This speech was delivered to the New York Society of Security Analysts on December 3, 2104, as part of a conference on systemic risk. I’ve tried to insert the slides with the reader in mind.
I was at the time chair of NYSSA’s Market Integrity Committee’s subcommittee on systemic risk, an extremely awkward role. 70% of NYSSA’s membership works at TBTF banks, a thought that wasn’t lost on me as I prepared and delivered the speech. I stand behind my first sentence just as strongly today as will be seen on this blog in subsequent weeks. I will update the bank assets and derivatives data shortly now that the Fed has published the banks’ year-end reports.
Derivatives and Systemic Risk
Emily Eisenlohr, CFA
At the New York Society of Security Analysts, December 3, 2014
Thank you, Jim. It’s an honor to be here. I bring no vested interest other than a desire to be part of a national dialog on government dependence.
Few are happy with the state of our financial sector and its regulation. The new jobs tend to be for compliance. Firms scramble for collateral.
Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” We may not experience the same kind of systemic bubble, but by examining some of the following sources, we can minimize future bubbles.
Derivatives embody irony, being promises of future performance that impact the present. They glue our biggest financial firms together in ways loans have never done.
The regulator’s dilemma in addressing derivatives is that they are like squeezing a wet bar of soap. Regulators squeeze on one side and the soap bursts out, unexpectedly, in unplanned directions.
I’ll describe the evolution of banking from its traditional style seen in It’s a Wonderful Life to the current environment, which is more like Star Wars. A few charts will provide snapshots in the story line. To see how collateral is both helping and confounding market practices, I’ll trace its role in regulatory capital.
This famous graph of housing prices from 1890 to 2010 (a version presented in the Big Picture blog) shows the magnitude of the housing price bubble. (Click on the link to see the slide.)
We don’t have such a tidy picture of the derivatives contribution. Derivatives are hidden.Off balance sheet.
Pictures can be misleading, too. The evolution of the financial bubble began well before housing prices took off.
Much of the debate on systemic risk has focused on the bailing itself. Seeing this bubble’s size an nearly instant collapse, how could anyone in a position of authority not do something to try to prevent chaos?
Understanding the Biggest Banks Using Data Reported to the Federal Reserve
The Federal Reserve maintains a list of the largest bank holding companies. The following list shows the top ten, which includes the insurance company AIG and GE Capital, the finance subsidiary of an industrial company.
In the following graphs, I’ve removed the outliers (insurance companies, subsidiaries of foreign banks, GE Capital) and labeled each bank just by its ranking number. The details surrounding any single bank are less important to this discussion than broader market structure issues.
Dodd-Frank deemed “systemic” financial institutions with at least $50 billion in assets. The following graph shows banks in the Top 50 exceeding that threshold.
Although all are deemed systemic, assets are highly concentrated among the top six.
When I’ve shown interested parties the same data with derivatives portfolios added, it’s always been an eye-opener.
Derivatives activity is also highly concentrated at the top. The derivatives visually swamp the assets.
The Fed calculates the notional amount of a bank’s derivatives portfolio divided by its balance sheet assets. The next graph more clearly illustrates derivatives compared to balance sheet assets using the Fed’s calculation — derivatives as a percentage of assets.
Any way you look at it derivatives activity is very concentrated among those at the top. The largest banks’ derivatives portfolios are generally 25 to 55 times their asset bases. In contrast, traditional commercial banks are not that active in derivatives. The Office of the Comptroller of the Currency, another bank regulator, notes the exceptional derivatives concentration among the largest banks in each of its quarterly derivatives reports.
Finally, Fed reports show how much of derivatives portfolios are held for trading.
Banks trade derivatives.
Glass-Steagall’s Divide: Lending Versus Trading
Trading has evolved over the past thirty years – where it occurs, who manages it and what backs it up. Starting with the best of intentions, some unintended consequences crept up on market structure.
To illustrate how the evolution of systemic risk relates to derivatives and their collateral, let’s start for simplicity with two types of financial contracts: loans and corporate bonds.
With a loan, money goes out the door on Day 1. The borrower is typically a small or private company. A commercial banker’s skill is in analyzing the borrower’s ability to repay the loan and monitoring the situation over time. The commercial bank’s business model is built on keeping assets on the balance sheet, taking responsibility for the lending decision.
The Federal government inserted itself into commercial banking with good reason through the FDIC deposit insurance scheme. The FDIC guarantee keeps depositors calm during bank stress so that loans, funded partially by deposits, didn’t have to be called. Due to the close relationship between the banker and the borrower, commercial banking compensation rewards expertise gained through experience and emphasizes salary over bonus.
Trading corporate bonds issued by large, public corporations is a short-term, market-intensive skill. Investment bank traders underwrite and sell securities issued by companies which provide detailed public information. Investment banks maintain broad distribution networks of investors. Traders typically work under short-term contracts, and compensation is bonus-driven.
Profits in commercial banking are earned over the long term by holding assets on the books. Investment bank trading floors earn their profits by quickly moving securities off their books.
