PrefBlog

The Bank of Canada has announced the release of the Autumn 2008 Review, a special issue focussing on “Structural Factors, Adjustment and productivity”:

This special issue covers a variety of topics dealing with how structural factors or developments affect the economic performance of an advanced economy such as Canada.

I can’t say I spent a lot of time with it, since the articles are not particularly well related to the nitty-gritty of financial markets that I follow keenly – but doubtless some regulator will come along some time and require me to correct my negligence.

The articles are:

• Productivity in Canada: Does Firm Size Matter?
• Offshoring and Its Effects on the Labour Market and Productivity: A Survey of Recent Literature
• Adjusting to the Commodity-Price Boom: The Experiences of Four Industrialized Countries
• The Effects of Recent Relative Price Movements on the Canadian Economy
• The Bank of Canada’s Senior Loan Officer Survey

It’s nice, however, to look at the titles and see that everything’s spelt properly (very rare in internationally available economic papers), but I’m afraid I must deprecate their use of “Can$” as the identifier for our currency.

BIS has released Working Paper #265, by Blaise Gadanecz, Kostas Tsatsaronis and Yener Altunbase, with the captioned title.

The paper is quite interesting. First, the authors grouped banks according to FitchRatings’ assessment of their external (state) support:

In addition to the more traditional types of creditworthiness assessment, Fitch Ratings assigns to banks ratings related to the strength of outside support. The so-called support rating is an assessment of the likelihood and level of outside financial support that the bank may receive from outside entities (the government, its owners or third parties) in case of financial difficulty. The rating scale ranges from very high support (level 1) to no support (level 5). For the purposes of this paper banks with a rating of 1 or 2 are identified as “supported”. This choice was based on the characterisation that Fitch gives to these rating classes in its manual. Level 1 support indicates “a clear legal guarantee or state support would be forthcoming”. Level 2 is assigned in cases where “state support would be forthcoming in the absence of a legal guarantee”. This choice is consistent with other studies in the literature that rely on the same indicator of safety net support.9 The ratings methodology does not strictly identify the government purse as the source of financial support. However, for the higher support rating categories the methodology points to the existence of a legal commitment or highlights the systemic importance of the institution in the national and/or international arena. For the purpose of this analysis this is treated as being practically tantamount to government support. No private entity would have the resources or the incentives to provide this financial support in the case of financial difficulty.

This was then compared with details of each bank’s participation in international syndicated loans:

The syndicated loan information has been extracted from the Dealogic Loanware database. Each loan facility record identifies the members of the syndicate and their role as senior or junior members.
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The information on the individual loan facilities was combined with information on the syndicate banks extracted from Bankscope. This database contains details about the balance sheet composition and income statement of individual banks.

The authors conclude:

Where supported banks seem to differ substantially from their peers is the attitude towards risk. Supported banks hold portfolios of loans that are on average lower priced than a market benchmark (although some of these lower spreads may be recouped in the form of higher fees, meaning that they may be substituting revenue for risk compensation). Moreover, as senior arrangers they tend to be involved in initiating loans that carry thinner spreads that the average loan with similar characteristics. Finally, they also seem to be less responsive to indicators of balance sheet risk in deciding whether to invest on a particular loan as compared to other banks.

This relatively relaxed attitude towards risk is more problematic from a policy perspective. It is an indication that support distorts the incentives of these banks and encourages risk taking that is not remunerated by market expected returns. Combined with a non-innovative attitude towards investment also suggests that these banks are likely to be using the funding benefits of their status to engage in price competition in the international loan market. This behaviour is not compatible with the typical motivation for support, and is akin to an abuse of their privileged status.

These results shed a sceptical light on the beneficial impact of state support. Clearly, the data used in this paper cannot examine the overall behaviour of the banks, but only a small component in their activities in the international arena. More research is needed to generate a more complete picture of the impact of support on the banks. Nevertheless, the results suggest that there are externalities from state support that go beyond the national markets. Hence, they warrant a more careful consideration of the conditions at which support is made available and the governance structures in these institutions.

