PrefBlog

DBRS has announced that it:

has today published updated versions of two Canadian structured finance methodologies:
— Stability Ratings for Canadian Structured Income Funds
— Rating Canadian Split Share Companies and Trusts

Neither of the methodology updates resulted in any meaningful changes and as such, neither publication has resulted in any rating changes or rating actions.

DBRS’s criteria and methodologies are publicly available on its website, www.dbrs.com, under Methodologies. DBRS’s rating definitions and the terms of use of such ratings are available at www.dbrs.com.

Of interest in the methodology is the explicit nature of their rating categories (I have added the Asset Coverage Ratio, calculated from the Downside Protection):

and

Also noteworthy is:

The importance of credit quality in a portfolio increases as the diversification of the portfolio decreases. To be included as a single name in a split share portfolio, a company should be diversified in its business operations by product and by geography. The rating on preferred shares with exposure to single-name portfolios will generally not exceed the rating on the preferred shares of the underlying company since the downside protection is dependent entirely on the value of the common shares of that company.

They are, quite reasonably, unimpressed by call writing strategies:

DBRS views the strategy of writing covered calls as an additional element of risk for preferred shareholders because of the potential to give up unrealized capital gains that would increase the downside protection available to cover future portfolio losses. Furthermore, an option-writing strategy relies on the ability of the investment manager. The investment manager has a large amount of discretion to implement its desired strategy, and the resulting trading activity is not monitored as easily as the performance of a static portfolio. Relying partially on the ability of the investment manager rather than the strength of a split share structure is a negative rating factor.

They even have a table for the effect of cash grind (which is a special case of Sequence of Return Risk):

I consider their VaR methodology highly suspect:

The steps in the VaR analysis completed by DBRS are as follows:
(1) Gather daily historical performance data for a defined period.
(2) Annualize each daily return by multiplying it by the square root of the number of trading days in a year.
(3) Sort the annualized returns from lowest to highest.
(4) Using the initial amount of downside protection available to the preferred shares, determine the appropriate dollar loss required for the preferred shares to be in a loss position (i.e., asset coverage ratio is less than 1.0)
(5) Solve for the probability that will yield a one-year VaR at the appropriate dollar-loss amount for the transaction.
(6) Determine the implied long-term bond rating by comparing the probability of default with the DBRS corporate cumulative default probability table.
(7) Link the implied bond rating to the appropriate preferred share rating using an assumption that the preferred shares of a company should be rated two notches below the company’s issuer rating.

As stated, it’s nonsensical. Whatever one’s views on long-term mean reversion of equity returns, there is definitely short-term mean reversion, so annualizing a single day’s return is far too pessimistic. Using the square root of the days in the year to annualize the results implies that each day’s returns are independent.

There’s a big table titled “Maximum Preferred Share Ratings Based on Portfolio Credit Quality and Correlation”, which I won’t reproduce here simply because it’s too big.

I am not a big fan of this “base case plus adjustments” methodology and (not surprisingly) continue to prefer my own stochastic model, which is used in every edition of PrefLetter. Implications of my methodology have been discussed in my articles It’s all about Sequence and Split Share Credit Quality.

An article in the Globe and Mail by Grant Bishop titled Canadian Banks: Bigger is better highlighted views regarding Canadian banking regulation that differ from my own:

A recently published paper by Columbia University’s Charles Calomiris argues that banking crises have political foundations. He contends that anti-populist political structures guard against the capture of the banking system by voters seeking easy credit. But parts of Mr. Calomiris’ thesis have raised eyebrows: he implies that the British aim of oppressing French Canada is the indirect root of Canada’s long-term banking stability.
…
What policy-makers should take away from Calomiris’ account is the importance of keeping politics away from banking regulation. As Anita Anand and Andrew Green of the University of Toronto also argue in a recent paper, the independence of financial regulation from politics in Canada is a cornerstone of the integrity of our system.

It is, of course, my argument that both OSFI and the Bank of Canada have become intensely politicized in over the recent past, with both Carney and Dickson acting as stalking horses for politically inspired regulatory ideas (mostly to do with contingent capital and the Ban The Bond movement).

In another recent paper, UBC’s Angela Redish and her colleagues ask “Why didn’t Canada have a banking crisis in 2008 (or in 1930, or 1907, or…)?” They conclude that, in contrast with the fragmented U.S. system, Canadian banking stability owed to the single overarching regulator and the high concentration of the sector.

A cross-country study by World Bank researchers reaches a similar conclusion: more concentrated banking systems appear to be more stable.

The paper by Anita Anand & Andrew Green titled REGULATING FINANCIAL INSTITUTIONS: THE VALUE OF OPACITY has the abstract:

In this article, we explore a question of institutional design: What characteristics make a regulatory agency effective? We build on the growing body of administrative law literature that rigorously examines the impacts of transparency, insulation, and related administrative processes. We argue that there are certain benefits associated with an opaque and insulated structure, including the ability to regulate unfettered by partisan politics and majoritarian preferences. We examine Canada’s financial institution regulator, the Office of the Superintendent of Financial Institutions (OSFI), whose efficacy in part explains the resilience of Canada’s banking sector throughout the financial crisis of 2008. In particular, OSFI operates in a “black box”, keeping information about the formation of policy and its enforcement of this policy confidential. With its informational advantage, it is able to undermine the possibility that banks will collude or rent-seek. Our conclusions regarding the value of opacity cut against generally held views about the benefits of transparency in regulatory bodies.

Huh. I wonder if they’re also in favour of re-establishing the Star Chamber, which worked very well until it didn’t.

The body of this paper commences with the startling claim:

Canada’s financial institutions weathered the crisis well relative to their international peers, an outcome that has been attributed at least in part to the presence of an effective regulator.[Footnote]

Footnote reads: See Canadian Securities Institute, Canadian Best Practices Take Centre Stage at Financial Conference in China (25 February 2009), online: Focus Communications Inc ; Financial Services Authority, Bank of England & Treasury, Financial Stability and Depositor Protection: Further Consultation (London: HM Treasury, 2008), online: HM Treasury

The Canadian Securities Institute is not something I consider an authoritative, or even credible, source, so I looked for the paper HM Treasury: Financial stability and depositor protection: further consultation, July 2008 which contains four instances of the word Canada (in each case, grouped with other countries as a participant or example), no instances of “OSFI”, one instance of “Superintendent” (the “Superintendents’ Association of Northern Ireland”, which responded to an earlier consultation), and two instances of “effective regulat”, both of which referred to the UK bodies aspirations.

