What a difference a credit rating notch can make. The biggest banks have used their FDIC-guaranteed, taxpayer-supported banking subsidiaries and the bank subsidiary’s credit rating advantage to reduce the capital behind their derivatives activities required by regulators to cushion against potential losses. This is another way that credit ratings influence derivatives through the taxpayer guarantee.
Finding Where Derivatives Are Booked
One of the most contentious issues in the Dodd-Frank debate was where to allow the biggest banks to book their derivatives contracts. The idea of pushing derivatives entirely outside an organization with government support received only brief consideration. The debate shifted inside. Should derivatives be allowed within the banking subsidiary with its government support or elsewhere within the organization? As the largest “systemic” banks dominate derivatives trading, this is a major issue.
With the passage of Dodd-Frank and subsequent Congressional actions, the biggest systemic banks won this debate. Nearly all benefit from booking derivatives contracts within their FDIC-guaranteed bank subsidiary. This reduces the amount of capital cushion against losses required under bank regulation.
The first step in this argument is to show where derivatives contracts are booked within the bank holding company structure and how their location may or may not have changed over time. To do that, I calculated the notional derivatives amount booked in the FDIC-guaranteed bank subsidiary as a percentage of the consolidated BHC notional amount.
The data are published in two tables in the Office of the Comptroller of the Currency’s (OCC’s) Quarterly Derivatives Report, which is compiled from the bank subsidiary (Table 1) and its parent’s (Table 2) regulatory filings. (Click the next link.)
The Fed Overrides the FDIC
My intellectual travel through the topic began with an October 18, 2011, article on Bloomberg, “BofA Said to Split Regulators Over Moving Merrill Derivatives to Bank Unit”. The article leads with the issue — a credit downgrade that instigated the transfer of Merrill Lynch’s derivatives contracts from Merrill’s books onto the books of Bank of America’s FDIC-guaranteed bank subsidiary, “flush with insured deposits”. The Fed had overridden the FDIC. Helping the biggest banks overrode protecting taxpayers.
When I read about the Fed staff person’s anonymous comment to the journalists, I looked up the OCC derivatives reports and calculated the percentage of the BHC’s derivatives booked in the FDIC-guaranteed bank subsidiary at the end of the quarter. It was pretty much what was described in the article for BofA (71%) and JPMorgan Chase (99%). So, I wondered, how about Goldman Sachs and Morgan Stanley, the two remaining U.S.-headquartered independent investment banks? I calculated those, too. And Wells Fargo’s. They didn’t show the same percentages. Also, Goldman Sachs and Morgan Stanley parent derivatives data wasn’t available prior to 2009. They weren’t BHCs.
The table below (click on the link) presents the comparisons of the percentage of the BHC’s derivatives that are booked in the FDIC-guaranteed bank subsidiary. (“N.A.” is the abbreviation for National Association, meaning a national regulated bank.)
The years shown mark events. 1998 was not only the farthest back the data was available at the time, but also the year removing Glass-Steagall barriers between investment and commercial banking was being debated in Congress. The Gramm-Leach-Bliley legislation that finalized the removal was signed by President Clinton in 1999. 2009 was the first year all the biggest banks were BHCs under Fed regulation. BofA had acquired Merrill Lynch. 2011 was the year of the article. Then I followed the percentages over every two years until year-end 2016.
Creating an Uneven Playing Field
Inserting the government into investment banking created a very uneven playing field among the largest. In 2007, the U.S. had five major independent investment banks. Their FDIC-guaranteed banking subsidiaries, if they had one, were only a tiny part of their businesses. By 2009, Goldman Sachs and Morgan Stanley remained the only two independent investment banks.
Goldman Sachs serves mainly institutional clients with its securities broker/dealer and trades derivatives. Morgan Stanley is also among the largest derivative traders, but its broker/dealer business serves both retail and institutional clients.
Currently, the “traditionally” commercial banks with big investment banking arms book all their derivatives in the FDIC-guaranteed bank subsidiary. Goldman’s are largely, but not entirely there.
Morgan Stanley, however, has hardly any derivatives in its FDIC-guaranteed bank subsidiary, chartered in Utah. Morgan Stanley actively uses that bank for its retail broker/dealer activities, a core business segment.
Goldman’s bank was chartered in Utah until Goldman was made a bank holding company, at which time its bank’s charter was moved to New York.
At the beginning of 2011, it seemed the Fed was prepared to compensate Morgan Stanley for this competitive disadvantage. However, Morgan Stanley was later required to post $44 billion in additional regulatory capital when regulators changed their mind. This was described in the bank’s third-quarter 10-Q (linked below) in the “Capital” section.
Credit Ratings Matter in Calculating Regulatory Capital Cushions
The next step is to show how a credit rating downgrade might add to the amount of capital cushion (against losses) required by regulators. This was the Merrill Lynch booking issue. I’ll show:
- the flow of thought behind the calculation,
- how derivatives’ risk-weighting is calculated, and
- the impact of credit ratings on the capital calculation.
The calculation of the required capital cushion is a pretty simple equation. (Click on the next link.) The amount of capital (various forms of equity) on the BHC’s balance sheet is divided by assets at risk.
Regulators now require risky assets that may not be on the balance sheet — like derivatives — to be included in the denominator. So the BHC has to estimate the value of each derivative contract that is at risk — the contracts in which their counterparty owes them money.
Some borrowers and derivatives counterparties are better “risks” than others. They have higher credit ratings. So regulators require banks to sort their risky assets into buckets reflecting credit quality.
