New regulations introduce new risks
admin | November 2, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Post-crisis consolidation and new regulatory regimes created a trend towards homogenization among the largest banks. Higher capital charges and liquidity provisions had a number of unintended consequences, which include a barbell of risk in bank portfolios amidst an erosion of commercial lending. Liquidity risk is a mounting concern as banks adapt to a transition away from LIBOR. These and other topics were discussed by industry experts and regulators at the “US Banking Forum” hosted by the Financial Times on November 1st.
Post-crisis regulatory regimes
Consolidation among financial institutions and evolving regulations drove banks to adapt their business models in the post-crisis world. These changes were reviewed by the head of supervision from the Federal Reserve.
Largest banks have grown to look the same
In an earlier era, the largest institutions were specialists in certain business lines, and competed with a smaller pool of peers. Now that the largest brokers have been acquired by banks or have themselves become banks, the business models of the SIFI banks more closely resemble each other than at any point in the past. While this has a number of concerning secondary problems, the question the Fed is focused on is whether this “homogenization” of the big banks has made a less efficient system.
Capital rules had unintended consequences
As is the case with many laws or regulatory statutes, there are secondary effects that create new sets of problems. When the Fed and other bank regulators drafted the “new era” capital and liquidity rules, the intent was to reinforce the safety and soundness of the banks. With so many rules constraining the nature of bank balance sheets, a “barbell” look became apparent: banks focused on high-quality liquid assets (HQLA) to cover the liquidity ratio requirements, and limited the highly risky forms of lending that require high capital charges. Trading assets remain elevated for some of the banks, which is on the risky side of the barbell. Missing in the middle of the risk spectrum are the commercial loans that used to be a hallmark of good bank lending books.
In the Q&A session, I asked the question of “what can the Fed do to reduce the flow of lending that is done in the unregulated ‘shadow banking’ system?” The response was effectively “nothing” as the Fed publicly views its review system as sufficient. However there cannot be a feeling of comfort to see so much levered loan access in the markets, and so many of those loans coming as “covenant lite”, which at some point will bring about its own “unintended consequences” to our economy. In a simple scenario, defaults will rise, loss given default will be material (under cov-lite rights) and a re-pricing of risk will drive the cost of capital higher in the US. All else being equal, that will slow GDP growth.
Homogeneous banks may cause harm to the economy
Again drawing on the theme of what the Fed had not foreseen when drafting the new era rules, was the idea that banks could hurt the markets due to sharing the same weaknesses. As banks look and feel more and more alike, they are more likely to suffer a grim fate together for a shared (though yet unknown) weakness. The idea here is effectively based on sense of “what we don’ know can hurt us.”
Risks are changing and credit is coming back into focus
For the better part of the last decade, credit risk has been the least of the risks that banks faced. The credit cycle will eventually turn and banks will need to contend with higher cost of credit in what remains a period of historically low rates. One panel member from a large regional bank highlighted that not only will credit risk eventually hurt banks’ profitability, but so will liquidity risk. This was based mostly on speculation that the loss of LIBOR will impair banks’ ability to model liquidity and the cost of funding as new models are still in the early development and testing period. Oddly enough, what was not discussed by the panel was quantitative tightening at the Fed and how it will further reduce the deposit funding banks have. We continue to view quantitative tightening as one of the biggest risks facing the banking system as it will impair not only deposit funding, but is inherently deflationary.
Considerations for the future
Consolidation in the domestic banking
The banking industry remains highly adverse towards M&A given the negative reception the public equity markets have had in response to some recent deals, according to the panelists. The equity markets are particularly skeptical of deals that have such steep premium to book values, and given the fact that the largest 25 banks have an average p/tbk of 1.9x, there are few deals to be had that won’t create considerable goodwill.
In the post-crisis era, scale among the banks has become increasingly important. Banks like Mellon that used to have diverse operations with institutional services and retail business, have been acquired and refined into more streamlined business models. Other banks like Citigroup who had custodial businesses were finding their scale too small and sold such business lines to the already large 2-3 players that consolidated the custodial and securities services business, and without retail operations in tow.
Though the panel discussion here was intended to focus on domestic consolidation, the legal counsel said there should be more consolidation among the EU banks with some meaningful pan-Euro mergers potentially. Though no specific names were discussed, there have been some names regularly discussed as looking for a partner. Major M&A candidates include Deutsche Bank, Commerzbank, and UniCredit; consolidation opportunities also exist among a wide range of German regional banks or smaller Italian banks potentially in need of more capital.
Lastly, and perhaps most helpful to Yankee bank bondholders is the potential for more work towards “single point of entry” (SPoE) in more EU countries as pan Euro bank mergers could bring about the holding company legal structure. Currently that is only in effect in the UK and Switzerland, and complicates the idea of bank resolution without the SPoE structure. The partner also discussed potential political and social conflicts from cross-border mergers of “lead banks”. For example, the largest German bank is not likely to merge with the largest Swedish bank (hypothetically) as the political pressures on where to have the headquarters, what to name the bank, or who runs it could force too many unsolvable problems.
Cyberbanking and trust
In cyber banking, the issue of “trust” was mentioned repeatedly as being of key concern. The “tri-polar” balance of power between the US, Europe and China must work together to standardize rules to keep the playing field somewhat level. Moreover, regulators must work to employ technologies to thwart cyber crimes and maintain stable platforms for transactions on a global basis.