Ratnovski and Huang, for example, examine the performance of the seventy-two largest commercial banks in OECD countries during the financial crisis, analyzing the factors behind Canadian banks’ relative resilience at this time.[Footnote 4] They identify two main causes, one of which is regulatory factors that reduced banks’ incentives to take excessive risks.[Footnote 5]

Footnote 4 reads: Lev Ratnovski & Rocco Huang, “Why Are Canadian Banks More Resilient?” (2009) IMF Working Paper No 152, online: Social Science Research Network .

Footnote 5 reads: Ibid. Other factors included a higher degree of retail depository funding, and to a lesser extent, sufficient capital and liquidity.

The Ratnovski & Huang paper was reviewed in my post Why Have Canadian Banks Been More Resilient?. The paper is available from the IMF

Specifically, Ratnovski & Huang say:

The second part of this paper (Section 3) reviews regulatory and structural factors that may have reduced Canadian banks’ incentives to take risks and contributed to their relative resilience during the turmoil. We identify a number of them: stringent capital regulation with higher-than-Basel minimal requirements, limited involvement of Canadian banks in foreign and wholesale activities, valuable franchises, and a conservative mortgage product market.

Returning to the Anand & Green paper, the guts of the argument is:

OSFI’s efficacy may at first be surprising. It is the primary regulator of Canada’s five big banks (which account for approximately 85 percent of Canada’s banking sector).10 Its power to overcome the possibility for rent seeking or capture by these institutions depends on its rule making and enforcement processes, and forms of accountability for its actions. That is, if not sufficiently independent, regulated institutions might seek rules that favour their profitability at the expense of consumers. Yet on many important issues, including capital adequacy requirements, OSFI relies on guidelines rather than regulations. OSFI creates these guidelines through a largely opaque process in which the regulated parties have early input. Other parties (such as consumers) not only face considerable collective action problems but are limited to a stunted notice and comment process. The comment process thereby potentially privileges the views of regulated institutions. Further, in addressing compliance with regulations or guidelines, OSFI attempts to work informally with regulated parties, ultimately rendering it unnecessary for it to take formal enforcement action. This structure seems to point more towards capture by the large (albeit regulated) players. To aid in the discussion of the appropriate institutional structure for banks, we examine whether Canada’s financial institutions—and banks in particular—have been successful because of, or despite, the presence of OSFI.

Later comes a real howler:

Despite its insulation and opacity, however, OSFI is almost universally viewed to be an effective regulator.[Footnote 17]

[Footnote 17 reads] The Strategic Counsel, Qualitative Research: Deposit-Taking Institutions Sector Consultation,
(Toronto: 2010) at 2-6, online: OSFI < http://www.osfi-bsif.gc.ca/app/DocRepository/ 1/eng/reports/osfi/DTISC_e.pdf >

So lets have a look at the OSFI document that says OSFI is doing a great job. It’s a survey. Who is surveyed, you may ask. So I will tell you:

A total of 49 one-on-one interviews were conducted among Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), Chief Risk Officers (CROs), Chief Compliance Officers (CCOs), other senior executives, auditors and lawyers of deposit-taking institutions regulated by OSFI.

The use of the phrase “almost universally” seems … a little strained.

The paper’s arguments are founded upon the premise that OSFI is doing a great job, therefore the way it does it must also be great. Unfortunately, the premises do not support the conclusions.

The Bank of Canada has released the Bank of Canada Review – Autumn 2012 with articles:

• Financial Transaction Taxes: International Experiences, Issues and Feasibility by Anna Pomeranets
• Access, Competition and Risk in Centrally Cleared Markets by Jean-Sébastien Fontaine, Héctor Pérez Saiz and Joshua Slive
• Monetary Policy and the Risk-Taking Channel: Insights from the Lending Behaviour of Banks by Teodora Paligorova and Jesus A. Sierra Jimenez
• The Changing Landscape for Retail Payments in Canada and the Implications for the Demand for Cash by Carlos Arango, Kim P. Huynh, Ben Fung and Gerald Stuber

The first article attracted some notice from the Globe and Mail, in pieces by David Parkinson and Kevin Carmichael. An earlier working paper by Ms. Pomeranets and Daniel G. Weaver which focussed on the historical experience in New York State was reviewed on PrefBlog. This paper was quoted in support of the conclusion:

On balance, the literature suggests that an FTT is unlikely to reduce volatility and may instead increase it, which is consistent with arguments made by opponents of the tax.

The current paper is introduced with:

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• The financial transaction tax (FTT) is a policy idea with a long history that, in the wake of the global financial crisis, has attracted renewed interest in some quarters.
• Historically, there have been two motivating factors for the introduction of the tax. The first is its potential to raise substantial revenues, and the second is its perceived potential to discourage speculative trading and reduce volatility.
• There is, however, little empirical evidence that an FTT reduces volatility. Numerous studies suggest that an FTT harms market quality and is associated with an increase in volatility and a decrease in both market liquidity and trading volume. When the cost of acquiring a security rises, its required rate of return and cost of capital also increase. As a result, an FTT may reduce the flow of profitable projects, decreasing levels of real production, expansion, capital investment and even employment.
• There are many unanswered questions regarding the design of FTTs and their ability to raise significant revenues.

The imposition of a 20bp transaction charge in France (which has resulted in a greater interest in derivatives such as Contracts For Difference) was discussed on PrefBlog on November 15.

The authors also see fit to highlight:

Umlauf (1993) examines how financial transaction taxes (FTT s) affect stock market behaviour in Sweden. In 1984, Sweden introduced a 1 per cent tax on equity transactions, which was doubled to 2 per cent in 1986. Umlauf studies the impact of these changes on volatility and finds that volatility did not decline following the increase to the 2 per cent tax rate, but equity prices, on average, did decline.

