PrefBlog

Scandinavians might find increased bank capital to be a mixed blessing:

Swedish regulators will require banks to set aside capital equivalent to at least 10 percent of their risk-weighted assets this year, with the minimum rising to 12 percent in 2015. The country’s four biggest banks, including Nordea, already exceed this target.
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Investors have rewarded the lenders for the perceived extra hedge against losses. It costs about 12 basis points less to insure against losses on senior notes issued by Nordea than it does for equivalent securities sold by Deutsche Bank AG, using five-year credit default swaps. Handelsbanken default-swaps trade 36 basis points lower.
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The stricter rules now being implemented across Europe will cost banks as much as 115 billion euros ($155 billion) a year, a figure that exceeds total financial industry profits for 2011, Clausen said. In response, banks need to adjust their business models and focus on “capital-light” areas that don’t burden their balance sheets, [European Banking Federation President Christian] Clausen said in an interview last month.

Many lenders have already started adjusting their business and cut jobs in retail and corporate lending to focus instead on debt underwriting. Nordea and Danske are both hiring more bankers in units that help manage corporate and agency bond sales. That’s in contrast to cuts elsewhere. Nordea is cutting 10 percent of its workforce, while Danske this month reiterated plans to eliminate 3,000 jobs.

There’s an interesting observation about the profitability of High Frequency Trading:

GETCO gets almost all its revenue from what it calls “market making,” which is essentially the high frequency trading business. In the first nine months of 2011, It brought it $714.1-million in revenue from market making. In the first nine months of last year, that had plunged 44 per cent to $398.5-million. About 68 per cent of that revenue came from equity trading.

GETCO blamed “industry specific trends such as lower market volumes and volatility across all asset classes,” as well as the fact that other players in markets are increasingly “internalizing” their orders – matching buys and sells in house – rather than sending them to markets where GETCO can trade against them. That resulted in lower market share, GETCO said.

This suggests to me that order flow – which comes from clients – is becoming more valuable. Which should, ultimately, result in even better deals for clients. Not to mention increased promotion of idiocy like stop-orders by the brokerages, and perhaps punitive surcharges for limit orders.

The Bank of Canada has released the December Financial System Review, with yet another attempt to justify the reckless imposition of central clearing for derivatives:

Canadian authorities judge that global CCPs will provide a safe, robust and resilient environment for clearing OTC derivatives, provided they comply with the CPSS-IOSCO Principles, meet the four safeguards and comply with specific recognition requirements imposed by Canadian regulators. While work on the safeguards is ongoing, Canadian authorities are satisfied with the direction and pace of the international efforts, including their implementation at global CCPs serving the Canadian market.

SwapClear, in particular, has established:

• Fair and open access: SwapClear’s access criteria ave been revised and are in line with the CPSSI-OSCO Principles and the access safeguard.[note] Five major Canadian banks have direct clearing access to SwapClear, while another is in the process of obtaining membership.
• …

Footnote reads: For example, SwapClear has reduced the minimum net capital requirement for clearing members from $5 billion to $50 million, scaled according to the risk assumed by a member. The requirement that SwapClear members hold a swap book with $1 trillion in notional amount outstanding has also been removed.

Why, the notion of Fair and Open Access just makes my heart go pitty-pat, especially when the fairness and openness of the access will be judged by bureaucrats with no skin in the game. I wonder if SwapClear will allow membership by terrorists, such as Iceland and whoever else the UK happens to be angry with next time?

It was another modestly good day for the Canadian preferred share market, with PerpetualPremiums winning 11bp, FixedResets gaining 2bp and DeemedRetractibles up 10bp. Volatility was low. Volume was above average.

The Federal Reserve bank presidents have written a comment letter on MMF reform:

As support for the Council’s proposed determination and to set the context for identifying the essential elements of reform, we briefly discuss some of the risks associated with MMFs’ activities and practices in Section I. Section II focuses on issues that should be addressed as part of any prime MMF reform proposal – most notably, suggestions for the enhancement of the accuracy of market-based net asset values (“NAVs” and each, a “NAV”), particularly in the context of Alternative 1, the Floating NAV. Section III then presents observations concerning each of the three reform alternatives included in the Proposal. Section IV briefly discusses standby liquidity fees and redemption gates and explains why these mechanisms, as proposed by some industry participants, do not meet reform requirements. Finally, we conclude by concurring with the Council’s view that more than one MMF reform alternative could address the financial stability concerns posed by MMFs, in which case fund complexes could be permitted to choose from among multiple alternatives. For example, a complex could offer both a floating NAV fund and separately a stable NAV fund with a capital buffer (and possibly coupled with a Minimum Balance at Risk (“MBR”)), from which investors could choose.