Eroding Glass-Steagall’s Divide: The Federal Reserve Fires the First Shots
In the 1980s the largest commercial banks at the time wanted to become universal banks like the big European banks – engaging in both commercial banking and securities trading. Meeting competition from Europe set off a series of events that contributed to the erosion of the Glass-Steagall barriers between investment and commercial banking.
The Fed in 1987 allowed the commercial banks to set up subsidiaries to engage in securities trading. At first the commercial banks were allowed to trade only municipal bonds and commercial paper. The subsidiaries could book no more than 5% of their total revenues from the new activity. Over the next eight years, the commercial banks were also allowed to trade corporate bonds and equities. The revenue limit was raised to 10% and then, in 1995, to 25%.
Remember that many of the largest commercial banks merged or acquired other banks at that time. Pretty soon, the marketplace had large commercial banks allowed to earn 25% of their revenues from the same securities trading done by the largest investment banks. How can an investment bank funding itself through private partnership capital compete with a publicly-owned and funded commercial bank that is also backed by Uncle Sam?
As is well known, from 1998 to 2000 Congress officially eliminated the barriers between the two types of banking and sheltered derivatives from regulation. That’s when not only the housing bubble, but also other forms of financial engineering took off. New kinds of contracts were invented, splitting bonds into component risks. Even commercial loans were sliced, packaged and sold.
Derivatives outstanding grew from $80 trillion in 1998 to nearly $600 trillion by 2008. What was less obvious was how senior executives with investment banking backgrounds took over management of many of the largest banks, bringing with them their culture and compensation systems that emphasized intense competition and the short term. The credit culture was overwhelmed by short-term profit opportunity and reward.
Derivatives’ Counterparty Risk: A More Complicated Type of Credit Risk
Unlike loans, derivative exposures are two-sided. Each party faces its counterparty’s credit risk, often into the very distant future. They address credit risk through collateral.
The International Swaps and Derivatives Association (ISDA) developed a document called the Master Agreement to cover derivatives trading between two parties. The Master Agreement requires each party to post collateral to account for changes in counterparty exposure due to market price movements and for declines in credit profile.
As you can see in the following table, the ISDA’s annual margin surveys show that collateral grew as derivatives outstandings grew. It is primarily cash collateral, but higher grade sovereign bonds are used, too.
How are changes in a counterparty’s credit profile measured? Even though regulators seek to reduce reliance upon credit ratings, the Master Agreements specify easily ascertained triggers: credit ratings.
During the first years after the bubble burst, the rating agencies incorporated government support into the assigned systemic bank ratings. The FDIC-guaranteed banking sub’s rating was one or two notches above its parent’s rating. All ratings were A- or A3 or better — the higher end of investment grade. The next chart shows these ratings back in 2008.
As you can see in the next chart, as the rating agencies more recently (AUTHOR’S NOTE: back in 2014) try to reflect the removal of government support, we see in the widening notching some difference of opinion.
It’s clearly advantageous to trade derivatives through the banking subsidiary just for its rating advantage. According to bank 10-Ks, a one- or two-notch downgrade could result in the demand for $1 to $2 billion in additional collateral. That may be small change for these organizations in normal circumstances, but more difficult in troubled times.
Further, Dodd-Frank’s requirement to shift over-the-counter derivatives onto exchanges, while improving transparency, has made the modeling and collateral management even more complex.
Credit Ratings, the Risk-Based Regulatory Capital Calculation and Gaming a System
Looking at collateral and the risk-based capital calculation illustrates this regulatory and management challenge.
The regulatory capital cushion is a pretty straightforward equation. The bank’s capital base, various types of equity to absorb losses and support growth, is the numerator. The bank can’t change the base day to day.
What can change are the risks taken. Those are measured and reflected in the denominator. Clicking on the next link will show you the equation.
The next table shows what a generic big bank’s calculation of its denominator looked like a few years ago.
The point isn’t the numbers. It’s the geography and river of thought that this snapshot hopefully conveys. The two green highlighted sections are the on-balance sheet assets (the first section) and the off-balance sheet exposures (in the second section). Each exposure type is sorted into its risk weight levels shown in the columns – zero, 20% (for A-rated), 50% (for BBB-rated) and 100% (for even lower rated). Each weighting bucket is summed, then the weighting percentage applied. The adjusted exposure amounts are then totaled, and – le violá – you have the risk-weighted assets used in the denominator. The derivatives line is highlighted in peach.
Next is a closer view. The derivatives credit exposure is an assessment called the “credit equivalent amount.” There isn’t a 100% weighting bucket for derivatives.
With that explanation, here are a few of regulators’ wet bars of soap. Under Basel II, when organized exchanges played a small role, a bank could risk weight an asset at zero percent if the counterparty were an exchange. That meant they wouldn’t need to post any regulatory capital against that exposure. But only if two conditions were met. The exchange had to be the legal counterparty. And it had to involve daily margining. That meant marking to market and posting collateral as required.