Furthermore, Umlauf concludes that 60 per cent of the trading volume of the 11 most actively traded Swedish share classes migrated to London to avoid the tax. After the migration, the volatilities of London-traded shares fell relative to their Stockholm-traded counterparts. As trading volumes fell in Stockholm, so did revenues from capital gains taxes, completely offsetting the 4 billion Swedish kronor that the tax had raised in 1988.

Pomeranets also points out:

Critics of the FTT argue that it reduces market liquidity by making each trade more costly, simply because it is a tax and also because market forces react to it by offering fewer and lower-quality trading opportunities. The cost impact is evident in the way the FTT widens the bid-ask spread. Bid-ask spreads compensate traders for three things—order-processing costs, inventory risk and information risk—often called the three components of the bid-ask spread. The FTT will increase the costs of these three components in the following ways:…

And finally, we get the the social function of markets – capital formation:

Another measure of market quality examined in the literature is the cost of capital. Amihud and Mendelson (1992) conclude that a 0.5 per cent FTT would lead to a 1.33 per cent increase in the cost of capital. This result is consistent with their previous work that finds a positive relationship between required rates of return and transaction costs (Amihud and Mendelson 1986). When the cost of acquiring a security increases, its required rate of return and cost of capital also increase. As a result, an FTT would increase the cost of capital, which could have several harmful consequences. It could reduce the flow of profitable projects, shrinking levels of real production, expansion, capital investment and even employment.

Ms. Pomeranets concludes:

This article examines the main arguments regarding the costs and benefits of FTTs and explores some of the significant practical issues surrounding the implementation of an FTT. Little evidence is found to suggest that an FTT would reduce speculative trading or volatility. In fact, several studies conclude that an FTT increases volatility and bid-ask spreads and decreases trading volume. Furthermore, a number of challenges associated with the design and effectiveness of an FTT could limit the revenues that FTTs are intended to raise. For these reasons, countries considering the imposition of FTTs should be aware of their negative consequences and the challenges involved in implementation.

The second article examines a hobby-horse of mine – central clearing for derivatives, a dangerous policy recklessly promoted by the political establishment both directly and through their mouthpiece, Lapdog Carney. The last BoC attempt at justification, in the June 2012 Financial System Review was discussed on PrefBlog.

In this go-round, the authors state:

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• Central counterparties manage and mitigate counterparty credit risk in order to make markets more resilient and reduce systemic risk. Better management of counterparty risk can also open up markets to new participants, which in turn should reduce concentration and increase competition. These benefits are maximized when access to central counterparties is available to a wide range of market participants.
• In an over-the-counter market, there is an important trade-off between competition and risk. Concentrated, less competitive markets are more profitable and thus participants are less likely to default. But a central counterparty that provides sufficient access can improve this trade-off, since the gains from diversification—which will become greater as participation grows—can simultaneously reduce risk and increase competition.
• Regulators have developed, and central counterparties are implementing, new standards for fair, open and risk-based access criteria. Such standards will, among other things, counter any incentives that might exist for members of a central counterparty to limit access in order to protect their market share.

In other words, a major goal of Central Clearing is to provide employment for regulators, who will make fair and open, and, it must be emphasized, entirely corruption-free decisions regarding which smaller and and less creditworthy firms will be admitted to the club.

The crux of the matter is this:

The improved management of counterparty credit risk at a CCP opens markets to greater participation, which can increase competition. In OTC markets that are cleared bilaterally, participants are directly exposed to the risk that their counterparties may default and therefore have an incentive to restrict trading to counterparties that are known to be creditworthy. When a CCP with strong risk controls takes on the management of credit risk, however, participants can feel more secure trading with others—even anonymously— since the CCP guarantees that the terms of the trade will be honoured.

In other words, when the Bank of Downtown Plonksville enters into a trade with central clearing, its counter-party will charge exactly the same risk premium as it charges to the Bank of Canada. Some people consider this to be an advantage of the new regime.

If direct access to a CCP was limited to the largest dealers, their systemic importance would increase, potentially exacerbating the “too-big-to-fail” problem and preventing the CCP from providing the full benefits of diversification. Limited access could also make mid-tier institutions more vulnerable in times of stress and slow the transition to central clearing (Slive, Wilkins and Witmer 2011).

I wonder if the CCP itself is “too-big-to-fail” ….

The authors emphasize the importance of regulators and their awesomely wise, highly informed decisions throughout the process.

The third article is introduced with:

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• The financial crisis of 2007–09 and the subsequent extended period of historically low real interest rates in a number of major advanced economies have revived the question of whether economic agents are willing to take on more risk when interest rates remain low for a prolonged time period.
• This type of induced behaviour—an increased appetite for risk that causes economic agents to search for investment assets and strategies that generate higher investment returns—has been called the risk-taking channel of monetary policy.
• Recent academic research on banks suggests that lending policies in times of low interest rates can be consistent with the existence of a risk taking channel of monetary policy in Europe, South America, the United
  States and Canada. Specifically, studies find that the terms of loans to risky borrowers become less stringent in periods of low interest rates. This risk-taking channel may amplify the effects of traditional transmission mechanisms, resulting in the creation of excessive credit.

This effect is also inherent in the offsetting behaviours of the “expectations” component and the “risk premium” component of long-term rates, discussed in the Summer 2012 review discussed in PrefBlog.

The results suggest that the difference in the all-in-drawn spreads between loans to risky and less-risky borrowers decreases when interest rates are low relative to periods when they are high. Accounting for loan, firm and bank balance-sheet factors, as well as yearly and quarterly factors, the results show that the difference in the all-in-drawn spread between risky and less-risky borrowers is 48 per cent smaller when interest rates are lower than when they are higher (based on the first definition). This result is also economically significant: it implies that the difference in loan rates between risky and less-risky borrowers is 107 basis points smaller when the rates are low than when they are high.

The fourth article, of great interest to those in the field and to the Bank, but of somewhat less importance to other investors, is summarized as:

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• The share of cash in overall retail payments has decreased continuously
  over the past 20 years.

