Pressure eased on Europe’s banks in the credit markets on Wednesday after Fed chairman Ben Bernanke soothed concerns over the fate of large US banks by saying no institution would be fully nationalised in the near-future.
The cost of protecting most of Europe’s banks against default eased on the news, with 5 year credit default swap spreads on Barclays tightening by 14 basis points to 225 basis points.
This means it costs €225,000 per year to purchase five years of protection on Barclays senior debt, down from a high of 253 in December.
Spreads for Societe Generale, Unicredit, BNP Paribas, UBS and Santander all came in. Deutsche Bank however was the notable exception, narrowly widening by 0.5bp to 153bp.
The Markit iTraxx Europe index of mostly investment grade companies tightened by 5bp to 179, while the iTraxx Crossover of mostly-junk rated firms came in by 12bp to 1066bp. In December the index, often seen as a useful barometer of credit market stress, rose to a record high of 1120bp.
But while anxiety over Europe’s banks has lessened in the short term, there could be trouble to come further down the line.
Axel Swenden and Olivia Frieser of the credit research team at BNP Paribas have hit on an interesting theme; that being the big changes of European investment bank’s balance sheets in recent months.
European banks with bulge-bracket capital market businesses which report under International Financial Reporting Standards (IFRS) have seen their derivatives assets and liabilities increase significantly over the last quarter as wide-spread volatility has led to higher valuations.
(IFRS, which all European banks use except for Credit Suisse, means banks record a derivative with a positive net present value as an asset, and a derivative with a negative NPV as a liability).
This, BNP Paribas notes, was the main factor in Barclay’s almost doubling its balance sheet in 2008. Derivatives now account for 30 to 55 per cent of total assets at the large European investment banks reporting under IFRS, compared with significantly lower amounts at their less adventurous peers.
In the money derivatives positions now comprise around 55 per cent of Deutsche Bank’s assets at the end of last year, while around 30 per cent is made up from securities. At UBS derivatives make up over 40 per cent of its assets, with securities being around 33 per cent.
The driving factor behind this increase is a volatility cycle. Sharp falls in dollar and euro interest rates, and violent swings in the forex market have made life difficult for investment banks.
The response to volatility across asset classes is to use derivatives to hedge. This same volatility in turn causes these positions to take a larger place on their balance sheets.
As derivatives dealing is concentrated between the large investment banks, and most contracts written are simply offset by entering into another contract, This leads to a piling up of contracts rather than a traditional turnover of assets.
BNP Paribas are not amused:
Although we cannot point at concrete, tangible risks we think there remains market, credit, model and operational risks, especially in periods of extreme market volatility like now. This leads us to conclude that these exposures are only as safe as the banks’ risk management systems are reliable.
Net derivatives exposure now accounts for 325 per cent of Barclay’s tier 1 capital, and 583 per cent for UBS – pretty scary figures indeed.
But while the increase in bank’s derivatives exposure is large, it might not be as troublesome as the figures first suggest.
Much of this has to do with the smoke and mirrors of competing accountancy models.
IFRS contrary to US GAAP, is quite restrictive as to the extent to which derivative assets and liabilities positions can be netted out on the balance sheet… US GAAP on the other hand does not require that the maturities of the payables and receivables on derivative match. This has a big impact on what can be netted out by Credit Suisse (to our knowledge the only major European bank reporting under US GAAP).
So in the end, they conclude, we will just have to wait and see what the consequences of this mini-derivatives explosion will be.
Derivatives exposures definitely pose risks but the overall risk exposure should be significantly smaller than IFRS leads us to believe. Having said that we can do little else than to rely on the banks’ risk management systems to make sure risks are properly managed. It is almost impossible to assess the effectiveness of such systems in any other way than acknowledging they seem to have worked so far with no major breakdown in asset-liabilities correlations. The past of course offers no guarantee for the future.