by Alasdair Macleod, GoldMoney:
With price inflation rising out of control and interest rates rising strongly, the trading environment for commercial banks has fundamentally changed. With bad debts looming and bond prices in entrenched downtrends, procrastination is now the enemy of bankers.
We are at the beginning of The Great Unwind, and this article elaborates on my first article for Goldmoney on the subject published here.
The imperative for bankers to respond to these conditions overrides all other matters if their businesses are to survive these changed conditions. We are entering a cyclical downdraft of the bank credit cycle which promises to be cataclysmic. And the monetary policy planners at the central banks can do nothing to stop it.
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After outlining the scale of the problems faced by each global systemically important bank, this article looks at the future for the $600 trillion derivatives mountain. It was born out of the long-term decline in interest rates from the mid-eighties, which ended last year. It is almost entirely distributed through banks and shadow banks.
The question to address is, what is the future for the derivative mountain, now that the long-term trend for falling interest rates is over? And what are the economic consequences?
If it’s you in the hot seat…
Imagine, for a moment, that you are the CEO of a commercial bank involved in lending to businesses and with profit centres acting in a range of financial activities. As CEO, you are answerable to the board of directors for the bank’s performance, and ultimately the bank’s shareholders for maintaining and advancing the value of their shares.
Furthermore, let us set this imaginary exercise in the present. These are the issues that should keep you awake at night:
- In common with your competitors, the ratio of your balance sheet assets to total equity is almost the highest in the history of the bank, in many cases for other banks over twenty times leaveraged.
- Official inflation, measured by the CPI is about ten per cent, and producer prices are rising somewhat faster. Your central bank expects a return to the 2% target in two- or three-years’ time. But your contacts at the central bank have privately admitted to you that they cannot imagine the circumstances where this would be true without a deep recession.
- Bond yields are rising, and losses are beginning to impact on the bank’s investments. The bank has relatively little direct exposure to corporate bonds and equities, but they are commonly held as collateral against customer loans.
- How are higher interest rates impacting the quality of the bank’s loan book? The bank supported its business customers through the covid pandemic, which increased the indebtedness of them all. This exposes the bank to excessive default risk if rates rise further.
- The mortgage loan book has been a profitable business for decades. But the bank is beginning to see a material rise in delinquencies. If loan guarantees are not forthcoming from government agencies, the bank may have to shut this activity down.
- What impact will higher interest rates have on the bank’s derivative exposure? What are the counterparty risks in derivative chains? Derivatives that involve inadequately capitalised counterparties should perhaps be sold on, or where the bank has the option to do so, closed down.
The underlying problem is that the conditions that led to the bank becoming increasingly involved in diversified activities, such as investment banking, trading, and investment management have now changed. Since financial deregulation in the 1980s, the bank has expanded into these profitable areas. The whole industry moved from dealing in credit into generating fee income. The growth in fee income can be directly related to the long-term trend of falling interest rates, which apart from interruptions such as the dot-com excesses and the Lehman crisis, stimulated growth in corporate finance, underwriting, investment management, and trading in financial securities. The expansion of these activities in turn led to a massive expansion of derivative markets, with new instruments being devised, such as credit default and interest rate swaps.
If, and this is really what should worry you, the long-term trend of falling global interest rates has ended and is now set to be reversed, not just temporarily but for the rest of the decade and perhaps beyond, then the reasons justifying the bank’s expansion away from its core lending business have come to an end. As CEO, how do you unwind the deep-rooted departmental interests, and keep the shareholders onside?
It is time for the whole executive to be urgently involved in a wide-ranging debate about how serious these threats might be and where you should take actions to protect the bank’s shareholders’ interests. Given the high level of balance sheet leverage, the bank’s survival is at stake if you act indecisively or too slowly. You are facing head-on the unpleasant prospect of The Great Unwind.
Balance sheet ratios
There are two ratios that concern bankers. The first is the relationship between liquid and illiquid assets with respect to sources of balance sheet funding. These are set by regulators through Basel regulations, now in their third iteration. Banks are required to submit details of their balance sheets periodically to bank regulators in accordance with the net stable funding requirement formula as set out in Basel III.
The second ratio is of less importance to regulators, which is the relationship between Tier 1 capital and the total balance sheet, which Basel regulations simply states that the maximum leverage ratio is for Tier 1 capital to not be less than 3% of the bank’s balance sheet assets. Put another way, subject to certain conditions, a bank can theoretically leverage its assets to equity as much as thirty-three times. But it should be noted that within that leverage ratio, a bank is permitted to net off certain classifications of credit, reducing its apparent balance sheet size. The following are examples of hidden forms of balance sheet assets and liabilities:
- Security financing transactions, which include repos and other derivatives, can be netted off where they are between the same counterparty and maturity. For a true accounting picture, a bank balance sheet should reflect credit and debt obligations on both sides of its balance sheet until they are extinguished.
- Long and short credit derivatives can be netted so long as there is no maturity mismatch. Again, the full obligations should be reflected on both sides of the balance sheet. And valuation methods give banks enormous wriggle room, an issue which regulators are unable to properly address.
- Off-balance sheet items are only partially recognised through standardised credit conversion factors. Where a bank has off-balance sheet activities, they should be properly reflected in its accounts.
Therefore, true bank balance sheet leverage can be considerably greater than a bank complying with Basel regulations will declare in its audited accounts. But while conforming with Basel regulations, the board of a bank has a primary duty, often forgotten even by some directors, to their shareholders.
It is changes in the ratio between a bank’s assets and its shareholders’ equity which drive the cycle of bank credit expansion and contraction, which in turn drives the business cycle.
While they have a specific expertise in assessing lending risk, bankers are human. When they perceive lending risk to decline, they increase the quantity of credit offered, recorded as assets on their bank balance sheets, without increasing shareholders’ equity. Their confidence is synchronised through individual banks’ market intelligence and commonly available information concerning lending conditions. What few bankers realise is that it is expansion of their cohort lending which creates the very confidence in the lending conditions being observed.
The benefit to the bank is enhanced by expanding the ratio of total balance sheet assets to shareholders’ equity. A gross lending margin of two per cent becomes 20% for the shareholders on a balance sheet ten-times leveraged. However, this depends on margins being maintained, which, when banks compete with each other for lending business, is unlikely. Furthermore, the trend for declining rates over the decades due to the policies of the monetary authorities has led to a general increase in shareholder leverage as banking cohorts try to maintain profitability on slimming margins.
We all know that this recently reached an extreme position, with unnaturally negative interest rates imposed by central banks principally in Japan, the Eurozone, and Switzerland. In response to heavily compressed rate margins, the large commercial banks in the Eurozone were leveraging up through repos to gear up the slimmest of lending margins. The European repo market has been rolling over in excess of €9 trillion in all currencies with euros the largest component by far.