I don’t like the “Minimum Balance at Risk” proposal (discussed on August 14, 2012), but the capital buffer idea is long overdue. I am not terribly enthusiastic about their idea that a floating NAV obviates the need for a capital buffer: MMFs are banks and should be regulated that way, as I have often argued in the past.

It was a mildly positive day for the Canadian preferred share market, with PerpetualPremiums gaining 4bp, FixedResets winning 8bp and DeemedRetractibles up 7bp. Volatility was minimal. Volume was average.

IIROC has gotten away with another shake-down, this time of Deutsche Bank. I’m sure every morally upright person will be shocked – shocked! – at their misconduct:

In late July and early August 2007, the Respondent failed to engage Compliance with emerging issues in the ABCP market.

That’s it. That’s the complete section titled “The Respondent’s Misconduct”. One part of the firm didn’t talk to another. No third parties were harmed – or even affected – in any manner whatsoever.

Aquiescing to this parody of justice were The Honourable Patrick Galligan and Mr. Michael Walsh. But there’s another million smackers in IIROC’s slush fund; I’m sure the folks at FAIR Canada will be pleased.

There’s a proposal for made-in-USA DSIBs:

The bill by [U.S. Representative John] Campbell would require banks with at least $50 billion in assets to hold an additional layer of capital in the form of subordinated long-term bonds totaling at least 15 percent of consolidated assets. If an institution were to fail, the long-term bondholders would be guaranteed at no more than 80 percent of the face value of the debt. As a result, banks would face pressure to reduce their balance sheets.

The extra layer of capital would be in addition to higher levels required as part of the Basel III international regulatory accords. The goal is to protect taxpayers from bailouts and equalize the competitiveness between large and small institutions, which face higher costs of capital, Campbell said.

Campbell also proposed using credit default swaps to help gauge when regulators should step in and assess a bank’s
riskiness. Under his bill, if the price of a bank’s credit default swaps increases more than 50 basis points, the Fed would
have to take steps to assess the banks’ soundness.

“We want this layer of debt to effectively be the canary in the coal mine,” Campbell said.

His legislation would also repeal Dodd-Frank’s heightened standards for systemic institutions and its ban on proprietary trading, known as the Volcker rule. Campbell said that with additional capital requirements, a ban on proprietary trading would be unnecessary.

The Governor Jeremy C. Stein gave a speech titled Overheating in Credit Markets: Origins, Measurement, and Policy Responses:

Let me suggest three factors that can contribute to overheating. The first is financial innovation. … The second closely related factor on my list is changes in regulation. …

The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to “reach for yield.”11 An insurance company that has offered guaranteed minimum rates of return on some of its products might find its solvency threatened by a long stretch of low rates and feel compelled to take on added risk. A similar logic applies to a bank whose net interest margins are under pressure because low rates erode the profitability of its deposit-taking franchise.

Moreover, these three factors may interact with one another. For example, if low interest rates increase the demand by agents to engage in below-the-radar forms of risk-taking, this demand may prompt innovations that facilitate this sort of risk-taking.
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One reason is that your view of the underlying mechanism shapes how you think about measurement. Consider this question: Is the high-yield bond market currently overheated, in the sense that it might be expected to offer disappointing returns to investors? What variables might one look at to shape such a forecast? In a primitives-driven world, it would be natural to focus on credit spreads, on the premise that more risk tolerance on the part of households would lead them to bid down credit spreads; these lower spreads would then be the leading indicator of low expected returns.