• Recent Bank of Canada research on consumers’ choice of payment instruments indicates that cash is frequently used for transactions with low values because of its speed, ease of use and wide acceptance, while debit and credit cards are more commonly used for transactions with higher values because of perceived attributes such as safety and record keeping.
• While innovations in retail payments currently being introduced into the Canadian marketplace could lead to a further reduction in the use of cash over the longer term, the implications for the use of cash of some of the structural and regulatory developments under way are less clear.
• The Bank of Canada will continue to monitor various developments in retail payments and study their implications for the demand for cash over the longer term.

This post is really late, I know. But I’m catching up slowly!

The Bank of Canada has released the Bank of Canada Review: Summer 2012 with the articles:

• Measurement Bias in the Canadian Consumer Price Index: An Update
• Global Risk Premiums and the Transmission of Monetary Policy
• An Analysis of Indicators of Balance-Sheet Risks at Canadian Financial Institutions

The first article, by Patrick Sabourin, makes the point:

Commodity-substitution bias reflects the fact that, while the weights of items in the CPI basket are held constant for a period of time, a change in relative prices may cause patterns in consumer spending to change. If, for example, the price of chicken were to increase considerably following supply constraints, consumers would likely purchase less chicken and increase their consumption of beef, since the two meats may be perceived as substitutes for each other. The CPI, however, assumes that consumers would continue to purchase the same quantity of chicken following a price change. This means that the measured change in the CPI will overstate the increase in the minimum cost of reaching a given standard of living (i.e., there is a positive bias).

I’ve always had trouble with this concept. I love beef. I despise chicken. As far as I am concerned, there is a separate quality adjustment that must be made that would mitigate, if not completely offset, the substitution adjustment when beef becomes too expensive and I have to eat chicken.

And, I am sure, this occurs for every other possible substitution. Although I might try explaining to my girlfriend that Coach handbags have become too expensive and I will follow theoretically approved procedure and get her, say, a plastic shopping bag for Christmas instead.

The second article, by Gregory H. Bauer and Antonio Diez de los Rios examines the relationship between long- and short-term interest rates:

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• An important channel in the transmission of monetary policy is the relationship between the short-term policy rate and long-term interest rates.
• Using a new term-structure model, we show that the variation in long-term interest rates over time consists of two components: one representing investor expectations of future policy rates, and another reflecting a term-structure risk premium that compensates investors for
  holding a risky asset.

• The time variation in the term-structure risk premium is countercyclical and largely determined by global macroeconomic conditions. As a result, long-term rates are pushed up during recessions and down during times of expansion. This is an important phenomenon that central banks need to take into account when using short-term rates as a policy tool.
• We illustrate this phenomenon by showing that the “conundrum” observed in the behaviour of long-term interest rates when U.S. monetary policy was tightened during the 2004–05 period was actually part of a global phenomenon.

In their model:

The long-term rate is decomposed into two terms in the following equation:
…
The first term involves market expectations, that is, the average expected 1-year interest rate over the next 10 years. In our model, we use the 1-year interest rate in country j as a proxy for that country’s policy rate. Observed yields will, on average, equal the expectations component only under the “expectations hypothesis,” which has been statistically rejected in many studies.

The rejection of the expectations hypothesis is typically attributed to the existence of the second term in equation (1), a time-varying term-structure risk premium. The risk premium represents the extra compensation that investors require for holding a 10-year bond. In our model, agents hold portfolios for one year, and the prices of long-term bonds may change considerably over that period, necessitating a higher expected rate of return. Several studies have focused on the properties of the term-structure risk premium (see Cochrane and Piazzesi (2005) and their references).
…
The second real-world aspect of the model consists of the constraints placed
on the time-varying risk premium, the second component of equation (1). Previous work has shown that imposing restrictions on the term-structure risk premium makes the forecast values of interest rates more realistic than those in unrestricted models.7 Our model restricts risk premiums on bonds through its assumption of global asset pricing; i.e., in integrated international markets, only global risks carry significant risk premiums. As a result, the term-structure risk premium on any bond is driven by the bond’s exposure to the global level and slope factors only. The local factors, while helping to explain prices at a point in time, do not affect expected returns (i.e., changes in prices), since investors can eliminate their effects by diversifying with a global portfolio.

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This effect is evident during the financial crisis of 2007–09. While short-term U.S. rates fell by 263 basis points, long-term U.S. rates decreased by a mere 23 basis points. This occurred because, although the Fed succeeded in lowering expectations of future policy moves by 224 basis points (Table 2), the term-structure risk premium rose by 190 basis points.
…
The analysis in this article demonstrates the extent to which the global term-structure risk premium as well as monetary policy actions influence long-term interest rates. The risk premium is countercyclical to the global business cycle and thus may affect long-term interest rates in the opposite direction to that related to central bank policy actions. As a result, central banks need to take these forces into account in appropriately calibrating their policy response. Indeed, given the current low level of long-term rates, understanding movements in the global risk premium is important for the monetary policy decision-making process.

Since monetary policy may affect expectations and the term-structure risk premium differently, the levels of these two components may, in turn, affect the macroeconomy in various ways. For these reasons, understanding the effects on growth and inflation of movements in market expectations and the global term-structure risk premium is an important aim for future research.

The third article, by David Xiao Chen, H. Evren Damar, Hani Soubra and Yaz Terajima, will be of interest to students of Canadian banking and regulation thereof:

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• This article compares different types of Canadian financial institutions by examining over time ratios that are indicators of four balance-sheet risks—leverage, capital, asset liquidity and funding.
• The various risk indicators have decreased during the past three decades for most of the non-Big Six financial institutions in our sample and have remained relatively unchanged for the Big Six banks, resulting in increasing heterogeneity in these indicators of balance-sheet risks.
• The observed overall decline and increased heterogeneity in the risk indicators follow certain regulatory changes, such as the introduction of liquidity guidelines on funding in 1995 and the implementation of bank specific leverage requirements in 2000. This suggests that regulatory changes have had significant and heterogeneous effects on the management of balance sheets by financial institutions and, given that these regulations required more balance-sheet risk management, they contributed to the increased resilience of the banking sector.