The buckets simplify the weighting process using just a few weights — 0%, 20%, 50%, and 100%. If the counterparty were a “risk-free” credit, say like the U.S. government, it would have a 0% weighting in the denominator. In other words, it won’t result in the BHC having to post any capital against that asset. If the borrower or derivative counterparty were rated A-/A3 or better, it would have a 20% weighting. Capital would be required against only 20% of the asset. The lower end of investment grade entails a 50% weighting for a derivative contract. That’s the lowest weighting for derivatives. Loans continue to be further weighted.
Here’s an example of a typical BHC regulatory capital calculation spreadsheet. (Click on the next link.) It’s from a TBTF bank’s regulatory capital filing of a few years ago. Think of the flow of thought rather than the specifics. Numbers are in thousands as are all regulatory filings I’ve examined. I added only a subtotal of their off-balance-sheet buckets, a line missing from the regulatory presentation, but part of the calculations. You can see familiar types of assets in the first lines (the balance sheet assets) followed by off-balance-sheet items like derivatives.
The balance sheet items are listed at the amounts published in their financial statements. Derivatives are valued at their “credit equivalent amount” (CEA), an estimate based upon modeling. I’ve highlighted that line.
Regulators seem not to require specific models, if the BHCs’ 10-Ks are illustrative. In presenting derivatives risks, Goldman Sachs, JPMorgan Chase, and Morgan Stanley state that they use a statistical 95% confidence level. The other three largest BHCs — Bank of America, Citigroup, and Wells Fargo use a 99% confidence level in their presentations. 95% means what happened in 95 out of 100 days, 99% in 99 out of 100 days. In fact, the OCC in its quarterly derivatives report states that the bank models are not comparable due to differences in methodology and scope of coverage.
Each loan or derivative contract is placed within its weighting category — 0%, 20%, 50% — by credit rating mostly, according to regulatory reports. Then the sum of each of the “buckets” for risk-weighting category is calculated for both on-balance-sheet assets like loans and off-balance-sheet assets including derivatives. Finally, the totals for each risk weighting category are multiplied by the weighting percentage. That number is the bank’s “risk-weighted” assets for that category. Then all the categories’ risk-weighted assets are summed. That total is the denominator of the bank’s regulatory capital cushion calculation — their risk-weighted assets.
The next link looks solely at the derivatives risk-weighting buckets. With bigger print it’s much easier to see how the derivatives are distributed by credit quality into weighting buckets.
The formula used to compute the capital cushion percentage required by bank regulators is the bank’s total regulatory capital (common, preferred, and other types of equity) divided by their risk-weighted assets. The percentage is then compared to the minimum required for that bank under law and regulations. The percentages vary among the biggest banks due to both size and the level of surcharges assessed by regulators based upon the degree of their systemic risk. (Article on TBTF Bank Capital Surcharges 2015)
The Measurable Impact of the Taxpayer Guarantee
The BofA parent credit rating downgrade below the single A level was a milestone for the industry. These banks or bank holding companies hadn’t been rated below single A in recent decades. After the bubble burst and Congress claimed there would be no more bailouts, the credit rating agencies debated how much support the government might extend to these entities. Whereas the rating differential between parent and banking subsidiary had been as narrow as one notch (which was typical for corporate parents and their operating subsidiaries when I was a Senior Credit Officer at Moody’s), it had widened to as many as three notches by the fall of 2016.
The following link presents a table showing the evolution of the biggest banks’ credit ratings and the widening of the notching between parent and banking subsidiary from 2008 to the fall of 2016. In mid-December 2016, S&P upgraded four bank subsidiaries to A+ (Citibank, N.A., Morgan Stanley Bank, N.A., Goldman Sachs Bank USA, and Bank of America, N.A.), widening the notching to three for those banks at S&P.
The widening reflects the rating agencies’ opinions that the Federal government would be less likely to support the parent holding company. The banking subsidiary may enjoy the benefit of the federal deposit guarantee, but it still has a degree of financial flexibility that is better or worse than other entities within the rating categories. All nationally-regulated banking subsidiaries therefore don’t carry exactly the same rating.
According to the Bloomberg article, BofA’s parent (BHC) credit rating had been downgraded from A2 to Baa1. The banking subsidiary also had a similar two-notch (incremental rating level) downgrade, which put its rating at A2 (from Aa3).
This is a perfect example to illustrate the math of reducing capital requirements using the taxpayer-guaranteed bank subsidiary to book derivatives. For BofA’s derivatives-trading counterparties, Merrill derivatives (rated at best at the parent level) would move from the 20% bucket to the 50% bucket. 30% more of Merrill’s derivatives would have to have the required percentage of capital. The Fed’s allowing BofA to move Merrill’s derivatives into the higher-rated banking subsidiary saved all the counterparties on the other side of Merrill’s derivatives contracts real money. Here’s the math, using a simple 10% regulatory capital percentage.
Let “x” stand for the amount of capital regulators require to back up the risk-weighted derivatives assets per $100 million of credit equivalent amount of exposure — $20 million if in the banking subsidiary and $50 million if at the parent or Merrill.
x / $20 MM = 10% x = $2 million of capital
x / $50 MM = 10% x = $5 million of capital
By moving the derivatives contracts to the taxpayer-guaranteed banking subsidiary, counterparties on BofA’s Merrill Lynch derivatives contracts saved having to set aside $3 million in equity capital to support those contracts for every $100 million of CEA exposure, freeing it for other uses. The CEA derivatives exposure in the big bank example above just in its 20% bucket was $195 billion. That’s BILLION.
For Bank of America and nearly all the major derivatives players, using the taxpayer-guaranteed bank subsidiary to book contracts has significant economic advantages.