PrefBlog

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.
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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!

SEC Chairman Mary L. Schapiro used her Remarks at SIFMA’s 2011 Annual Meeting to discuss Money Market Fund reform, a topic which I consider very important for financial stability.

Ms. Schapiro said:

While the SEC’s new money market fund reforms were a critical first step, and many voices have said “you’ve done enough,” I believe additional steps should be taken to address the structural features that make money market funds vulnerable to runs.
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As was stated in the FSOC Annual Report issued in July, the SEC – working with FSOC – is evaluating options to address the structural vulnerabilities posed by money market funds. We are focused in particular on a capital buffer option to serve as a cushion for money market funds in times of emergency and floating NAVs, which would eliminate the expectation of stability that accompanies the $1.00 stable NAV. Both of these reform options would ensure that investors who use money market funds realize the costs that might be imposed during rare market events.

The current focus on these two reform options is the result of a long and careful review conducted jointly with fellow financial regulators. In October 2010, the President’s Working Group released a Report on Money Market Funds.

The President’s Working Group report is titled Money Market Fund Reform Options and on its release:

The PWG now requests that the Financial Stability Oversight Council (FSOC), established by the Dodd-Frank Wall Street Reform and Consumer Protection Act, consider the options discussed in this report and pursue appropriate next steps. To assist the FSOC in any analysis, the Securities and Exchange Commission, as the regulator of money market funds, will solicit public comments, including the production of empirical data and other information in support of such comments. A notice and request for comment will be published in the near future.

The 2011 Annual Report of the FSOC has been discussed on PrefBlog. Anyway, back to Schapiro:

While floating NAVs would reinforce what money market funds are – an investment – and what they are not – a guaranteed product – this option poses challenges for policymakers, particularly in fostering an orderly transition from stable NAVs to floating NAVs.
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Another option, a capital buffer for money market funds, also holds promise. And much of the SEC staff’s energy, working jointly with staff from other FSOC member agencies, is focused on developing a meaningful capital buffer reform proposal. In addition, a capital buffer potentially could be combined with redemption restrictions in order to address incentives to run that may not be curtailed by a capital buffer alone.

I don’t remember seeing redemption restrictions being proposed before. Good old regulators! When in doubt, impose rationing, that’s the motto!

An express and transparent capital buffer would make explicit what for many, but not all, money market funds is implicit today: namely that there is a source of capital available to the fund in times of emergency. Today that source of capital comes from discretionary sponsor support. If a money market fund held a troubled security, for example, the fund’s sponsor – or the sponsor’s well-capitalized parent – might buy the security out of the fund’s portfolio.

Clearly such activity saved investors from losses and was in their interests. But it also had the perverse effect of lulling investors into the belief that losses were extremely remote, if not somehow impossible, due to sponsor support.
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A dedicated capital buffer, or similar structure, could provide that type of cushion. It could mitigate the incentive for investors to run since there would be dedicated resources to address any losses in the fund
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In assessing potential capital buffer structures, we are examining the pros and cons of various sources of the capital. The capital in a money market fund could come from (1) the fund’s sponsor, (2) the fund’s shareholders, or (3) the market, through the issuance of debt or a subordinated equity class. In addition, we are closely examining the appropriate size of any capital buffer. A challenge is how to establish a capital buffer that offers meaningful protection against unexpected events, without over-protecting and unnecessarily interfering with the prudent and efficient portfolio management of the fund.

Capital buffers have achieved a good level of academic support, as reported on PrefBlog in the post Squam Lake Group on Money Market Fund Regulation.

In a speech picked by Reuters, the new Republican SEC commissioner Daniel Gallagher made a speech on the topic titled SEC Reform After Dodd-Frank and the Financial Crisis:

To put a finer point on it, in light of the extensive disclosures regarding the possibility of loss, money market funds should not be treated by investors or by regulators as providing the surety of federally insured demand deposits.

So what is prompting this urgency to reform money market funds? What are the particular risks that money market funds, as currently constituted, pose to investors and to the capital markets? What problem are we solving here?

Well, as the events following the Lehman bankruptcy and Primary Reserve’s breaking of the buck showed, investors are treating money market funds as being perfectly safe – disclosures nonwithstanding. And problem is the effect on financial stability of the breathtaking run on money market funds that followed.

Like it or not, US MMFs have a huge systemic importance, as pointed out in an opinion piece by two partners at Dechert LLP (a law firm) titled How the Dodd-Frank Act Should Affect Mutual Funds, Including Money Market Funds:

Money market funds are an intermediary of short-term credit to the economy. They hold over 40 percent of outstanding commercial paper and approximately 65 percent of short-term municipal debt. Money market funds also manage a substantial portion of U.S. business short-term assets (24 percent as of 2006). As of December 29, 2010, money market funds had approximately $2.8 trillion of assets, or approximately 25 percent of all U.S. fund assets. Of the $2.8 trillion in money market funds, more than $1.8 trillion was invested in institutional money market funds.

