Forward Guidance

The Basel III Endgame | Steven Kelly on “Stable But Fragile” Banking System & Forthcoming Bank Capital Requirements

Tue Jul 11 2023

BankingCapital RequirementsRisk WeightingInterest Rate RiskHedgingUnrealized LossesBanking StabilityDeposit AttritionMoney Market FundsCredit CrunchBanking ChallengesFuture OutlookFinancial StabilityInterest Rates

Description

The episode covers new bank capital requirements, the role of capital in banking, risk weighting and interest rate risk, hedging and interest rate risk management, unrealized losses and banking stability, capitalization and accounting practices, deposits and money market funds, banking fragility and credit crunch, banking challenges and future outlook, and interest rates and financial stability.

Insights

New Bank Capital Requirements

The Federal Reserve has released new bank capital requirements, including limiting banks' use of internal models and tightening stress testing. The largest banks will see a two percentage point increase in capital, and G-SIBs will face an extra 2% capital requirement.

Interest Rate Risk Management

Banks rely on interest rate risk to live as they borrow short-term and lend long-term. They hedge by taking care of their depositors rather than relying on literal hedges. Large regional and G-sit banks have huge swap positions but do not hedge held maturity securities or loan for failure.

Banking Stability and Deposit Attrition

Unrealized losses were not the direct cause of Silicon Valley Bank's failure; it was the bank run on deposits. Deposits tied to the equity market make banks vulnerable when interest rates rise. Potential regulation may require banks to include available-for-sale losses in their capital calculations.

Deposits and Money Market Funds

Banks have seen a downward trend in deposits, with some disappearing and others being transferred into money market funds. The reverse repo facility allows funds to exit the banking system and park at the Fed. Customers are withdrawing money from banks and putting it into money market funds that invest in treasuries and use the reverse repo facility at the Fed.

Banking Fragility and Credit Crunch

The US banking system is currently stable but more fragile than in February. There are concerns about the economy, particularly commercial real estate. The most likely risk is a credit crunch, with smaller banks getting squeezed on interest rates and potentially closing.

Banking Challenges and Future Outlook

Some banks may need to issue more long-term debt to absorb losses and reduce the cost of potential bank failures. Basel 3 endgame refers to the ongoing implementation of post-2008 international banking regulations. The level at which interest rates threaten financial stability depends on the strength of the economy and other factors specific to each bank's business model.

Interest Rates and Financial Stability

The Fed's ability to raise interest rates depends on the state of the economy and credit losses. However, there is a point where funding costs and interest rate risk within the banking system become a risk themselves. Higher rates make things more fragile over time.

Chapters

New Bank Capital Requirements
Capital and Risk in Banking
Risk Weighting and Interest Rate Risk
Hedging and Interest Rate Risk Management
Interest Rate Risk and Unrealized Losses
Banking Stability and Deposit Attrition
Capitalization and Accounting Practices
Deposits and Money Market Funds
Banking Fragility and Credit Crunch
Banking Challenges and Future Outlook
Interest Rates and Financial Stability

Summary

Transcript

New Bank Capital Requirements

00:05 - 07:19

The Federal Reserve has released new bank capital requirements.
The 8 largest banks will not receive special treatment compared to other large banks.
Changes include limiting banks' use of internal models and tightening stress testing.
The new requirements will result in a two percentage point increase in capital for the largest banks.
G-SIBs will face an extra 2% capital requirement.
The new requirements are risk-weighted based capital, not total leverage ratio.
Backup capital ratios are used as a backstop due to subjective risk weights.
Reserves at the Fed were not excluded from the calculation as expected.
Changes may be reconsidered if there is another treasury market break.

Capital and Risk in Banking

06:58 - 14:17

Capital is a way for banks to fund themselves and take losses before depositors.
Banks create deposits when they make loans, increasing their leverage.
High capital levels can limit a bank's ability to intervene and make more loans.
Raising capital quickly is not feasible during a market crisis.
Deposits are crucial for banks as they provide funding for loans.
There are risk-based and non-risk-based capital requirements.
Risk-free assets like treasuries and agency mortgage-backed securities still have interest rate risk.
Total leverage is another measure of a bank's capital adequacy.