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Of particular interest is the funding ratio, defined as:

we define a funding ratio as the proportion of a bank’s total assets that are funded by wholesale funding (a relatively less stable funding source than retail (personal) deposits, for example):

Funding ratio (%) = 100 x (Non-personal deposits + repos)/Total assets.

A higher funding ratio indicates that a bank relies on greater market-based funding and is therefore more exposed to adverse shocks in the market that could disrupt continuous funding of its assets.

The Funding Ratio is of great interest due to Moody’s recent highlighting of:

the large Canadian banks’ noteworthy reliance on confidence-sensitive wholesale funding, which is obscured by limited public disclosure, increases their vulnerability to financial markets turmoil.

The BoC paper also highlights the eagerness of the politicians to inflate the housing bubble:

In addition, the growing popularity of mortgage-loan securitization in the late 1990s, following the introduction of the Canada Mortgage Bonds Program, raised the percentage of mortgage loans on bank balance sheets, especially among large and medium-sized financial institutions.(note)

Note reads: Increasing demand for mortgage loans caused by demographic shifts and lower down-payment
requirements has also played a role. See Chen et al. (forthcoming) for more details.

The authors conclude:

This article analyzes the balance-sheet ratios of Canadian financial institutions. Overall, various measures of risk have decreased over the past three decades for most non-Big Six institutions and have remained relatively unchanged for the Big Six banks. We find that smaller institutions, particularly trust and loan companies, generally have lower leverage and higher capital ratios than other types of financial institutions, including the Big Six banks. They also have larger holdings of liquid assets and face lower funding risk compared with other financial institutions. The observed overall decline and increased heterogeneity in risk (as measured by divergent trends in the leverage, capital and asset-liquidity ratios) followed certain regulatory changes, such as the introduction of liquidity guidelines on funding in 1995 (which preceded a sharp decline in, and more dispersion of, funding ratios among non-Big Six institutions) and the implementation of bankspecific leverage requirements in 2000 (which preceded a divergence in leverage ratios between the Big Six and non-Big Six institutions). This suggests that regulatory changes had significant and heterogeneous impacts on the management of balance sheets by financial institutions, resulting in the increased resilience of the banking system. While market discipline may have also played a role, more research is needed to identify changes in the degree of market discipline in the Canadian banking sector.

Given the observed variation in behaviour among Canadian financial institutions, continued analysis of different types of institutions can enable a more comprehensive assessment of financial stability. Understanding the different risks faced by various types of financial institutions improves the framework that the Bank of Canada uses to monitor developments of potential risks in the banking sector.

The statement that “This suggests that regulatory changes had significant and heterogeneous impacts on the management of balance sheets by financial institutions, resulting in the increased resilience of the banking system.” strikes me as being a little bit fishy. Regulatory change did indeed have “significant and heterogeneous impacts on the management of balance sheets by financial institutions”, but whether this resulted “in the increased resilience of the banking system.” has not been addressed in the paper. That was the intention, certainly, and may well be true, but a cause and effect relationship has not been demonstrated.

Manfred Gärtner and Björn Griesbach have published a paper titled Rating agencies, self-fulfilling prophecy and multiple equilibria? An empirical model of the European sovereign debt crisis 2009-2011. The introduction for the paper was reproduced badly on the link provided; there’s another version on Scribd:

We explore whether experiences during Europe’s sovereign debt crisis support the notion that governments faced scenarios of self-fulfilling prophecy and multiple equilibria. To this end, we provide estimates of the effect of interest rates and other macroeconomic variables on sovereign debt ratings, and estimates of how ratings bear on interest rates. We detect a nonlinear effect of ratings on interest rates which is strong enough to generate multiple equilibria. The good equilibrium is stable, ratings are excellent and interest rates are low. A second unstable equilibrium marks a threshold beyond which the country falls into an insolvency trap from which it may only escape by exogenous intervention. Coefficient estimates suggest that countries should stay well within the A section of the rating scale in order to remain reasonably safe from being driven into eventual default.

The literature review shows some controversy:

Among the first to put rating agencies into the game, in the sense that ratings might have an influence on outcomes if multiple sunspot equilibria exist, were Kaminsky & Schmukler (2002). In a panel regression they show that sovereign debt ratings do not only affect the bond market but also spill over into the stock market. This effect is stronger during crises, which could be explained by the presence of multiple equilibria. As a consequence they claim that rating agencies contribute to the instability in emerging financial markets. Carlson & Hale (2005) argue that if rating agencies are present, multiple equilibria emerge in a market in which otherwise only one equilibrium would exist. The purely theoretical paper is an application of global game theory and features heterogeneous investors. Boot, Milbourn & Schmeits (2006) arrive at the opposite conclusion: ratings serve as a coordination mechanism in situations where multiple equilibria loom. Using a rational-herd argument, they show that if enough agents base their investment decisions on ratings, others rationally follow. Since ratings have economic consequences, they emphasize that the role of rating agencies is probably far greater than that of the self-proclaimed messenger.

“Multiple sunspot equilibria”? I had to look that one up:

‘Sunspots’ is short-hand for ‘the extrinsic random variable’ (or ‘extrinsic randomizing device’) upon which agents coordinate their decisions. In a proper sunspot equilibrium, the allocation of resources depends in a non-trivial way on sunspots. In this case, we say that sunspots matter; otherwise, sunspots do not matter. Sunspot equilibrium was introduced by Cass and Shell; see Shell (1977) and Cass and Shell (1982, 1983). Sunspot models are complete rational-expectations, general-equilibrium models that offer an explanation of excess volatility.