I don’t think that there can be any doubt regarding the role played by MMFs in financial stability. But back to Gallagher:

I’ll admit that I just posed a bit of a trick question. We cannot know what risks money market funds pose unless – and this brings me to my second point – we have a clearer understanding of the effects of the Commission’s 2010 money market reforms. For some reason, much of the discussion surrounding the current need for money market reform sweeps aside the fact that the Commission has already responded to the 2008 crisis by making significant changes to Rule 2a-7. Notably, those amendments only became effective in May 2010.

The Rule 2a-7 amendments do not address the problem. Oh, they require a bit more liquidity, and they require a bit more box-ticking on credit quality – but the problem is, what if a money market fund holds a security that goes bust? There is no amount of box-ticking, no amount of analysis, that is going to eliminate that possibility.

First, I am hesitant about any form of so-called “capital” requirement, whether it takes the form of a “buffer” or of an actual capital requirement similar to those imposed on banks. Although I am not opposed to a bank-like capital requirement in principle, it is my understanding that the level of capital that would be required to legitimately backstop the funds would effectively end the industry.

His claim regarding his understanding is not footnoted, which is a shame.

However, if having sufficient capital would end the industry, then is the industry worth having? MMFs exist mainly for the purpose of doing an end-run around the banks – providing essentially the same services without having to submit to all the capital rules. In that sense, imposing a capital buffer rule that ends the industry can be seen more as a closing of a loophole than anything else.

In a very big sense, a bank with a large MMF operation can be viewed as simply having an unrecognized off-balance sheet obligation – something we’re trying to get away from!

I will note, however, that at least one industry participant has suggested the possibility of a stand-alone redemption fee. Although the details of the imposition of such a fee would need to be carefully considered, this suggestion avoids my worries about capital requirements. This minimal approach does not set up false expectations of capital protection, externalizes the costs of redemptions, and could be part of an orderly process to wind down funds when necessary. And, a meaningful redemption fee may cause a healthy process of self-selection among investors that could cull out those more likely to “run” in a time of stress. But despite my initial positive reaction to the notion of a redemption fee standing alone, grafting the fee onto a capital buffer regime will not assuage my concerns with such a capital requirement. Indeed, a combined approach retains all the problems of any capital solution, unless something significant is done to manage investor expectations regarding the level of protection provided.

His mention of a possible redemption fee has been left unfootnoted, but may be related to the paper by the Dechert partners referenced above:

The alternative suggested here is that, during a period of illiquidity, as declared by a money market fund’s board (or, alternatively, the SEC or another designated federal regulator), a money market fund may impose a redemption fee on a large share redemption approximately equal to the cost imposed by the redeeming shareholder and other redeeming shareholders on the money market fund’s remaining shareholders. For example, if redemptions in cash are expected to impact the market value of the fund’s remaining portfolio securities by an estimated dollar value or percentage, then the redeeming shareholders would be entitled to receive their principal value (i.e., the $1.00 NAV) minus the market impact that the redemptions have on the fund. Thus, during a period of declared illiquidity, a shareholder who insists upon making a large redemption of its shares would receive less than the full amount of its shares’ NAV. As soon as the declaration is withdrawn at the end of the period of illiquidity, money market funds would no longer be permitted to impose a redemption fee on redeeming shareholders and, once again, share transactions would occur at the $1.00 NAV.

I can’t say I’m very impressed with the redemption fee argument. Most importantly, it implies breaking the buck in all but name – there’s no insurance aspect to it, as there is with a capital buffer, or guarantees from a credible counterparty.

Update, 2011-12-23: Bloomberg’s editors suggest:

To add another level of security, regulators should consider one other change the industry has proposed: Allow funds to quickly close the door on redemptions when management deems it necessary. Hedge funds routinely used this lifesaver during the financial crisis. Few failed as a result. We would prefer that, instead of the industry deciding whether to shut the gate, which could leave millions of small investors in a cash crunch, the SEC make that decision in consultation with the Fed and the Treasury.

I don’t buy it. As soon as one MMF locks its doors, there will be a run on all the others. Additionally, there will be very grave effects on holders who need the money and to whom $0.98 now is worth a lot more than (maybe) $1.00 in two weeks.

The Bank of Canada has released the Financial Stability Review for December 2011 with articles:

• Risk Assessment
  • Macrofinancial Conditions
  • Key Risks
    • Global Sovereign Debt
    • Economic Downturn in Advanced Economies
    • Global Imbalances
    • Low Interest Rate Environment in Major Advanced Economies
    • Canadian Household Finances
  • Safeguarding Financial Stability
• Strengthening Bank Management of Liquidity Risk:
  The Basel III Liquidity Standards

• A Fundamental Review of Capital Charges Associated
  with Trading Activities

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Market-making activity has decreased, with U.S. primary-dealer inventories of corporate bonds falling in recent months (Chart 4).