Risk Weighting and Interest Rate Risk

13:53 - 21:26

The supplementary leverage ratio is not being raised, but the risk weighting is.
Banks are being asked to reconsider and standardize how they account for their specific assets.
The idea internationally is to put a floor under banks' risk modeling.
There are no changes expected in risk rates and treasuries as the system is built around their safety.
Some banks argue that treasuries should be exempt from capital ratios since they are credit risk-free.
Treasury rating was zero in 2020, but it was exempted from non-risk weight calculation due to COVID-related market volatility.
Interest rate risk is not explicitly addressed in the capital rules, but hedging practices vary among banks.
Most of the research on interest rate risk focuses on swaps, which help mitigate liquidity risk for banks.
Banks rely on interest rate risk to live as they borrow short-term and lend long-term.
Banks hedge by taking care of their depositors rather than relying on literal hedges.

Hedging and Interest Rate Risk Management

20:56 - 28:08

Banks hedge by taking care of their depositors and offering non-monetary services.
Maintaining the deposit franchise is a hedge for banks.
Banks make more on new loans or write out fixed yield assets as they mature.
An analogy of a corn producer is used to explain hedging in banking.
If banks don't take care of their deposits, they have a huge exposed financial position on the asset side.
Asking banks to put on hedges is double hedging if they're already taking care of their depositors.
Only 6% of aggregate assets in the US banking system are hedged by interest rate swaps.
Banks commonly do not hedge held maturity assets.
The notion that banks borrow short and lend long is not entirely true due to options like callable CDs and long-term bank deposits.
The real hedge for banks lies in assumptions about weighted average deposit life and deposit beta.
Large regional and G-sit banks have huge swap positions but do not hedge held maturity securities or loan for failure.
First Republic had to borrow at a higher rate due to losing depositors, while JP Morgan has an amazing deposit franchise with low yields on liabilities.
Interest rate risk management in banking is about managing duration and quantity of liabilities, not just market rates.

Interest Rate Risk and Unrealized Losses

27:47 - 34:30

The real interest rate risk in this story is the quantity of liabilities, not the price of liabilities.
SVB and Signature bet their senior liabilities on interest rate sensitive sectors, which puts them at risk if interest rates rise.
Banks like Citigroup and Bank of America have significant unrealized losses, but they are unlikely to realize them due to their deposit franchises.
If large banks face unrealized losses on securities, it could lead to a financial crisis that would require the Fed to cut interest rates.
JP Morgan did a good job hedging their interest rate risk by not taking on a lot of interest rate risk in the first place.
Unrealized losses at large banks are unlikely to become a problem without bank runs.
The idea that unrealized bond losses caused the crisis at SVB is not true; equity investors were valuing the bank based on its reported losses.

Banking Stability and Deposit Attrition

34:20 - 41:16

Equity investors have read the 10K and valued the bank at $280 a share.
If a bank needs equity funding when its stock price is low, it can be difficult to find investors.
Warren Buffett's investment in Goldman Sachs during the 2008 crisis was a huge endorsement for the business.
Credit Suisse's biggest shareholder refusing to put in new capital led to its failure.
The crisis at Silicon Valley Bank was triggered by the bank revealing that its business was worse than expected.
Unrealized losses were not the direct cause of Silicon Valley Bank's failure; it was the bank run on deposits.
Deposits tied to the equity market make banks vulnerable when interest rates rise.
Potential regulation may require banks to include available-for-sale losses in their capital calculations.

Capitalization and Accounting Practices

40:56 - 47:52

Capital ratios for banks do not take into account business models or governance.
Including held-to-maturity securities in regulatory capital would improve the banking system's capitalization.
Accounting practices for marking assets to market may not accurately reflect banks' actual costs.
Better classification of held-to-maturity assets is needed to avoid misleading accounting practices.
Deposit attrition has been observed across banks due to tightening policies and loan maturation.
Money leaving the banking system has been flowing into money market funds.
The impact of deposit attrition and fund flows on small versus large banks is unclear.

