts that for the current episode, some of the main crisis-affected economies will return to their pre-crisis level of GDP by the second half of 2010.
Technorati Tags: banking-system, economic-policy, financial crisis, GDP, recession, recovery
McKinsey expects the US banking and securities industry to incur losses averaging $125 billion per quarter through 2010, with the bulk of it concentrated in commercial banking loans.
McKinsey research estimates that total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession. Some $1 trillion of these losses has already been realized, McKinsey says in a review of the banking industry.
“Since US banks hold about half of US-originated debt, the US banking and securities industry will incur about $750 billion to $1 trillion of the remaining $1.5 trillion to $2 trillion of projected losses on this debt, which includes residential mortgages, commercial mortgages, credit card losses, and high-yield/leveraged debt, McKinsey says. These numbers are in the same range as those of the US government, which calculated a $600 billion high-end estimate of credit losses for the 19 largest institutions.”
Since the middle of 2007, the US banking and securities industry has absorbed some $490 billion of losses, or $80 billion per quarter.
If the industry incurs additional losses of $1 trillion in 2009 and 2010, the losses will be about $125 billion a quarter … these losses will be concentrated in commercial-banking loans.
Importantly, many of these losses will be concentrated in the banks that the stress tests revealed to be undercapitalized, McKinsey says. The five most undercapitalized major banks under the stress tests were Bank of America Corp. (NYSE: BAC) Wells Fargo & Co. (NYSE: WFC), GMAC LLC (NYSE: GJM), Citigroup Inc. (NYSE: C) and Morgan Stanley (NYSE: MS).
Technorati Tags: (bac), (c), (MS), (WFC), Add new tag, bank bailout, bank losses, Bank-of-America, banking-system, Citigroup-Inc., GMAC, morgan-stanley, stress test, U.S. banks, Wells-Fargo-&-Company
A new position paper* put together by the International Monetary Fund’s research department looks at the options for restructuring systemically important banks while minimizing the burden on taxpayers. The paper finds no magic bullet and concludes given the difficulties in arranging debt-for-equity swaps ,taxpayer involvement is inevitable.
“When designing a restructuring plan for a systemically important bank, a key issue is to limit transfers from taxpayers. Essentially, this involves avoiding unnecessary subsidies to debt holders and maximizing the economic value created by the restructuring.”
We find that there is no magic bullet.
Some of our key findings are the following.
- • In a framework in which cash flows are independent of capital structure, restructuring is theoretically possible by converting some debt into equity. This is, however, difficult in practice.
- • Without changing debt contracts, all restructuring involves transfers from the government. A plan subsidizing common equity issues and buying back debt is close to optimal. Subsidized asset sales are more costly to taxpayers, since debt holders benefit more.
- • The precise design of a restructuring should take into account the value created or destroyed because of changes in the participants’ behavior. Expertise and incentive of managers are concerns that should be addressed in restructuring.
- • If assets are undervalued as a result of liquidity or “lemons” problems, the government can make profits by buying assets above market value but below fundamental value. A caveat is that such undervaluation is difficult to assess.
- • Asymmetric information on the value of future payoffs makes equity holders reluctant to support restructurings involving new-claim issues. A restructuring impasse can be avoided through (1) conducting stress tests with credibly publicized results, (2) using compulsory rather than voluntary schemes, (3) providing contingent guarantees for banks to avoid new-claim issues, or (4) making banks issue low-information-sensitive claimssuch as convertible debt or preferred stocks.
“In summary, systemic bank restructuring should combine several elements to address multiple concerns and trade-offs on a case-by-case basis. In any plan, the costs to taxpayers and the final beneficiaries of the subsidies should be transparent. To forestall future financial crises, managers and shareholders should be held accountable and face punitive consequences. In the long run, various frictions should be reduced to make systemic bank restructuring quicker, less complex, and less costly.”
*The Economics of Bank Restructuring: Understanding the Options
Technorati Tags: banking-system, banks, systemic risk
Moody’s says both the US banking industry rating outlook and the industry’s broader fundamental credit outlook continue to be negative because of the sharp economic recession that is cutting deeply into US bank balance sheets.
Moody’s states that it expects US rated banks will incur a total of approximately $470 billion (pre-tax) of loan and security losses and write-downs in 2009 and 2010. The lending portion of this estimated loss is $415 billion, or 8% of the industry’s outstanding loans at the end of last year.
As a result of these substantial asset quality problems and the need to build reserves, many US banks will be unprofitable in 2009, placing considerable strain on their capital levels, the rating agency says in its Annual Banking System Outlook for the United States. .Highlighting the key challenge to bank profitability, Moody’s said that, despite heightened provisioning over the past several quarters, banks’ coverage of bad loans continues to drop; the ratio of allowance for loan losses to non-performing loans stood at 70% at March 31, 2009 versus 100% in the first quarter of 2008.
“Under more adverse conditions, numerous US banks could become insolvent by the end of 2010,” said Moody’s. “More specifically, based on our modeling of such an adverse scenario,” the analyst states, “we calculate that US rated banks could incur a total of approximately $640 billion (pre-tax) of loan and security losses and write-downs in 2009/2010; without additional capital, this means that more than a third would fall below investment grade on a standalone basis …”
“Additionally, if the US economy worsens beyond expectations US banks would need to raise significant amounts of additional equity capital. For instance, under this adverse scenario we estimate that recapitalizing all rated banks back to a B- financial strength level would require a $112 billion investment.”
Technorati Tags: banking-system, U.S. banks
The Economist argues for incremental changes to the financial system rather than a complete overhaul, in a leader accompanying a new Special Report on the financial crisis.