It remains to be seen whether this is a normal reaction to the ebb and flow of trading activity, or whether the Volcker Rule – and all the other rules that have been introduced in the past few years – have permanently damaged corporate bond market liquidity.

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European banks’ access to U.S.-dollar funding has again come under mounting pressure, motivating the ECB to enhance its program to provide U.S.-dollar liquidity. Since European banks hold large amounts of assets denominated in that currency, they have a significant and persistent need for U.S.-dollar funding. This was heightened in recent months as U.S. money market mutual funds reduced their positions in European bank debt (Chart 10), shortened the maturities of their loans to euro-area banks and placed limits on overall counterparty credit exposure. In September, the ECB announced three 3-month U.S.-dollar liquidity operations, allowing financial institutions to secure financing in U.S. dollars beyond the year-end, which is typically a period when funding needs rise owing to seasonal factors. In addition, 1-week U.S.-dollar liquidity operations, which were set to expire in August 2011, have been extended until August 2012.

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With tensions in U.S.-dollar funding markets particularly acute as a result of rising counterparty concerns in Europe (Chart 11), a group of six central banks, including the Bank of Canada, took action on 30 November to extend U.S.-dollar swap lines with the U.S. Federal Reserve to 1 February 2013. The rate was lowered by 50 basis points, and the network of swap lines was expanded to include bilateral swaps among all pairs of currencies to provide financing if needed. For a number of the central banks involved, including
the Bank of Canada, the U.S.-dollar swap lines have been precautionary in nature, but the ECB has made use of its swap facility to provide U.S.-dollar financing to European banks.

So, obviously, if your requirements are killing you, the best thing to do is reduce your requirements, right? That’s what has the Canadian banks salivating:

This deleveraging is likely to be accelerated by the requirement to boost core Tier 1 capital to 9 per cent of risk-weighted assets by mid-2012, which was announced as part of the 26 October package of measures. Given market conditions, it seems likely that the higher capital ratios will be achieved at least in part through asset sales, as well as retained earnings and capital issuance. In an extreme scenario where only asset sales are used, up to €2.5 trillion of disposals would be required to raise core Tier 1 capital ratios to 9 per cent by next June as agreed to by euro-area leaders. Based on last year’s earnings, and assuming that no dividends are paid, the lower bound for asset sales would be €1.4 trillion.

Asset sales are likely to be concentrated in non-core business lines. For instance, there are reports that European banks have been selling assets in emerging-market economies.
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Some European banks are also selling U.S.-dollar assets, which has the advantage of reducing the funding-currency
mismatch that has plagued them for the past several years.

With recent quarterly results, banks have also announced a number of cost-cutting measures, including downsizing trading desks and other capital market operations. This raises the possibility of a marked decrease in their market-making activities, especially since this appears to be a strategy being used by many banks in Europe and abroad.

Somewhat surprisingly, the FSR points out that the Europeans might have shot themselves in the foot:

Positions in credit default swap (CDS) markets are used to hedge sovereign risk exposures. Since a credit event triggering payments on sovereign CDSs would entail losses for institutions that have sold credit protection, there is a risk that this could be an important channel of contagion to other markets and institutions. At the same time, the usefulness of such protection is called into question by recent proposals for voluntary writedowns of Greek sovereign debt by 50 per cent without triggering a credit event. The resulting inability to hedge exposures to sovereign credit risk could further reduce investor demand for these securities.

Cheery news for pensioners:

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… and for those (ahem!) with high exposure to insurers:

Recent market developments have had a similar negative impact on the life insurance sector. Some large Canadian insurers reported sizable losses in
the third quarter, reflecting the impact of lower interest rates, the decline in equity markets and revisions to actuarial assumptions. The recent market turmoil has also intensified sensitivities to market risk. Equity hedging strategies designed to help mitigate the impact on profit and loss will be less effective under very stressful financial market conditions to the extent that these strategies may be subject to basis and counterparty risk. These issues are especially challenging for firms that have been more aggressive in providing guarantees on investment products and in operating with greater asset-liability mismatches.

To my disappointment, the article by Grahame Johnson on capital charges in the trading book glosses over what I consider to have been the most egregious, and most easily fixed, element of regulatory failure in the run-up to the Panic of 2007: the fact that regulators do not impose a surcharge on trading book positions based on the age of those positions:

Drawing the boundary between the trading book and the banking book on the basis of intent has proven to be vulnerable to misuse. Trading intent is extremely difficult
either to define or to enforce; as such, there is a risk that some assets that might not be readily tradable (or hedgeable) will be held in the trading book. As well, there is a potential for regulatory arbitrage, where firms move positions into whatever classification provides the most favourable capital treatment.