Deposits and Money Market Funds

47:36 - 54:38

Banks have seen a downward trend in deposits, with some disappearing and others being transferred into money market funds.
In March, there were concerns over the safety of certain banks, leading to sharp withdrawals and an increase in money market funds.
Money from money market funds can find its way back to the banking system via repo or commercial paper.
The reverse repo facility allows funds to exit the banking system and park at the Fed, which has raised its cap to $160 billion.
There is a risk that reserves are not in the right place at the right time if they leave the banking system.
The decline in the reverse repo facility may be due to a transfer of money from it to the Treasury's checking account at the Fed.
$400 billion coming out of banks and going to Treasury could impact liquidity and its availability when needed.
The Fed is still doing QE while also taking reserves out of the banking system through the reverse repo facility.
Customers are withdrawing money from banks and putting it into money market funds that invest in treasuries and use the reverse repo facility at the Fed.
The Fed incentivizes this movement with interest rates and has raised limits for funds accessing the reverse repo facility.

Banking Fragility and Credit Crunch

54:09 - 1:01:09

The US banking system is currently stable but more fragile than in February.
Banks are paying more for deposits and using more market-based funding.
There are concerns about the economy, particularly commercial real estate.
The most likely risk is a credit crunch, with smaller banks getting squeezed on interest rates and potentially closing.
This risk is more of a monetary policy issue that may be difficult to solve with financial stability intervention.
There is no line of contagion to the core of the banking system, but there could be more closures of small banks.
The Federal Reserve may need to cut interest rates in response to credit crunchiness rather than a financial crisis.
Cutting rates may help ease repayment burdens and valuations in the commercial real estate market, but it won't solve toxic asset problems.
The Fed cannot directly intervene in commercial real estate like it did with money markets during the 2008 crisis.
Commercial real estate is not being used as collateral for bank funding like subprime loans were in 2008.
It's harder to draw a line from commercial real estate to money markets until there is a bank failure.

Banking Challenges and Future Outlook

1:00:50 - 1:07:45

Commercial real estate is not directly linked to money markets until a bank failure occurs.
Banks' discussion of deposit costs and consumer awareness of higher rate options will be important to watch during earnings reports.
Mergers are stabilizing but unpopular due to the consolidation of big banks, so analysts will inquire about possible acquisitions.
Some banks may need to issue more long-term debt to absorb losses and reduce the cost of potential bank failures.
Basel 3 endgame refers to the ongoing implementation of post-2008 international banking regulations, including standardization and model risk usage.
The issuance of long-term debt can be seen as a way to trick bond investors into buying equity, but it may lead to contagion during crises.
The level at which interest rates threaten financial stability depends on the strength of the economy and other factors specific to each bank's business model.
If the economy remains strong with low credit losses, the Fed can continue raising rates, but funding costs and interest rate risk within the banking system could become a risk in itself.

Interest Rates and Financial Stability

1:07:18 - 1:11:49

The Fed's ability to raise interest rates depends on the state of the economy and credit losses.
If the economy remains strong and credit losses stay low, the Fed can raise rates higher.
However, there is a point where funding costs and interest rate risk within the banking system become a risk themselves.
A precipitating event or a significant change in behavior could impact how high the Fed can go with rates.
Higher rates make things more fragile over time.
Stephen Kelly is involved with the Yale program on financial stability and writes for Without Warning Research.
The next project for Without Warning is uncertain, as it does not have a fixed publishing schedule.
Without Warning focuses on providing targeted financial insights without lengthy introductions.
Financial crises often strike without warning, hence the name of the publication.
At L-Point 1 Financial Stability, they focus on fighting financial crises and have an online platform of historical interventions to learn from past experiences.
They are currently working on policy matters related to 2023 to be better prepared for future crises.