Excerpts:
“Some argue that only draconian re-regulation can spare taxpayers from the next crisis. The structure must be changed … Yet this search for a big, structural answer runs into two problems. One is that the reform is not as neat as it first appears. Nobody wants to have banks that are so big that they stifle competition (itself a source of stability), but breaking big banks up into tiny bits that pose no systemic risk would be a horribly complex and lengthy task.”
“The second drawback is inefficiency. Limiting banks’ size could stop them from attaining the scale and scope to finance global business.”
Instead, it is better to focus on two more fiddly things that could produce fairly radical results: regulation and capital.
“Regulators should focus on function: if an outfit behaves like a bank, it should be regulated as one, whatever it says on the brass plate. Ideally each jurisdiction will incorporate a set of broad global principles, which establish a benchmark of prudent finance.”
“Regulators can also use markets. Banks’ solvency depends on a bedrock of capital. Regulators could monitor how this trades, or use markets that gauge the risk of insolvency, to help decide when banks must raise more capital. Regulators could get managers to watch for systemic risks by linking their bonuses to the bank’s bonds … Incentives matter: with higher risk charges on banks’ trading books, bankers would become more discerning about how they put their money to work, and less prone to make dangerous bets in pursuit of huge bonuses.”
“Smarter regulators and better rules would help. But sadly, as the crisis has brutally shown, regulators are fallible. In time, financiers tend to gain the advantage over their overseers.”
“Hence the overwhelming importance of capital. Banks should be forced to fund themselves with a lot more equity and other risk capital—possibly using bonds that automatically convert to equity when trouble strikes. Higher capital requirements would put more of the shareholders’ money at risk and, crucially, enable banks to absorb more losses in bad times. Think of it as a margin for regulatory error.”
“Regulation cannot prevent financial crises altogether, but it can minimise the devastation. Loading banks with equity slows the creation of credit, but the reward for a healthy financial system is faster growth over the long term. There are three trillion reasons to think that the trade-off is worth it.”
The full Special Report includes articles on the following topics and can be downloaded as a pdf (fee for non-subscribers):
- Rebuilding the banks
- Banks and society
- Canada’s banks
- Bank balance-sheets
- The future of securitisation
- Gaining from the crisis
- Banking and risk
- Swedish lessons for banks
- The future of banking
Technorati Tags: banking-system, banks, financial crisis, financial-regulation, securitization
Despite the cautious optimism creeping into the financial markets, in light of what some believe are better-than-expected results from the government stress testing of 19 large banks, Standard & Poor’s Ratings Services believes that “banks are far from a recovery, and the banking crisis has merely entered a new phase.”
…although our analytical time horizon for losses extends only through 2010 … there’s nothing to say that this banking crisis can’t go on for another three or four years. - Tanya Azarchs, managing director at Standard & Poor’s
One thing is clear, however: banks will have a tough time surviving unless they have “more capital than even Basel envisioned,” according to Azarchs.
The Federal Reserve Board’s stress testing, the results of which were announced May 7, found that that 10 of the 19 largest banks need a total of $75 billion in capital to maintain at least 4% of common equity Tier 1 capital if the environment becomes a lot more adverse than experts currently expect.
This compares with Standard & Poor’s assessment of an $18 billion need for these 19 banks on the basis solely of credit stress testing. “Despite the significantly higher capital requirements determined by the Fed’s stress tests as compared to our stress tests, we do not see this as an unmanageable amount, and most management teams of the identified banks promptly issued statements about how they would raise the capital (see “The U.S. Federal Reserve’s Stress Test Results: The Beginning Of The End Or The End Of The Beginning For U.S.
Banks?
Standard & Poor’s completed its own base-case stress testing of banks’ loan portfolios, focusing on credit and earnings risks and their impact on capital adequacy (see What Stress Tests Reveal About U.S. Banks’ Capital Needs. On May 4, S&P placed ratings on 23 financial institutions on CreditWatch with negative implications. The results, and the rating actions, are wholly independent of the stress testing regulators conducted and indicate widespread, though not necessarily severe, capital needs that could result in downgrades of several notches.
S&P says The Fed’s stress test has been just another step toward the eventual recovery of the global financial industry, but the industry still faces challenges presented by these developing trends:
- Industry risk is generally creeping higher rather than stabilizing;
- Losses during this downturn will likely be greater than the industry thought when it began;
- Franchise stability and market confidence are increasingly critical components of credit;
- There’s a greater focus on capital adequacy;
- Government support is now explicit in our ratings for highly systemically important U.S. banks;
- Hybrid securities appear to be riskier than we thought;
- The industry structure is changing;
- Volatility appears to be here to stay;
- The originate-to-distribute model is being rethought; and
- Regulation is generally increasing.
Technorati Tags: bank crisis, banking-system, financial-regulation, stress test, U.S. banks
Deloitte has issued a handy summary of the U.S. Treasury’s proposed framework for regulatory reform of the financial system.
Consistent with other announcements a set of guiding principles was put forth with additional details to follow. However, in this instance, U.S. Treasury Secretary Geithner provided specific information on an approach to systemic risk which recommends a new single regulator with broad oversight across the whole financial system.
Deloitte provides a simple summary of the four broad components to the framework:
- Addressing systemic risk: The U.S. Treasury defines systemically important institutions and proposes an orderly process for unwinding them.
- Consumer and investor protection: The U.S. Treasury proposes greater transparency for investor and consumer protection.
- More effective regulation: The gaps between regulatory agencies will be reduced creating a more comprehensive approach.
- Global coordination: The plan proposes greater global coordination.
Technorati Tags: banking-system, financial-regulation