This incentive to move positions can work in both directions. For example, credit exposures generally require a lower amount of capital if held in the trading book (given the use of internal models that allow for the benefits of hedging). This provides a strong motivation to securitize credit and hold it in the trading book, even if it is ultimately impossible to sell the exposure. The banking book, on the other hand, does not require assets to be marked to market, which would allow institutions to avoid recognizing (temporary) losses. For securities that have seen sharp declines in market price (which the bank views as temporary), there is an incentive to move these positions to the banking book, where the short-term loss would not have to be recognized. Highly rated sovereign government bonds present an example of this second arbitrage opportunity. In a volatile market, a portfolio of high-grade sovereign bonds could require a significant capital charge in the trading book (based on movements in the market price of the bonds); yet if the holding was moved to the banking book, the securities would have a risk weight of zero and would therefore require no capital.

In addition, long term readers will remember that I also advocate a certain separation of function: banks should declare whether they are primarily traders or primarily bankers, and face a surcharge on their capital requirements for their secondary function.

The Bank of Canada has released the Bank of Canada Review: Autumn 2011 with major articles:

• The International Monetary System: An Assessment and Avenue for Reform
• Liquidity Provision and Collateral Haircuts in Payments Systems
• Extracting Information from the Business Outlook Survey: A Principal-Component Approach
• Modelling the Counterfeiting of Bank Notes: A Literature Review

The second article, on Liquidity provision, is by James Chapman, Jonathan Chiu and Miguel Molico, all of whom are bank employees. They explain:

The study presented in the following section argues that the central bank’s haircut policy can therefore directly affect liquidity in these markets and indirectly influence market participants’ choice of asset portfolios, as well as the pricing of credit and liquidity spreads. The central bank is concerned not only about its own exposure to credit risk, but also about the efficiency and stability of the financial system. Consequently, in setting its haircut policy, the central bank must consider the impact of the policy on the financial system and its participants.

A growing need for high quality collateral is forecast:

Policy-makers also face the challenge of a growing demand for high-quality collateral. Modern financial systems tend to utilize more collateral because of the increased private use of collateral, and because of the need to post additional collateral with payment and settlement systems. The G-20 countries committed to have all standardized over-the-counter derivatives contracts cleared by central counterparties (CCPs) by the end of 2012 to help strengthen the global financial system. Such an increase in CCP activity has the potential to increase the need for collateral. In addition, revisions to the core principles for financial market infrastructure, currently being considered by the Bank for International Settlements’ Committee on Payment and Settlement Systems and by the International Organization of Securities Commissions, will further increase the demand for collateral by financial market participants. The haircuts set by central banks are important parameters in determining the ability of financial systems to make the most efficient use of high-quality collateral.

The Bank of England has released its 2011Q3 Quarterly Bulletin with the following research articles:

• The United Kingdom’s quantitative easing policy: design, operation and impact
• Bank resolution and safeguarding the creditors left behind
• Developments in the global securities lending market
• Measuring financial sector output and its contribution to UK GDP
• The Money Market Liaison Group Sterling Money Market Survey
• Summaries of recent Bank of England working papers
  • An estimated DSGE model of energy, costs and inflation in the United Kingdom
  • The impact of permanent energy price shocks on the UK economy
  • Evolving UK and US macroeconomic dynamics through the lens of a model of deterministic structural change
  • Preferred-habitat investors and the US term structure of real rates

I was very interested in the second article, as it contains a defense of Special Resolution Regimes relative to bankruptcy; the politicians favouring of the former at the expense of the latter is a particular hobby horse of mine:

Commencement of insolvency leads to a freeze in the bank’s ability to make payments, which effectively results in the end of its business.(2) The sudden severing of these interconnections between a bank and the rest of the financial system and wider economy can have highly undesirable systemic effects. Individuals and small companies are entitled to compensation by the Financial Services Compensation Scheme (FSCS) for the first £85,000 of their deposits. But even a relatively short delay in the time needed by the FSCS to process and pay many deposit insurance claims can lead to hardship for households and businesses left temporarily without access to their savings. Disruption of this kind can undermine depositor confidence, potentially triggering contagion to other banks and endangering financial stability.

This fear on the behalf of depositors is a red herring. The authors would have us believe that delays by the deposit insurance corporation are inevitable, while delays by Special Resolution bureaucrats are non-existent.

The legal power to transfer some or all of the business of a failed bank to another company lies at the core of the United Kingdom’s SRR and of most other bank resolution regimes around the world.[Footnote]

Footnote reads: The transfer powers are called ‘stabilisation powers’ in the United Kingdom’s SRR and a ‘purchase (of assets) and an assumption (of liabilities)’ in the United States. The United States has had a bank resolution authority since 1933 and Canada since 1967. Transfer powers have also existed in Italy for some time and have been recently adopted in Germany.

I see no reason why these transfer powers can’t be incorporated into the regular bankruptcy process as a special case for defined institutions. Given bankruptcy, the regulator steps in as receiver and splits the bank with the objective of making the “Good Bank” as small as possible consistent with the purpose of maintaining financial stability. The “Bad Bank” holds all the common shares of the Good Bank and may sell them at leisure, although it may wish to do so on the weekend. I don’t see that this is different in practice from the aims of special resolution, or inconsistent with existing bankruptcy law. All that’s needed is an adjustment to bankruptcy law allowing this to happen when (i) the failed company is a bank and (ii) the receiver is the regulator.