The authors regress a nine-factor model:

• Rating
• GDP Growth
• GDP per capital
• Budget Surplus
• Primary Surplus
• Debt Ratio
• Inflation
• Bond Yield
• Credit Spread

These indicators explain 60 percent of the variance of sovereign bond ratings in our panel. All estimated coefficients possess the expected signs, though not all are significantly different from zero. Ratings are found to improve with higher income growth and income levels, or with better overall and primary budget situations. Ratings deteriorate when the debt ratio, inflation or government bond yields go up.
…
Applying the test proposed in Davies (1987), the null hypothesis of no break was rejected, and the break point was found to lie between a BBB+ and a BBB rating.23 Regression estimates for the resulting two segments are shown as regressions 2a and 2b in Table 3. The differences between the two segments are striking. The slope coefficients differ by a ratio of ten to one. While, on average, a rating downgrade by one notch raises interest rates by 0.3 percentage points when ratings are in the range between AAA and A-, which comprises seven categories, a downgrade by one step raises the interest rate by 3.12 percent once the rating has fallen into the B segment or below.

That makes sense, at least qualitatively – default probabilities are not linear by notch, according to the agencies.

Now they get to the really controversial part:

This means that at sovereign debt ratings outside the A-segment, i.e. of BBB+ or worse, a downgrade generates an increase in the interest rate that justies or more than justies the initial downgrade, and may trigger a spiral of successive and eventually disastrous downgrades. Only countries in the A-segment of the rating scale appear to be safe from this, at least when the shocks to which they are exposed are only small. However, this only applies when marginal rating shocks occur. Larger shocks, and these have not been the exceptions during Europe’s sovereign debt crisis, may even jeopardize countries which were in secure A territory. We may illustrate this by looking at the impulse responses of equation (11) to shocks of various kinds and magnitudes. This provides us with insolvency thresholds that identify the size of a rating downgrade required to destabilize the public finances of countries with a given sovereign debt rating.
…
When rating shocks last, however, as has apparently been the case for the eurozone’s PIGS members, much smaller unsubstantiated rating changes may play havoc with government bond markets and suce to run initially healthy countries into trouble, as shown in Figure 6(b). In this scenario, an arbitrary, yet persistent, downgrade by two notches would trigger a downward spiral in a country with an AA rating. Rising interest rates would call for further downgrades, which would appear to justify the initial downgrade as an apparently good forecast.

And then they get to the real meat:

A more detailed look at the dynamics of the effect of debt rating downgrades on interest rates revealed that at least for countries with sovereign debt ratings outside the A range even erroneous, arbitrary or abusive rating downgrades may easily generate the very conditions that do actually justify the rating. Combined with earlier evidence that many of the rating downgrades of the eurozone’s peripheral countries appeared arbitrary and could not be justified on the basis of rating algorithms that explain the ratings of other countries or ratings before 2009, this result is highly discomforting. It urges governments to take a long overdue close look at financial markets in general, and at sovereign bond markets in particular, and at the motivations, dependencies and conflicts of interest of key players in these markets.

This paper has S&P’s shorts in a knot, and they have indignantly replied with a paper by Moritz Kraemer titled S&P’s Ratings Are Not “Self-Fulfilling Prophecies”:

In questioning the agencies’ integrity, the authors appear to suggest that the agencies follow some hidden agenda that has led them to act “abusively”. As is usually the case with conspiracy theories, little by way of evidence or persuasive rationale is offered to explain who benefits from the agencies’ supposed “strategic” or “disastrous” downgrades. Alas, the reality is not nearly as spectacular: rating agencies take their decisions based on their published criteria and are answerable to regulators if they fail to do so.

The authors also claim that the agencies’ rating actions “cannot be justified” because they do not accord with a mechanistic “ratings algorithm” of the authors’ own devising. Apart from the fact that ratings are subjective opinions as to possible future creditworthiness (and, like other opinions, neither “right” nor “wrong”), the authors fail to justify why their algorithm has more merit than the published comprehensive methodologies of the rating agencies. Nevertheless, so persuaded are the authors of their own algorithm they admonish the agencies for “manipulating the market by deviating” from the authors’ “correct rating algorithm”!

Standard & Poor’s, for one, long ago rejected an algorithmic approach to sovereign ratings as simplistic and unable to account for the subtleties of a sovereign’s political and institutional behavior.

Even more seriously:

At the heart of the paper’s confusion is its treatment of causality and correlation. The paper suggests that investors react to rating changes by asking for higher interest rates when a rating is lowered, but provide no evidence for their claim. In fact, the authors probably cannot provide such evidence as their data set has merely an annual observation frequency. To show causality, the paper should present data that played out during a period bounded by at least two yearly observation points. With such limited data, one cannot determine what came first: rating action or interest movement, or, indeed, whether one caused a change in the other at all!
…
The suggestion that in Europe’s financial crisis, the underlying pattern was one of ratings causality is effectively contradicted by the fact that spreads did not react for several years to our downgrades (starting in 2004) of several eurozone periphery countries.
…
Until early 2009, the CDS-market traded swaps on Portugal as though it were a ‘AAA’ credit (i.e. four notches above our rating at the time). When sentiment changed rapidly, the market “downgraded” Portugal to around ‘B’ in 2010, a full eight notches below the S&P rating at the time. Suggesting that the relatively modest rating changes had caused this massive sell-off appears far-fetched.

And then they get downright nasty:

We note that under the paper’s algorithm Greece should have been downgraded by a mere 0.15 notches between 2009 and 2011. In our view, the algorithm therefore would have entirely missed the Greek default in early 2012, the largest sovereign restructuring in financial history. By contrast, far from having acted in an “arbitrary or abusive” manner, Standard & Poor’s anticipated Greece’s default well before it occurred.

The Bank of Canada has released the Bank of Canada Review – Spring 2012 with articles:

• On the Adjustment of the Global Economy
• On the Adjustment of the Global Economy
• Understanding Systemic Risk in the Banking Sector: A MacroFinancial Risk Assessment Framework
• Conference Summary: New Developments in Payments and Settlement

They have also released the June 2012 Financial System Review with articles:

• The Resolution of Systemically Important Financial Institutions
• Reducing Systemic Risk: Canada’s New Central Counterparty for the Fixed-Income Market
• An Improved Framework for Assessing the Risks Arising from Elevated Household Debt

The article by Pothik Chatterjee, Lana Embree and Peter Youngman on central clearing chants the familiar slogan:

The introduction of an appropriately risk-controlled CCP for the fixed-income market improves this market’s resilience by mitigating counterparty credit risk, thus reducing the potential for disruptions to be transmitted through the financial system.

