Cazenove produced a note earlier this week focussing on European banks. All of whom, forget not, operate with very high levels of leverage. Although Euro-specific, the note has implications for all banks. We’d be more bearish than Caz is: on the basis that much of this won’t be captured by banks’ risk models. and, as it happens, may catch them by surprise.
To our mind, this is the (a?) crucial graph (click to enlarge):
It depicts the change in asset risks on banks’ balance sheets. As can be seen from the dark blue bars, all of the banks can make the claim that they are “deleveraging” (reducing risky assets) when they report their results.
The paler blue bars represent market risk-weighted assets: those really at the centre of the current crisis so far. CDOs, CLOs, CDS positions, prop positions and so on. What is striking, of course, is the dramatic growth in such market risk-weighted assets through Q3 08 at Deutsche, Commerzbank and Dresdner. Deutsche has, of course, just reported a disastrous loss from its prop-desks and wealth management division. And CBK and DRN required a huge amount of fresh capital last week.
UBS and Credit Suisse meanwhile, have done better on the pale blue front. Largely because they wrote down the value of their major market-risk products to zero (or else sold them all off) in Q2.
It’s the yellow bar, though, that is curious. It represents credit risks – the default risks of the corporate loans, credit lines and such that are the rudiments of any commercial banks’ business. As can be seen, those assets risk-weightings have gone down, which has been a big benefit to banks whose market RWAs (pale blue) have been increasing. Because credit RWAs make up the larger part of the balance sheet, they have in most cases more than offset the increase in toxic assets’ risk weightings (thus the total RWA – dark blue – decreases across the board).
As Piers Brown at Caz notes:
To date, the banks have been able to offset most of the drag from higher market risk assets with falling credit risk assets… ytd to Q3, UBS had experienced a reduction in credit risk assets of 23%, DBK 17% and CS 12%. Remarkably, these reductions were achieved in spite of net growth in customer loans, up to 15% growth in the case of DBK.
That last sentence we’ve highlighted is the important one. The risk weightings on credit assets have been decreasing even though the amount of credit assets has been increasing.
In other words, banks’ risk-weighted assets have yet to be impacted by a corporate downturn. Indeed, quite the opposite. So far, banks’ balance sheets continue to benefit from the relatively benign corporate reporting through most of 2008.
Can this continue? Almost certainly not. As corporates begin to suffer (which we have only really begun to see since Oct/Nov) and experience downgrades and defaults, banks’ corporate asset risk-weightings will increase. In some circumstances, hugely. Caz’s analysis sees core Tier 1 ratios falling by 60bps at UBS, 110bps at CS and 180bps for DB based on a 2001 default rate.
If the default rate moves higher, the situation will be far more grave.
Will the banks spot these losses coming? Possibly not. Assumptions about default rates are not the only things that will throw banks. The Basel II risk-weighting calculations are based on correlation methodologies which are flawed. The same methodologies tripped up banks with CDOs. One thing that is certain is that in a banking crisis, corporate default correlation will be very high. And no model currently in use factors in data which covers a banking crisis.