Now that over-the-counter derivatives are being moved to exchanges, the weighting of 2% for a derivative with an exchange can be found. This may seem low, but the banks are members of the exchanges, contributing capital to them. And the exchanges themselves will do daily margining and collateral management.
The movement of a contract’s counterparty from a bank to an exchange may involve lower amounts of regulatory capital. Further, as seen in the credit ratings, movement of a contract from the parent or non-FDIC-guaranteed sister subsidiary into the FDIC-guaranteed banking sub has collateral implications. These issues arise.
- Among the capital posted by the big bank, the collateral collected by the exchange and the exchange members’ capital contributions, is there enough cushion to cover the unexpected major events? This is a measurement challenge of heroic proportions.
- How well do the banks keep records of trades? Recent regulatory reports state that the world’s largest banks have made some progress, but have a long way to go.
- Beware of language. Reading the news, one can see the exchanges being described as “guarantors” of derivatives trades. Should the marketplace heavily rely on a choice of word?
The Regulatory Ruse: Ring Fencing
Ring-fencing has been pursued as a containment tool, attempting to keep the good assets in the regulated bank and the undesirable risks out. It can be helpful under normal circumstances. But let me squeeze a bit on that bar of soap.
Look at the following simple organization chart.
We have the parent, which issues the stock certificates, and three subsidiaries. A derivatives subsidiary, a broker/dealer engaged in securities trading and an FDIC-guaranteed banking subsidiary.
The way cash resources are moved around the organization is through upstreamed dividends, from subsidiary to parent.
There are several issues here. Where is the risk? Inside the FDIC-guaranteed bank or in a sister subsidiary? What are the implications for losses from derivatives trading? Ring-fencing helps, but can you ring-fence out fear or ring-fence in trust? In a systemic event, investors care little about where extraordinary risks are located. They don’t want to be associated with any of it.
In late 2011, movement of investment bank derivatives into FDIC-guaranteed banking subsidiaries attracted some media attention. While this shifting wasn’t necessarily consistent across institutions, the truth was that “universal banks” created here in the late 1990s had always had their derivatives in their FDIC-guaranteed subsidiary. Interest rate swaps were and remain the largest type of derivative and are very useful to managing a commercial bank’s funding. So this isn’t an easy issue to address.
Credit Default Swaps (INSURANCE PRODUCTS): The Ultimate Weapon of Mass Destruction
Credit default swaps and interest rate swaps are both considered derivatives, deriving their value from underlying market price changes. But credit default swaps are insurance. You pay a premium to insure against an event. Not the pooling of the risk of your house burning down or your car being demolished. The event is the default by a single big borrower.
This next chart, from an FDIC call report of a few years ago, shows the credit derivatives written by (guarantor) and purchased by (beneficiary) a bank.
Note that most “credit derivatives” are credit default swaps.
When a big bank is asked to write credit insurance contracts, it offsets the risk of selling insurance by buying the same from another institution. The modeling is more complex. But generally the bank is making money by writing contracts at higher premiums than they pay when purchasing protection.
This next chart is a source of concern. It’s from the IMF’s April 2013 Global Financial Stability Report. Chapter 2 of the report describes the benefits of using sovereign credit default swaps.
Notice the shift in the Top Ten credit default swaps outstanding over time. Large financial institutions were among the Top Ten in 2008 and were still slightly represented in 2010. By 2012, the Top Ten were solely sovereign credit default swaps, with much larger numbers, and led by EU countries. The $1 billion of wagers on Argentina’s defaulted debt just paid out at 60 cents on the dollar. These wagers are vastly larger. Who is underwriting this insurance? Where is it booked? Should the banks net their exposures when calculating regulatory capital cushions?
Given all these considerations, I for one can certainly sympathize with global regulators who seem to lean more and more toward just requiring more regulatory capital from systemic banks. The banks may push back, saying that demanding more capital risks shrinking the supply of credit. But what the TBTF banks are describing is the movie It’s a Wonderful Life when what’s playing on the screens in the largest systemic banks is more like Star Wars.
Derivatives and Collateral: It’s Also About Jobs
Looking back at the double concentration slide,
I’d suggest there is an even more subtle, but very significant impact from derivatives proliferation.
When individuals and businesses leave deposits at commercial banks, the bank can lend a portion of the deposits. When collateral supporting derivatives is provided, it can’t be lent out. The amounts go in and out as market prices and therefore exposures change. Global reported collateral is over $2 trillion. Some portion supports derivatives in the U.S. In the fall of 2008, in a letter to the top Federal financial officials for a purpose not related to derivatives, the American Bankers Association President stated that one dollar of bank capital supports 7.6 dollars of loans. While many types of derivatives are very useful, the growth in derivatives has shifted a huge amount of cash from supporting loans to supporting future promises.
A financial firm cannot earn profits without taking risks. Those at the top face the Super Bowl of risk competition. But who goes to the Super Bowl without a strong defense? It’s important to get this right.