… but does admit …

Given the centrality of the underlying market, the Bank considers that CDCS could pose systemic risk if appropriate risk controls are not in place (i.e., it is systemically important).

It has long been a puzzle to me just exactly why all these art-school dweebs who control politics and regulation are in favour of a system subject to single-point failure as opposed to a network. Can networks freeze? Sure:

During the financial crisis, the Canadian fixed-income repo market, like those in other countries, experienced periods of illiquidity as a result of lenders of cash taking measures to reduce their credit exposures to borrowers. When many lenders undertook these measures simultaneously, the amount of financing available was abruptly reduced, creating severe funding pressures in the repo market.

I always thought that reducing exposure to dubious credits was what bankers are paid to do, but I’m just old fashioned that way. I agree that sometimes this can go too far and lead to an unjustified and harmful credit lock-up, but this does not prove that single-point systems are better; if for no other reason than that is the point at which the central bank is supposed to step in and provide liquidity at above market rates – an alternative which is not discussed.

The authors also point out:

The decrease in repo activity was relatively more pronounced in Canada than in other jurisdictions, since repo business accounted for a greater share of the balance sheets of domestic banks than it did for their global competitors.

Sadly, they do not provide a business purpose for this statistic, nor do they discuss the regulatory implications of this preference.

However, they do disclose that a major source of the industry’s enthusiasm for such a move is regulatory arbitrage via elimination of the gross position:

To minimize the potential contraction of the repo market resulting from balance-sheet pressures during future stressful periods, members of the Investment Industry Association of Canada (the industry) sought ways to increase netting efficiencies in order to offset repo and reverse repo transactions on the asset and liability sides of the balance sheet.[footnote] The industry concluded that an appropriately designed CCP would allow them to reduce their balance-sheet exposures to the repo business by netting offsetting positions without changing their underlying repo activity. Using a CCP would therefore create a more resilient and efficient balance sheet that could absorb financial shocks with greater ease.

[Footnote] Without a CCP, if a bank transacts in both a repo and a reverse repo for the same security and term, but with different counterparties, both a liability and an asset are created on the bank’s balance sheet. If both trades are novated by a CCP, however, the bank would have offsetting trades with the same counterparty, allowing the counterparties to net the trades and not create separate assets and liabilities on their balance sheets.

Sure – just like netting out all deposits and loans would help shrink the balance sheet, too.

Credit risk is addressed as follows:

As depicted in Figure 3, in the event that CDCC faced a credit loss in closing out a member’s positions, the defaulter’s variation and initial margin and clearingfund contributions would be used first to absorb these losses. If this were insufficient, CDCC would use its capital to absorb the next $5 million of losses. If these funds were still not enough, residual losses would be borne by the surviving members’ contributions to the clearing fund. Members would be obliged to make an
additional “top-up” contribution to the clearing fund of up to 100 per cent of the value of their original contribution.

So clearly, another incentive to support the scheme is the ability to collectivize credit risk. You want to do a $20-billion deal with the Bank of Porky’s Corners? No problem! Other guys are worrying about credit quality and in the event of default your competitors will bear most of the cost!

But don’t worry about default. Everybody knows that a 22-year-old regulator with a degree in Medieval Horticulture and a certificate in boxtickingology can make much more judicious credit decisions than any dumb old banker.

You don’t actually have the $20-billion you’re lending to the Bank of Porky’s Corners and you have to fund it yourself with a reverse-repo? Again, no problem! You’ll be able to net out your repo positions and the offsetting transactions won’t attract any capital charge! Jack it up to the skies, man! If you can make a margin of a millionth of a beep, it’s all profitable! It’s all free money!

But that’s not the best part. The best part is:

Completion of the second phase will allow interdealer brokers to offer anonymous trading for repos cleared by the CCP, which are known as “blind” repos.

No moral hazard there, no sir!

Should all of CDCC’s private sources of liquidity be insufficient to manage a default, the Bank of Canada has the discretion to act as liquidity provider of last resort on a secured basis.

There’s no mention of this being done at a stiff premium to market (which didn’t happen during the crisis anyway).

Update, 2012-7-14: Note that the provisions for covering losses are equivalent to Unfunded Contingent Capital – whereas the BCBS speaks approvingly of pre-funded Contingent Capital and so does OSFI boss Dickson. The fact that the CCP’s notional capital is unfunded is a serious flaw in the scheme.

Mind you, though, I have no intrinsic objection to the idea of a CCP … but if it lends like a bank and borrows like a bank, it should be capitalized like a bank and regulated like a bank.

The Boston Fed has released the 11H2 Research Review highlighting:

• Public Policy Discussion Papers
  • An Economic Analysis of the 2010 Proposed Settlement between the Department of Justice and Credit Card Networks
  • Classroom Peer Effects and Student Achievement
  • Securitization and Moral Hazard: Evidence from Lender Cutoff Rules
  • Quantifying the Role of Federal and State Taxes in Mitigating Income Inequality
  • Economic Literacy and Inflation Expectations: Evidence from a Laboratory Experiment
  • Do Borrower Rights Improve Borrower Outcomes? Evidence from the Foreclosure Process
  • Account-to-Account Electronic Money Transfers: Recent Developments in the United States
• Working Papers
  • House Price Growth When Kids Are Teenagers: A Path to Higher Intergenerational Achievement?
  • Customer Recognition and Competition
  • On the Distribution of College Dropouts: Household Wealth and Uninsurable Idiosyncratic Risk
  • Trade Adjustment and Productivity in Large Crises
  • Trends in U.S. Family Income Mobility, 1969–2006
  • The Role of Expectations in U.S. Inflation Dynamics
  • Further Investigations into the Origin of Credit Score Cutoff Rules
  • Core Competencies, Matching, and the Structure of Foreign Direct Investment
  • Managing Self-Confidence: Theory and Experimental Evidence
  • Games with Synergistic Preferences
  • The Great Recession and Bank Lending to Small Businesses
  • The Great Recession and Bank Lending to Small Businesses
  • Inflation Dynamics When Inflation Is Near Zero
  • Designing Formulas for Distributing Reductions in State Aid
  • Childhood Lead and Academic Performance in Massachusetts
• Public Policy Briefs
  • Potential Effects of an Increase in Debit Card Fees
  • Inflation Expectations and the Evolution of U.S. Inflation
• Research Reports
  • State Foreclosure Prevention Efforts in New England: Mediation and Financial Assistance