As the authors remarked in the introduction:

Public sector interest is often associated with the existence of explicit forms of financial support or the market perceptions of implicit guarantees should the banks come under stress. Banking is also a business of taking and managing risk. The theory of moral hazard suggests that ill-conceived insurance against downside risks may lead to distorted incentives and excessive risk taking by banks.

We can only hope that the conclusions of this paper make their way into the hands of the G-20 planners of the New World Order (Financial Department).

The IIAC has announced:

Total equity issuance in Canada fell to $6.5 billion in the third quarter, the lowest in over 6 years— down 44 per cent from the previous quarter and 24 per cent year-over-year. However, equity trade volumes reached an all-time high surpassing the record reached earlier this year with $25.7 billion shares being traded for the quarter. The Investment Industry Association of Canada (IIAC) issued today its quarterly publication Review of Equity New Issues & Trading, highlighting Canadian equity financing and trading activity.

The report itself notes:

Preferred shares followed suit falling to $1.5 billion on 5 offerings— a decrease of 36% from the previous quarter but still on pace for a record year in issuance for 2008 (Chart 4)

Year-to-Date figures are:

The BIS Semi-Annual OTC Derivatives Package has been released … and CAD interest rate options got a mention!

Concentration in options on Canadian dollar interest rates rose to the highest level recorded so far.
…
The Herfindahl index represents a measure of market concentration and is defined as the sum of the squares of the market shares of each individual institution. It ranges from 0 to 10,000. The more concentrated the market, the higher the measure becomes. If the market is fully concentrated (only one institution), the measure will have the (maximum) value of 10,000.

The Herfindahl Index for CAD Interest Rate options was 3,314.

The press release summarizes:

The notional amounts outstanding of over-the-counter (OTC) derivatives continued to expand in the first half of 2008. Notional amounts of all types of OTC contracts stood at $683.7 trillion at the end of June, 15% higher than six months before. Multilateral terminations of outstanding contracts resulted in the first ever decline of 1% in the volume of outstanding credit default swaps (CDS) since the first publication of CDS statistics in December 2004. The average growth rate for outstanding CDS contracts over the last three years has been 45%. In contrast to CDS markets, markets for interest rate derivatives and FX derivatives both recorded significant growth. Open positions in interest rate derivatives contracts rose by 17%, while those in FX contracts expanded by 12%. Gross market values, which measure the cost of replacing all existing contracts and are thus a better gauge of market risk than notional amounts, increased by 29% to $20.4 trillion at the end of June 2008.

The October 2008 edition of the BoE’s Financial Stability Report has been released.

There’s an interesting graph of Sterling credit spreads:

Despite the slowing economy, corporate insolvency rates remain near historical lows. Many companies extended debt maturities during the recent boom, with Dealogic data suggesting that only about 10% of the stock of sterling-denominated bonds and loans outstanding are due to mature in 2009. But within that aggregate picture, there are pockets of vulnerability. Company accounts suggest that the proportion of debt held by businesses whose profits were not large enough to cover their debt interest payments picked up sharply in 2007 to around a quarter of the outstanding stock of debt

Also of interest is the continuing disconnect between fundamental value and market price of AAA subprime paper:

They update their estimation of ultimate credit losses (as opposed to mark-to-market losses) initiated in the April Financial Stability Report and conclude:

As Chart C shows, it is difficult to reconcile the outlook for expected credit losses on UK prime RMBS (Chart B), and hence the likely economic value of those securities, with current implied market values (Chart A). Based on this comparison, it is estimated that a little under half of the loss of market value of UK prime RMBS is likely to reflect discounts for uncertainty about future collateral performance and market illiquidity.(12) And around one third of mark-to-market losses on US sub-prime RMBS can be attributed to the premia demanded by investors for uncertainty and market illiquidity.