Creditors, such as bondholders or other wholesale funders, that the resolution authority may have decided to leave behind in the residual bank do not enjoy these benefits [of being creditors of a solvent firm]. They must claim instead for repayment of their debts in the bank’s insolvency. But as is shown in the box on page 217, a decision to split the balance sheet in a way that fully protects depositors and certain other creditors could, on the face of it, put those creditors left behind in a potentially worse position than had the transfer powers never been used and the bank had been left to go through normal insolvency.

One reason for this lies in the fact that, under UK insolvency law, depositors in the United Kingdom rank equally — or ‘pari passu’ — with other ordinary senior creditors and therefore should share any losses equally between them.[Footnote]

Footnote reads: This contrasts with some other jurisdictions, most notably the United States, where depositors rank ahead of the other creditors (so-called ‘depositor preference’).

Seems to me that if the problem is the seniority of depositors, this is most easily addressed through legislation changing the seniority of depositors. You don’t need a Special Resolution Regime to do that. Another means of achieving the same end is for the deposit insurer to put up all the funds required to cover to the insured depositors and give the insurer and the uninsured depositors a senior claim in the Bad Bank.

The authors conclude, in part:

Bank special resolution regimes are designed to address systemic risks caused by bank failure while freeing the public authorities from the dilemma of having to use public funds to bail out all of a bank’s creditors. By doing so, they offer benefits to a financial system not only at the point of use but more generally through their effect on the behaviour of banks and their creditors.

There’s nothing here that can’t be addressed by small adjustments to existing bankruptcy law. However, the most objectionable part of the article is contained in the box which describes their plans for adusting the resolution regime:

Augment the existing SRR by developing ways to restructure a firm’s balance sheet without splitting it into separate parts. There is currently much discussion around the possible use of a ‘bail-in’ tool to write down or convert into equity some classes of unsecured debt of a firm in resolution. This would enable the resolution authority to allow losses to fall on some creditors by reducing the value of their claims on the firm without having to deal with the operational and legal consequences of transferring some of the business to a purchaser. The practical benefits of such an approach may be significant articularly when dealing with large and complex banks with huge numbers of counterparties and contracts governed by different laws.

This business of giving the resolution authority the ability to change the seniority of claims in an insolvency by fiat, instead of in accord with existing bankruptcy law, is what really sticks in my craw. Discretionary “bail-in” provisions at the whim of the regulator are an affront to the rule of law.

The other article I found of interest was “Developments in the global securities lending market”, but this was a review of the topic and how it is changing, with little that was particularly new or controversial.

The Bank of Canada has released a working paper by Anna Pomeranets and Daniel G. Weaver titled Security Transaction Taxes and Market Quality:

We examine nine changes in the New York State Security Transaction Taxes (STT) between 1932 and 1981. We find that imposing or increasing an STT results in wider bid ask spreads, lower volume, and increased price impact of trades. In contrast to theories of STT imposition as a means to reduce volatility, we find no consistent relationship between the level of an STT and volatility. We examine the propensity of traders to switch trading locations to avoid the tax and find no consistent evidence that they will change locations. We do find evidence to suggest that taxes imposed on the par value of stock will result in corporations managing the par value in the direction of minimizing the impact of the tax on investors.

Section II of the report, “Regulatory History”, give a highly entertaining account of the history of STT with the New York state government attempting to collect as much revenue as it could, with the affected companies, investors and competitors attempting to minimize the figure. A lot of time, and highly skilled time at that, must have been burned up in these games – which is the most insidious effect of a targetted tax.

Similar fun and games have been observed elsewhere, particularly with respect to preferred shares, as discussed on the blog in the post Par Value.

The literature review in section III traces the debate from the beginning:

The earliest proponents of STTs, Keynes (1936) and Tobin (1978), argue that an STT will improve market quality. In particular, Keynes contends that chasing short-term returns, while potentially profitable to specific individuals, is a zero-sum game in terms of economic welfare. Since one investor’s gain is another’s loss and trading utilizes resources, the value-added through trading is negative. As a result, imposing an STT may increase welfare by reducing wasted resources. Second, since trading is speculative by nature, it potentially contributes to financial instability when trades are driven by short-term capital gains and not fundamental information. Keynes argues that an STT will curtail short-term speculation, and thereby reduce wasted resources, market volatility and asset mispricing. Consistent with Keynes, Tobin (1978) proposes a tax on foreign exchange transactions that would make short term currency trading unprofitable. He suggests that a transaction tax would “throw some sand in the wheels of speculation.”

