Banks are being asked to not choke off the real economy and strengthen their capital levels at the same time.
They are, however, finding it rather difficult to get funding from anywhere except central banks, unless that funding is secured. And even secured markets are proving dysfunctional. As a result, banks are shrinking their balance sheets. Deleveraging is the theme of the year, and the move is only being exacerbated by the continued sovereign debt crisis.
The Bank of England, as always, has some lovely charts to illustrate the problem in its latest Financial Stability Report, which came out on Thursday.
First, let’s take a look at how intertwined banks are with their sovereigns:
At first glance, FT Alphaville wondered if the graphics guys were having a drink when they put this one together, since the line isn’t fitted. Then we had a cup of coffee and realised that it matches the values on x- and y-axes, as the purple line we added to prove this to ourselves illustrates.
The farther above the line the dot is, the more the (perceived) creditworthiness of the banking sector has deteriorated compared to the deterioration of the sovereign.
FT Alphaville Graph Geek Box
Isn’t it cool how they asset-weighted the banking sector CDS? That’s brilliant!! Data companies, please make an index out of that. Thank you. And we think the dot to the left of Ireland and Italy is Belgium.
The message from the graph is that banks and their sovereigns move nearly in tandem, though banks have had a worse time. And just in case you need a reminder (from the FSR):
Euro-area banks hold large amounts of debt issued by euro-area governments and, in some cases, are perceived to rely on support from these governments. Partly for these reasons, the creditworthiness of some European sovereigns and many euro-area banks have been closely intertwined (Chart 5.2).
Closer to home, here’s a graph that looks at how UK banks are exposed to the above chart’s peripheral banks and sovereigns, with Greece also thrown in:
Looks like RBS is in the most precarious position, followed by Barclays, in the ongoing sovereign debt saga. Interestingly, RBS is currently short the Spanish government while also being the UK bank that is most exposed to the Spanish financial sector.
The FSR notes that while the major British banks did a good job of recapitalising in the immediate aftermath of the crisis, issuance over the last year has slowed rather significantly for all but HSBC:
Though banks did meet their funding requirements earlier in the year. In 2012, £140bn of term funding matures, and this is concentrated in the first half of the year.
Now, as leverage ratios are generally going down…
… and banks aren’t going to town on the funding side, but just raising the minimum, they must reducing risk-weighted assets. Lowering risk-weighted assets is a good thing when said assets are toxic waste impaired legacy holdings from the securitisation boom. It’s less good though when it’s more to do with tweaking risk-weights, i.e. “optimisation” of risk-weighted asset calculations. And also not good for the real economy when that means that banks will want to lend less to businesses, kind of like this:
Hence the recommendations from the Financial Policy Committee to “improve the resilience of their balance sheets” without “reducing lending to the real economy”.
It’s a bit chicken and egg though. Do you lend now, in the hope that it strengthens the economy, making the banks more profitable, so that funding markets open up to them again? Or, do you raise funds, perhaps at any cost, so that you can lend? The Bank is in any case aware that it’s not going well:
There was an increased risk that banks would respond to pressures by accelerating the reduction in their balance sheets in ways that would exacerbate economic or financial fragility. Success in raising capital levels could maintain the confidence of funding providers and the lending capacity of the system.
So raise capital now in order to maintain lending capacity. Easier said than done at the moment. Hence another recommendation — that banks at least retain earnings, i.e. “limit distributions”, and “give serious consideration to raising external capital in the coming months.”
Concerning the recommendation for banks disclose their leverage ratios early (Basel III dictates disclosure only from January 2015), that’s about giving investors something to look at that doesn’t have those ridiculous opaque risk-weights built in.
A key influence on the way banks choose to manage their balance sheets in the medium term are the risk weights assigned to different types of exposures in the current regulatory framework. These risk weights determine how much capital banks have to hold against different exposures. But there are a number of weaknesses in the way that risk weights are currently determined.
The methods used by banks to calculate risk weights, particularly those calculated using internal models, are opaque to investors. Market intelligence suggests that this opacity has led to a lack of confidence in risk-weighting methods and could be undermining market confidence in the capital adequacy of banks. That suggests there is a potentially useful role for a leverage measure that does not attempt to adjust for the riskiness of banks’ exposures, as an alternative to risk-sensitive measures of solvency. A leverage ratio is due to be introduced under Basel III. As well as being an alternative solvency metric which may be useful to investors, it can play a useful backstop role to existing risk-sensitive capital requirements.
To illustrate how dodgy risk-weights can be, the FSR previously did some work that uncovered how much variation there is in the way that different banks calculate weights on the exact same portfolios. They have a graph for this too:
The Basel Committee is looking into more consistent ways to calculate the ratios. This does not give FT Alphaville comfort. The same committee gave sovereigns zero risk weights and is introducing CVA calculations that push credit default swap spreads wider, leading to death spirals in those markets. Nonetheless:
the Committee will consider further at future meetings the issue of the relative risk weights applied to intra-financial sector and real-economy exposures. The Committee will also consider whether banks should be required to disclose further details of their risk weights for specific asset categories.
Interesting. Changing the relative risk-weighting to distinguish activity that actually touches the real economy? Goodness, will this possibly give banks extra credit for actually being the financial intermediaries that we all thought they were meant to be all along? Isn’t it crazy that we potentially have to incentivise banks to perform that role?!
More on the FSR from FT Alphaville to come…
Related links:
BoE governor asks the impossible - FT Alphaville
Bank of England urges banks to strengthen reserves – BBC
Financial Stability Report - Bank of England