The Bank of Canada has released the Bank of Canada Review: Winter 2011-12, a special issue devoted to Household Finances and Financial Stability, with articles:

• What Explains Trends in Household Debt in Canada? by Allan Crawford and Umar Faruqui
• Household Borrowing and Spending in Canada by Jeannine Bailliu, Katsiaryna Kartashova and Césaire Meh
• Medium-Term Fluctuations in Canadian House Prices by Brian Peterson and Yi Zheng
• Household Insolvency in Canada by Jason Allen and Evren Damar

Jennifer Ryan of Bloomberg reports that U.K.: Banks to Split Consumer, Investment Arms:

The U.K. will force banks to separate their investment and consumer businesses as part of its acceptance of the findings of the John Vickers-led Independent Commission on Banking, business secretary Vince Cable said.

“Tomorrow, the government is going to launch this initiative on the banks, accepting in full the Vickers commission,” he told BBC television today. “We’re going to proceed with the separation of the banks, the casinos and the business lending parts of the banks.”

Former Bank of England Chief Economist Vickers recommended in a Sept. 12 report that banks build fire breaks between their consumer and investment banks and boost the amount of loss- absorbing equity and debt they hold to between 17 percent and 20 percent. Since 2007, the government has had to spend, pledge and loan 850 billion pounds ($1.3 trillion) to rescue British banksChancellor of the Exchequer George Osborne will say in Parliament tomorrow that the government will enact the reforms stemming from the report and the Treasury will publish its response. The changes are to be implemented by 2019.

The units inside the fire breaks will include all checking accounts, mortgages, credit cards and lending to small- and medium-sized companies, the report said in September. As much as a third of U.K. bank assets, or about 2.3 trillion pounds, will be included, the document said. Trading and investment banking activities will be excluded from the ring-fence. Standard & Poor’s said Sept. 14 the elements of a bank outside the ring fence face a credit-ratings cut as they won’t be able to count on government support.

This is echoed by the Guardian and the BBC, but journalists rarely do anything more than copy each other’s press releases anyway, so whether one can use the word “confirmed” is a matter of luck.

If it’s true – and if the attempt is successfull – I’m very pleased. As I said on March 24, 2008:

As I have stated so many times that Assiduous Readers are fed up to the back teeth with the incessant drone – we want a shadow banking system! We want to ensure that there are layers of regulation, with the banks at the inner core and a shock-absorber comprised of brokerages that will serve as a buffer between this core and a wild-and-wooly investment market. This will, from time to time, require (or, at least, encourage) the Fed to step in and take action, but the alternative is worse.

The Independent Commission on Banking has a refreshingly focussed website. In his opening remarks, Sir John Vickers made the points:

Structural separation would bring three main benefits:

• it would help insulate vital UK retail banking services from global financial shocks, which is of particular importance given the way that major UK banks combine retail banking with global wholesale/investment banking;
• it would make it easier and less costly to sort out banks – whether retail or investment banks – that still got into trouble despite greater loss-absorbing capacity. This is all part of getting taxpayers off the hook for the banks; and
• it would be good for competitiveness because UK retail banking can be made safer while international standards apply to the global wholesale and investment banking activities of UK banks.

The separation is intended to take place as follows:

We are recommending a strong ring-fence – otherwise there would be little point in having one – but also a flexible one. This in essence is how it would work.

Only ring-fenced banks would supply the core domestic retail banking services of taking deposits from ordinary individuals and SMEs and providing them with overdrafts.

Ring-fenced banks could not undertake trading or markets business, or do derivatives (other than hedging retail risks) or supply services to overseas (in the sense of non-European) customers, or services (other than payments services) resulting in exposures to financial companies.

Other activities – such as lending to large domestic non-financial companies – would be allowed either side of the fence.

The aggregate balance sheet of UK banks exceeds £6 trillion – more than four times annual UK output. On the basis above, between a sixth and a third of the balance sheet would be inside the fence.

The degree of capital required for core banks will be awesome:

The other element of reform for financial stability concerns the ability of banks, especially those of systemic importance, to bear losses. On this our main recommendations are:

• that large ring-fenced banks should have equity capital of at least 10% of risk-weighted assets and corresponding limits on overall leverage;
• that the retail and other activities of large banks should have primary loss-absorbing capacity – equity plus long-term unsecured debt (‘bail-in bonds’) that readily bears loss at the point of failure – of 17%-20% of risk-weighted assets.
• Remaining unsecured debt should also bear loss on failure if necessary; and depositor preference, so that insured deposits rank above all other unsecured debt.

The complete Final Report: Recommendations weighs in at a whopping 363 pages. I am quite disappointed at the discussion of “bail-in” debt:

First, the authorities should have a ‘primary bail-in power’ to impose losses in resolution on a set of pre-determined liabilities that are the most readily lossabsorbing. This should include the ability to be able to write down liabilities to recapitalise a bank (or part thereof) in resolution.46 As described in Paragraph 4.63, the class of (non-capital) liabilities that bears loss most readily is long-term unsecured debt. The Commission’s view is therefore that all unsecured debt with a term of at least 12 months at the time of issue – ‘bail-in bonds’47 – should be subject to the primary bail-in power.
…
Second, the authorities should have a ‘secondary bail-in power’ that would allow them to impose losses on all unsecured51 liabilities beyond primary loss-absorbing capacity (again, including the ability to write down liabilities to re-capitalise a bank) in resolution, if such loss-absorbing capacity does not prove sufficient.

As I have said so many times, I strongly dislike giving “the authorities” so much discretionary power. But at least it means that bank regulators will be treated to many excellent meals when the next crisis rears its head!