I have a bit of a problem with this. In the first place, speculators help long term investors by providing liquidity when they wish to buy and sell; in the second place, market prices are a very important signal to issuers, who can choose to start new companies or issue additional stock in accordance with the prices. A dramatic (if rather unfortunate) example of this was the Tech Boom of the late 1990’s, in which all kinds of companies were able to get financing thanks to the influence of speculators on the price of Internet stocks. All good things can be taken too far!

After examining the data, the authors conclude (in part):

Our findings largely come down on the side of opponents of the tax who suggest that an STT will harm market quality. Since spreads have been shown to be directly related to a firm’s cost of capital, imposing an STT may hinder economic growth by reducing the present value of projected profits.

The Bank for International Settlements has released a working paper by Mathias Drehmann, Claudio Borio and Kostas Tsatsaronis titled Anchoring countercyclical capital buffers: the role of credit aggregates:

We investigate the performance of different variables as anchors for setting the level of the countercyclical regulatory capital buffer requirements for banks. The gap between the ratio of credit-to-GDP and its long-term backward-looking trend performs best as an indicator for the accumulation of capital as this variable captures the build-up of system-wide vulnerabilities that typically lead to banking crises. Other indicators, such as credit spreads, are better in indicating the release phase as they are contemporaneous signals of banking sector distress that can precede a credit crunch.

They explain:

We find that the variable that performs best as an indicator for the build-up phase is the gap between the ratio of credit-to-GDP and its long-term trend (the credit-to-GDP gap). Across countries and crisis episodes, the variable exhibits very good signalling properties, as rapid credit growth lifts the gap as early as three or four years prior to the crisis, allowing banks to build up capital with sufficient lead time. In addition, the gap typically generates very low “noise”, by not producing many false warning signals that crises are imminent.

The credit-to-GDP gap, however, is not a reliable coincident indicator of systemic stress in the banking sector. In general, a prompt and sizeable release of the buffer is desirable. Banks would then be free to use the capital to absorb writedowns. A gradual release would reduce the buffer’s effectiveness. Aggregate credit often grows even as strains materialise in the banking system. This reflects in part borrowers’ ability to draw on existing credit lines and banks’ reluctance to call loans as they tighten standards on new ones. A fall in GDP can also push the ratio higher. Aggregate credit spreads do a better job in signalling stress. However, their signal is very noisy: all too often they would have called for a release of capital at the wrong time. Moreover, as spread data do not exist for a number of countries their applicability would be highly constrained internationally.

We conclude that it would be difficult for a policy tool to rely on a single indicator as a guide across all cyclical phases. It could be possible to construct rules based on a range of conditioning variables rather than just one, something not analysed in this paper. However, it is hard to envisage how this could be done in a simple, robust and transparent way. More generally, our analysis shows that all indicators provide false signals. Thus, no fully rule-based mechanism is perfect. Some degree of judgement, both for the build-up and particularly for the release phase, would be inevitable when setting countercyclical capital buffers in practice. That said, the analysis of the political economy of how judgement can be incorporated in a way that preserves transparency and accountability of the policymakers in charge goes beyond the scope of this paper.

It’s a lucky thing that judgement is required for the process to work – otherwise there might be layoffs in the regulatory ranks! It’s also a lucky thing that details regarding the incorporation of judgement are beyond the scope of the paper, as otherwise one might have to examine the track record of the regulatory establishment in predicting crises.

I suggest that incorporating the judgement of the regulators into the process will have numerous effects:

• Increasing politicization of the regulatory bureaucracy
• Fewer crises (since the regulators will tend to err on the side of caution)
• More severe crises (since the range of judgments existing in the private sector will be replaced by a one-size-fits-all judgment imposed according to the fad of the day)
• increased uncertainty during a crisis, as both the sellers and the buyers of new bank capital will be unsure as to whether or not the buffers will be released.

I suggest that eventually we will regret the role of regulatory judgement to the extent that it is incorporated into the process.

I believe that the release of countercyclical buffers should be linked to the amount by which a bank’s write-offs have exceeded the norm for the past one (maybe two?) years. This would encourage (or at least mitigate the discouragement) of recognition of losses and provide a time limit for raising replacement capital (since the release will be effective for only one (maybe two) years.

The authors considered using bank losses as the anchor (building-up) indicator:

Aggregate gross losses: This indicator of performance focuses on the cost side (non-performing loans, provisions etc). The financial cycle is frequently signalled by the fall and rise of realised losses.

Although the use of this signal is not supported by the raw data, I suggest that:

• It provides the most logical link to the condition that one is trying to alleviate, and
• the knock-on effect of such a change (i.e., the way in which behaviour will be adjusted to account for the adjustement in rules) is in this case highly desirable – losses will be recognized faster.

As the authors’ graph shows, there’s no magic formula for predicting a bank crisis:

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Although the credit-to-GDP gap is the best-performing indicator for the build-up phase, Graph 2 indicates that it declines only slowly once crises materialise. This is also borne out by the statistical tests shown in Tables 5 to 7. As before, bold values for “Predicted” highlight thresholds for which a release signal is issued correctly for at least 66% of the crises. The bold noise-to-signal ratio indicates the lowest noise-to-signal ratio for all threshold values that satisfy this condition.