On the other hand, in an institutions-driven world, where agents are trying to exploit various incentive schemes, it is less obvious that increased risk appetite is as well summarized by reduced credit spreads. Rather, agents may prefer to accept their lowered returns via various subtler nonprice terms and subordination features that allow them to maintain a higher stated yield.
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It is interesting to think about recent work by Robin Greenwood and Sam Hanson through this lens.14 They show that if one is interested in forecasting excess returns on corporate bonds (relative to Treasury securities) over the next few years, credit spreads are indeed helpful, but another powerful predictive variable is a nonprice measure: the high-yield share, defined as issuance by speculative-grade firms divided by total bond issuance. When the high-yield share is elevated, future returns on corporate credit tend to be low, holding fixed the credit spread. Exhibit 1 provides an illustration of their finding. One possible interpretation is that the high-yield share acts as a summary statistic for a variety of nonprice credit terms and structural features.
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As can be seen in exhibit 2, issuance in both of these markets has been very robust of late, with junk bond issuance setting a new record in 2012. In terms of the variables that could be informative about the extent of market overheating, the picture is mixed. On the one hand, credit spreads, though they have tightened in recent months, remain moderate by historical standards. For example, as exhibit 3 shows, the spread on nonfinancial junk bonds, currently at about 400 basis points, is just above the median of the pre-financial-crisis distribution, which would seem to imply that pricing is not particularly aggressive.15

On the other hand, the high-yield share for 2012 was above its historical average, suggesting–based on the results of Greenwood and Hanson–a somewhat more pessimistic picture of prospective credit returns.
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Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.
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… one lesson from the crisis is that it is not just bad credit decisions that create systemic problems, but bad credit decisions combined with excessive maturity transformation. A badly underwritten subprime loan is one thing, and a badly underwritten subprime loan that serves as the collateral for asset-backed commercial paper (ABCP) held by a money market fund is something else–and more dangerous.

This article on plastic bag bans deserves wide distribution – particularly in Toronto:

Warning of disease may seem like an over-the-top scare tactic, but research suggests there’s more than anecdote behind this industry talking point. In a 2011 study, four researchers examined reusable bags in California and Arizona and found that 51 percent of them contained coliform bacteria. The problem appears to be the habits of the reusers. Seventy-five percent said they keep meat and vegetables in the same bag. When bags were stored in hot car trunks for two hours, the bacteria grew tenfold.

That study also found, happily, that washing the bags eliminated 99.9 percent of the bacteria. It undercut even that good news, though, by finding that 97 percent of people reported that they never wash their bags.

Jonathan Klick and Joshua Wright, who are law professors at the University of Pennsylvania and George Mason University, respectively, have done a more recent study on the public-health impact of plastic-bag bans. They find that emergency-room admissions related to E. coli infections increased in San Francisco after the ban. (Nearby counties did not show this increase.) And this effect showed up as soon as the ban was implemented. (“There is a clear discontinuity at the time of adoption.”) The San Francisco ban was also associated with increases in salmonella and other bacterial infections. Similar effects were found in other California towns that adopted such laws.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums flat, FixedResets up 14bp and DeemedRetractibles off 6bp. Volatility was normal. Volume was low, with a notable presence of ENB FixedResets, which go ex-Dividend on Wednesday.

Some pension notes from the States:

Scituate, Rhode Island, population 10,329, operates a pension plan for its police department. The plan is underfunded to the tune of $8.4 million, a liability that has quadrupled since 1999. That doesn’t sound like a big shortfall until you realize that Scituate’s pension plan has only 33 participants, meaning that it is short by more than a quarter million dollars per employee.

Worse, Scituate isn’t alone. Rhode Island, with just 41 cities and towns, has 36 separate municipal pension systems, and their unfunded liabilities total more than $2.3 billion. Most, like Scituate’s, are less than 50 percent funded. Cranston, Rhode Island’s third-largest city, has funded just 17 percent of its $330 million pension liability. All but one of these plans have fewer than a thousand members.
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The more promising long-term fix, floated by some Rhode Island lawmakers including State Treasurer Gina Raimondo, is to close municipal pension plans and have one pension system for municipal workers overseen by the state government. This would build on the progress Rhode Island has made in improving its statewide pension systems, which already cover some local employees. A 2011 reform improved the largest system’s funding ratio from 48 percent to 61 percent. Benefits were restructured so that some of the risk of investment returns is shifted from taxpayers to employees.

What a great way to balance the books! Just renege on your promises!

It was a positive day for the Canadian preferred share market, with PerpetualPremiums winning 12bp (as the median YTW dipped below zero again), FixedResets gaining 1bp and DeemedRetractibles up 3bp. Volatility was normal. Volume was above average.