Monday, 25 June 2018

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Who’d want to be a G-SIFI?

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Keith Mullin, Editor at Large, International Financing Review

Keith Mullin, Editor at Large, International Financing Review

Well, everyone actually. In creating this ugly acronym, code for banks that are too big to fail, might regulators unwittingly be pushing cusp institutions towards greater risk-taking in order to qualify? As the Financial Stability Board attempts to find some common ground between warring factions in the G20 about how much supplementary capital Globally Systemically Important Financial Institutions will have to hold – note to FSB: there is no common ground – banks are vying to be seen to be too big to fail because the effective state guarantee will cheapen their wholesale funding lines.

Weighing up the additional burden of higher capital charges and marginally lower ROEs against the benefits of cheaper debt is likely to result in a positive-sum game over a relatively short time period, as analysts are comfortable that the surcharge won’t actually create much of a capital deficit, if any at all.

While there’s no clarity as yet as to how many supplementary capital buckets there’ll be or what the required mix of capital will be (ie, common equity versus hybrid forms), the consensus surcharge is coming out at around three percentage points over the 7% Basel III 2013 core capital levels, with a long lead time to ensure that any additional capital-raising can be conducted slowly and be absorbed by the market.

There’s not a lot of consensus on that number, though. The UK would like total core capital of 15% – all in common equity. The Swiss have already laid down their marker at 10% core plus 9% in contingent forms, while the US Fed is playing it a bit loose with 3% over Basel (but all in common equity).

Ahead of first drafts of the rules, investors in bank stocks are playing a cautious game, putting higher than expected surcharge forecasts into their pricing models for certain institutions, which has had the effect of depressing bank stock prices. This is a buy signal. As more concrete information starts to become available from mid-July and assuming the SIFI surcharge comes out around 3%, we’re likely to see a pop in stocks that are being overly penalised.

The 3% supplementary charge, an effective proxy for the cost of a state guarantee, is not a bad trade. But one G-SIFI measure is the degree of inter-connectedness a bank has vis-a-vis the rest of the financial system. This might just be an incentive for a bank that thinks it may be on the cusp of G-SIFIness to get out there and ramp things up a bit to make sure.

Myron Scholes, Nobel prize winner but perhaps better known today as the man whose models helped blow up LTCM and send the global market into a tailspin, thinks subjecting major banks to higher capital requirements could cause more volatility in financial markets.

Writing in Risk, he reckons that higher capital needs will force banks to wait for larger price deviations before they intermediate in order to generate acceptable returns on that higher capital. “As intermediary services stop, markets then become more chaotic,” he says.

Of course, beyond actual levels of capital, a potentially more convoluted issue is liquidity. As banks start to focus on required liquidity coverage and net stable funding ratios, it’s becoming apparent that this has more latitude to disrupt the availability and cost of senior bank funding. Watch this space.

No default testing

I know I’ve been banging on a bit about bank stress tests, but the comedy keeps on getting darker. In Europe dumb politics (or do I mean politicians?) have properly ensured that political outcomes have triumphed over proper testing of financial stress using realistic base case scenarios, to the extent that the whole process has become unfit for purpose. EU tests will exclude the assumption of default of a eurozone country because default or debt restructuring of an EU country is not a politically acceptable possibility.

At best, this is pure sophistry; at worst it is reckless endangerment. The whole point of a bank stress test is to enhance investor sentiment. Whether restructuring or default is on or off the table as an acceptable option for politicians is irrelevant against the realities of bank balance sheets, exposure to weak sovereigns, and potential mark-to-market losses. And it ignores and the not insignificant issues of whether debtors such as Greece actually have any money to maintain debt service over the medium term.

At the end of the day, stress tests are an exercise. If you’re testing for the impact of some sort of long-lived macroeconomic malfunction, why not throw a Greek default in there as well? But no. Olli Rehn, the EU’s Commissioner for Economic and Financial Affairs, said that because capital adequacy had been tightened, excluding default assumptions from the official tests was a deliberate choice.

“We do not believe restructuring is good for Greece or other countries. We have decided … that we are engaged in a Vienna-style initiative on a voluntary basis, which will avoid a credit default, which does not mean debt restructuring and we do not envisage default as a scenario,” he said.

Back on Planet Earth, national regulators have asked their banks to quantify potential losses from holdings of Greek debt and debt of other shaky sovereigns on trading and banking books because they want to know what the risks are. But they’re doing so without having to acknowledge default as a possibility. Incredible.

I’m not fluent in EU techno-babble, but if officials are so convinced that default can’t happen, I can only imagine that means they’ll stand behind Greece and other bankrupt sovereigns in their darkest hour. In that case, in a fit of potentially counter-intuitive folly, I’m an aggressive seller of synthetic Greece protection – no matter that Greek CDS levels infer an 82% probability of default – and I’m using the positive carry to hoover up cash bonds at the front of the curve, targeting the two-year. If my trade blows up, I’m sending the bill to Olli.

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