None of the macro variables and of the indicators of banking sector conditions satisfy the required degree of predictive power to make them robust anchor variables for the release phase, ie none of these variables signals more than 66% of the crises. The best indicator is a drop of credit growth below 8%. This happens at the onset of more than 40% of crises and such a signal provides very few false alarms (the noise-to-signal ratio is around 10%).

A backtest of the Credit Gap as an anchor variable is encouraging:

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Part of the authors’ conclusion is:

The analysis shows that the best variables to signal the pace and size of the build-up of the buffers differ from those that provide the best signals for their release. Credit, measured by the deviation of the credit-to-GDP ratio from its trend, emerges as the best variable for the build-up phase, as it has the strongest leading indicator properties for financial system distress. A side-benefit of using this variable as the anchor is that it could help to restrain the credit boom and hence risk taking to some extent.
…
A final word of caution is in order. Are our empirical results subject to the usual Lucas or Goodhart critiques? In other words, if the scheme proved successful, would the leading indicator properties of the credit-to-GDP variable disappear? The answer is “yes”, by definition, if the criterion of success was avoiding major distress among banks. As credit exceeds the critical threshold, banks would build-up buffers to withstand the bust. If, in addition, the scheme acted as a brake on risk-taking during the boom, the bust would be less likely in the first place. However, the answer is less clear if the criterion was the more ambitious one of avoiding disruptive financial busts: busts could occur even if banks remained reasonably resilient. In either situation, however, the loss of predictive content per se would be no reason to abandon the scheme.

One thing I will note is that it may be helpful to disaggregate the accumulation signal. As has previously been reported on PrefBlog, residential real-estate now makes up more than 40% of Canadian banks’ credit portfolios, vs. the more normal 30%. I suggest that it would be useful to examine the components of the credit gap, in the hopes that one or more of them will prove a better signal than the complete set.

It may also be the case that changes in the proportion of various components of aggregate credit are just as important as the aggregate amount itself – these changes could be indicative of dislocations in the economy that will have grievous effects if, as and when they return to normal.

The Bank of Canada has released the Summer 2011 Bank of Canada Review:

This special issue, “Real-Financial Linkages,” examines the Bank’s research using theoretical and empirical models to improve its understanding of the linkages between financial and macroeconomic developments in the wake of the recent global financial crisis.

Very important, I know – and it’s what the Bank’s job is all about! – but not my favourite topic.

Articles are:

• Introducing Multiple Interest rates in ToTEM
• The BoC-GEM-Fin: Banking in the Global Economy
• Bank Balance Sheets, Deleveraging and the Transmission Mechanism
• Mortgage Debt and Procyclicality in the Housing Market
• Developing a Medium-Term Debt-Management Strategy for the Government of Canada

I found the last article, by Marc Larson and Étienne Lessard, to be too general to be satisfying, but there were some interesting points:

Step 3 – Selecting optimal strategies In this step, a wide range of different financing strategies are reviewed, some of which may involve issuing debt in only some maturity sectors but not others. An optimization algorithm is then used to select those strategies with the best cost-risk tradeoffs, or the lowest cost for a specific level of risk. The output of this work is a curve that represents the most efficient financing strategies, similar to an efficient portfolio frontier, as well as the composition of the most efficient financing strategies.

Chart 2 and Chart 3 illustrate the results of the optimization exercise based on debt rollover as a risk measure. Note that the same exercise can also be performed using other risk measures. Chart 2 shows the efficient frontier of the optimal debt structures (lowest cost for a specific level of risk). Moving along this frontier from left to right shows how expected borrowing costs decrease—and rollover risk increases—as the government shifts the proportion of its borrowing program from long-term debt to shortterm debt. Chart 3 illustrates how the proportion of short-term debt in the optimal portfolio changes as one moves along the efficient frontier. Each colour represents a different debt instrument issued by the Government of Canada. As shown in this chart, low risk debt structures contain mainly long-term maturity instruments (10-year and 30-year nominal bonds and Real Return Bonds), while high-risk debt structures contain mostly short-term debt instruments (3-, 6- and 12-month treasury bills and 2-year bonds).

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I find the relationship between efficient amounts – as defined – of long nominals vs. RRBs to be fascinating. I suppose part of the reason for the relationship is that they are considered to have similar cost, but a big chunk of the RRB return is paid only on maturity; therefore they will have a lower quarterly rollover rate (less risk) at the same [relationship of] cost. Maybe! I’d have to look at the model in more detail!

However, rest assured that I will be quoting the bank’s conclusions on risk to support my “security of income” vs “security of principal” argument until you are all heartily sick of it, never fear! The risk of variance of investor’s income is exactly the flip side of the risk of variance of the Bank’s expenses.