They emphasize that uncertainty and excess leverage are working together to greatly increase the calculated probability of default:

The uncertainty about the underlying values of banks’ assets was amplified by the high leverage with which UK and global financial institutions entered the downturn. To give an illustrative example,(1) in the middle of 2008 major UK banks had assets of just over £6 trillion and equity capital of around £200 billion. So if the standard deviation of asset returns pre-crisis was, say 1.5% per year, then levels of UK banks’ capital would have delivered a probability of default of a little over 1% a year (Chart 4.4). But if uncertainty doubled to 3% in the crisis — for example, as a result of higher macroeconomic and counterparty risk — then the implied default probability would rise to a little under 15%. In essence, that was what happened to UK and global banks during the summer, as the combination of asset valuation uncertainty and leverage markedly increased default fears and thus raised questions about the adequacy of banks’ capitalisation. That was the case despite capital ratios being above regulatory minima throughout the period (Chart 4.5).

… which in turn places a greater importance on the mark-to-market value of assets …

When the probability of default is low, the value of assets on banks’ balance sheets is determined by their economic value — the value built up from underlying expected cash flows on those assets on the assumption that they are held to maturity. But as default probabilities rise, so do the chances of the assets needing to be liquidated prior to maturity at market prices. So as the expected probability of bank default rose during September (Chart 3.1 in Section 3), it became rational for market participants to alter the way by which they assessed
the underlying value of banks’ assets, effectively placing more weight on the mark-to-market value of these assets. Given the high illiquidity and uncertainty premia in market prices (discussed in Section 2), this implied lower asset values and higher potential capital needs for banks. This valuation effect served as an additional amplifier of institutional distress.

It appears that the BoE will be pushing for better bank capitalization:

By historical standards, banks have operated with relatively low levels of capital in recent years. For example, long-run evidence shows that capital ratios for US banks have fallen significantly from levels of around 50% in the mid-19th century (Chart 6.1). The structure of banking systems, and the safety nets in place to support them, have changed dramatically over the period. While it is difficult to determine the optimum level of capital, recent events suggest that capital levels across the financial system as a whole have fallen too far.

Existing regulatory tools need to be adapted and new ones developed, to ensure that the financial system is better capitalised in advance of the next downturn and to address the build-up of risk through the cycle. A range of specific proposals have already been put forward. A leverage ratio — a minimum ratio of capital to total assets — would impose a constraint on the growth of banks’ balance sheets relative to their stock of capital. A system of dynamic provisioning would force banks to build up reserves against future losses in good times, providing a resource which could be drawn on in bad times. These and other proposals are outlined in detail in Box 6.

All in all, a very good review of the situation.

The Bank of Canada released its October 2008 Monetary Policy Report on Thursday …

Core inflation is projected to remain below 2 per cent until the end of 2010. Assuming oil prices in a range of US$81 to US$88 per barrel, consistent with recent futures prices, total CPI inflation should peak in the third quarter of 2008, and is projected to fall below 1 per cent in mid-2009 before returning to the 2 per cent target by the end of 2010.
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In line with the new outlook, some further monetary stimulus will likely be required to achieve the 2 per cent inflation target over the medium term.
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Over the 1978–2004 period, which is long enough for cyclical and irregular effects to wash out, the growth in labour productivity for the total economy averaged 1.2 per cent per year. Recently, this trend appears to have fallen to slightly below 1.0 per cent, owing partly to the considerable amount of structural adjustment under way in the economy and perhaps partly to firms hiring additional labour, given concerns about tightening labour markets (Chart A). As these factors dissipate, aggregate productivity growth should pick up.
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As a simple illustration, major Canadian banks have an average asset-to-capital multiple of 18. The comparable figure for U.S. investment banks is over 25, for European banks, in the 30s, and for some major global banks, over 40.
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Credit spreads for financial institutions, as measured by the difference between a weighted average of borrowing rates across the term structure and the expected overnight rate, spiked to around 200 basis points in early October. While strong actions taken by governments and central banks to support financial institutions have led to some retracement in these spreads, it is expected that spreads will be reduced only slowly as confidence is gradually rebuilt. Since the onset of the financial market turbulence in August 2007, effective borrowing costs for Canadian financial institutions have eased somewhat, with the rise in credit spreads more than offset by the 225-basis-point cumulative reduction in the target overnight rate (Chart 13). These indicative borrowing costs likely do not, however, adequately take account of the decreased availability coming from illiquid and risk-averse interbank markets.