The article on bank balance sheets by Césaire Meh uses a model to derive interesting relationships between counter-cyclical capital buffers and monetary policy. Note that “(demand-type) financial shocks … generate simultaneous downward pressures on inflation and credit contractions.” – i.e., a standard recession,while “(supply-type) financial shocks … cause credit contractions and upward inflation pressures,” i.e., a financial crisis / credit crunch:

Overall, these results suggest that the impact of countercyclical capital buffers on the transmission mechanism of monetary policy and, consequently, the nature of the coordination between these two tools, depend on the nature of the shocks experienced by the economy. Demand-type financial shocks pose no inherent trade-offs between stabilizing credit and achieving price stability. In this case, the use of countercyclical capital buffers eases the pressure on monetary policy, and less-aggressive movements in the interest rate would be required to achieve economic stability. Supply-type financial shocks, however, can generate a tension between stabilizing credit and price stability. In this case, activating countercyclical capital buffers could make it harder to stabilize inflation, and more-aggressive movements in the interest rate would be required. Under such circumstances, proper coordination between the two policy instruments will lead to a better policy outcome. [Footnote]

Footnote: Countercyclical capital buffers should be considered neither a substitute for monetary policy nor an all-purpose stabilization instrument. Rather, they should be viewed as a useful complement to monetary policy in a world in which financial shocks have become an important source of economic fluctuations.

The Bank of Canada has released a working paper by Jason Allen, Ali Hortaçsu and Jakub Kastl titled Analyzing Default Risk and Liquidity Demand during a Financial Crisis: The Case of Canada:

This paper explores the reliability of using prices of credit default swap contracts (CDS) as indicators of default probabilities during the 2007/2008 financial crisis. We use data from the Canadian financial system to show that these publicly available risk measures, while indicative of initial problems of the financial system as a whole, do not seem to
correspond to risks implied by the cross-sectional heterogeneity in bank behavior in short-term lending markets. Strategies in, and reliance on the payments system as well as special liquidity-supplying tools provided by the central bank seem to be more important additional indicators of distress of individual banks, or lack thereof than the CDSs. It therefore seems that central banks should utilize high-frequency data on liquidity demand to obtain a better picture of financial health of individual participants of the financial system.

Essentially, the paper provides further evidence that the bond market is excitable:

In contrast to public measures of bank risk (such as CDS prices), which varied widely both crosssectionally and in the time-series, we show that Canadian banks’ bidding behavior in the liquidity auctions as well as their behavior in the payment system and overnight interbank market was largely indicative of low risk. The fact that overnight market remained quite active throughout the crisis – total loans transacted stayed virtually unchanged while prices actually fell – indicates that participants did not believe there were significant liquidity or counterparty risks. Similarly, Afonso, Kovner and Schoar (2010) find that the overnight Feds Fund market remained active following the collapse of Lehman Brothers, although they do find evidence of increased counterparty risk. We argue that the impact of various liquidity-providing actions undertaken by the cental bank and federal government during 2008 might have led to a surplus of liquidity in the market, resulting in overnight unsecured loans transacting even below the target rate. In contrast, we find that during the asset-backed commercial paper (ABCP) crisis in the summer of 2007, when these extraordinary liquidity facilities did not exist, interbank rates did increase. Similar to Acharya and Merrouche (2010) this suggests liquidity was more scarce at this time. In neither episode, however, do we find evidence of an increase in counterparty risk.
…
We will provide evidence that in the case of Canadian financial institutions, for which CDS spreads varied substantially both in the cross-section and in the time series, the corresponding variation in the short-term spreads was lacking. We will argue based on further indirect evidence that it therefore seems that in case of fairly illiquid CDS markets, the short term spreads recovered from the bidding behavior in liquidity auctions may provide a more useful source of information about counterparty risk and potential financial trouble in the turbulent times of a crisis.
…
The situation in Canada was remarkably different. While the default probabilities of individual banks implied by the prices of their respective CDS contracts followed a similar pattern as their European counterparts, the Canadian banking system showed very limited signs of stress (or increase in liquidity demand) in 2007 and in the first half of 2008. In particular, the Canadian banks were much less willing to pay a premium above the reference overnight rate to obtain liquidity from the Bank of Canada. Figure 4 depicts the aggregate bidding functions in each auction that the Bank of Canada conducted before September 2008. It suggests that virtually all banks judged that even if they would not have their demands in these auctions satisfied, they could secure the liquidity elsewhere and hence were bidding at, or very close to, the reference overnight rate (OIS).

Using the standard
formula (see e.g., Hull (2007)):

Pr (Default 5y)_T = 100 * (1 – (1/(1 + (cds_T /10000)/(1 – recovery))^T ))

we can recover the risk-neutral default probabilities implied by the CDS prices. For the largest institutions, banks A,E and K, the implied default probabilities (assuming 40 per cent recovery rates) went from close to zero to over 15 per cent. Given the increase in default risk implied by the CDS contracts on the banks in our sample we might expect an increase in liquidity hoarding during the crisis.

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