The huge spread on 5-year money may go a long way to explain why Royal Bank was willing to issue Fixed-Resets at 5.60%+267. Who knows … with a new fiscal year on the way, we may see more issues like that …

The World Economic Forum Global Competitiveness Report has been getting a lot of media ink lately.

For instance, Gwyn Morgan writes in the Globe:

Are Canadian banks in trouble? The World Economic Forum just ranked Canada’s banking system as the soundest in the world.

and in the same edition in a column that does not appear to be available online, Murray Leith of Odlum Brown wrote:

Our Canadian banks were even rated the “safest” in the world, according to a survey conducted by the World Economic Forum

It is important to understand exactly what this means. First, the good news:

Canada moves up three places to join the top 10 (ranked 10th). Canada benefits from top-notch transport and telephony infrastructure; highly efficient markets, particularly labour and financial markets (ranked 7th and 10th respectively); and well-functioning and transparent institutions (ranked 15th). In addition, the educational system gets excellent marks for quality, which has prepared the country’s workforce to adopt the latest technologies for productivity enhancements (ranked 9th). Canada’s main weakness remains its macroeconomic stability, where it is ranked 43rd, mainly linked to the significant government debt of nearly 70% of GDP, which places the country 107th out of 134 countries on this indicator. On a more positive note, however, the government has been running small surpluses over recent years, which is allowing the country to put the debt level on a downward trend.

I don’t know how much longer the surpluses will last if old ‘What Debt?’ Harper gets his majority tomorrow, but that’s another issue.

But what does it all mean? The key word was used by Mr. Leith – “survey”. According to Chapter 2.1 of the report:

The World Economic Forum has conducted the annual Survey for nearly 30 years.This year, the Survey was completed by 12,297 top management business leaders—an all-time high—in 134 countries between January and May.This represents an average of 91 respondents per country.Table 1 shows key attributes of the Survey respondents for the 2008 dataset.

The Survey asks the executives to provide their expert opinions on various aspects of the business environment in which they operate.The data gathered thus provide a unique source of insight and a qualitative portrait of each nation’s economic and business environment, and how it compares with the situation in other countries.
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The collected respondent-level data are subjected to a careful editing process.The first editing rule consists of excluding those surveys with a completion rate inferior to 50 percent.

OK, so what is this based on? A survey of executives, who are providing opinions described as “expert” on virtually every aspect of their own nation’s competitive position; these are then ranked against other executives expert opinion of virtually every aspect of the other executives’ nations’ competitive position.

Sorry, this doesn’t make sense; the answers are not particularly reliable for any given nation and are not reliable at all when making comparisons. I personally believe that Canadian banks are quite sound, but my opinions – and those of the respondents – are valueless when attempting to draw an objective comparison against Tuvalu’s banks. I stand ready to be corrected, but I cannot find any indication on the WEF Website of any testing that has been done regarding the predictive capability of past surveys.

Sorry, guys. While it makes for pleasant hearing, and may for policy purposes assist governments in setting priorities, the survey is meaningless.

The European Covered Bond Council has released its 2008 Fact book:

The Fact Book presents five articles on key issues in Chapter I with a focus on developments in primary and secondary markets during the recent financial turmoil:

• Assessing the state of play in secondary markets;
• Analysing the role of Covered Bonds as a funding tool;
• The investor’s perspective;
• Investigating general law framework (structured) Covered Bonds; and
• Looking at pooling models.

The second Chapter explains more about covered bonds and their main features and includes articles comparing Covered Bonds with RMBS as well as how the Capital Requirements Directive relates to Covered Bonds.

In the third Chapter, detailed explanations are presented on the legislation and markets for covered bonds for 29 countries, including seven countries added since the last edition of the Fact Book.

Chapter IV gives the rating agencies the opportunity to present their Covered Bond methodologies as well as providing a brief comparison of their different approaches.

In Chapter V, a description of trends in the covered market as well as a complete set of covered bond statistics are presented.

Can’t say I’ve read it thoroughly – there have been other things to observe today – but the last handbook, mentioned in the PrefBlog Covered Bond Primer was most informative.