Ideas to Bank On

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Chinese Shadow Banking: Solution or Problem?

By Katie Lebling

As concern mounts over slowing growth in China’s economy, it is important to understand the role of “shadow banking” in the country’s economic risk profile. According to the Financial Stability Board, which just released its 2015 Shadow Banking Monitoring Report, shadow banking is credit intermediation by entities outside the regulated banking system. The FSB estimates shadow bank lending that may pose a risk to financial stability rose to $36 trillion in 2014 from $35 trillion in 2013, driven by growth in the United States, Ireland, and China.[i]  Although the global shadow banking industry remains concentrated in the U.S., the UK and the euro area,[ii] (see accompanying chart), shadow banking in China, which accounts for about 8 percent of the total, has garnered significant attention in recent years, largely due to rapid growth.

Compared to other advanced countries, China’s banking system is more constrained by state controls and favors state-owned entities over the private sector — factors that give shadow banks space to compete with the formal sector. Chinese banks must adhere to regulations from the People’s Bank of China (PBOC) and the China Banking Regulatory Commission (CBRC), which set strict limits on loan-deposit ratios, reserve requirements and lending volumes.

These regulations, along with very high expectations for non-performing loans, make it particularly difficult for private small and medium enterprises (SMEs) to access credit. Further, in comparison to other countries, Chinese companies rely primarily on loans and equity issuance instead of  debt financing, making the role of banks all the more critical. When SMEs are forced to turn to shadow banks, they generally seek credit that they are unable to obtain at regulated banks because of lending caps.

As China’s economy has appeared increasingly fragile and the shadow banking industry has grown, concern has centered on the potential implications of a crisis in the sector. Bailouts of trust companies in recent years have caused concern that intervention will encourage risky lending at the same time that the proportion of complex financial instruments in the economy increases.[iii],[iv] However, among academics and analysts, there seems to be agreement that the chances of a shadow banking crisis are relatively low. Further, any crisis in the shadow banking sector would likely not endanger the rest of the financial system because it remains small compared to the formal banking sector and because of low central government debt-to-GDP ratios.  

Shadow banking provides important economic benefits by increasing access to capital and reducing its cost. It provides services traditional banks cannot and takes on riskier customers or those in less-favored industries. However, shadow banks lack the safety net and liquidity that traditional banks are required to maintain, creating greater risk of instability.  Both the PBOC and the CBRC have tentatively welcomed shadow banks given their critical role in the Chinese economy while recognizing the risks they pose. In response to these concerns, the government has issued guidelines to increase transparency while still acknowledging shadow banking’s important role in the economy. Rather than severely restrict shadow banking, regulators would do well to continue this path of measured steps that mitigate the risks without eliminating credit lines that are critical to economic growth.

[i] Global Shadow Banking Monitoring Report. Financial Stability Board. November 2015.

[ii] Chinese Shadow Banking: Solution or Problem. CFA Institute. June 2, 2015.

[iii] China Shadow Banks Appeal for Government Bailout. Financial Times. August 18, 2015.

[iv] China Sets Up Fund to Bail Out Troubled Trust Firms. Wall Street Journal. December 12, 2014.

Link to the interactive chart

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Bank Competition and Opacity

By  Ross Levine  with Chen Lin, the University of Hong Kong, and Liangliang Jiang, Lingnan University

When banks engage in “earnings management”—the manipulation of their financial statements to smooth earnings, circumvent capital requirements and reduce taxes—it becomes more difficult for investors to assess bank performance. This increased opacity complicates governance and impedes regulators’ efforts to ensure the safety and soundness of the banking system. Opacity reduces bank stability, harms efficiency, and lowers the quality of loan portfolios. Yet little is known about the impact of bank regulations and competition on bank opacity.

In our new paper, “Competition and Bank Opacity,” my co-authors, Chen Lin of the University of Hong Kong and Liangliang Jiang of Lingnan University, and I provide the first evaluation of the impact regulatory reforms that spurred greater competition among banks on the quality of information disclosed by banks to the public. We test whether a regulatory-induced intensification of competition among banks increases, decreases, or has no effect on bank opacity.

Some economists propose that greater competition will compel firms to adopt enhanced corporate governance mechanisms, potentially leading to more transparent, higher quality financial statements, to attract funds from investors. In contrast, others argue that competition increases opacity by either inducing firms to manipulate financial statements to hinder the entry of potential rivals or by spurring executives to engage in unethical behavior, including more aggressive accounting practices, to extract as much as possible before competition puts the company out of business.

To evaluate the impact of bank competition on opacity, we examined the removal of regulatory impediments to bank competition among U.S. banks during the last quarter of the 20th century. Interstate bank deregulation eased the regulatory impediments faced by bank holding companies headquartered in one state wanting to establish subsidiaries in other states. These reforms progressed in a chaotic, state-specific process of bilateral and multilateral agreements over two decades that spurred competition among banks.

We use two measures of bank opacity. First, we use the frequency with which banks restate their earnings with the Securities and Exchange Commission (SEC). Restatements imply that banks misstated their financial statements and needed to correct their reports with the SEC. While not all restatements involve earnings management, the incidence of earnings management is positively associated with them.

The second measure focuses on loan loss provisions (LLPs), which are the most important tool used by banks to manage earnings and regulatory capital. There are numerous models for estimating and predicting corporate LLPs, backed by extensive study. This literature also uses these models to calculate the difference between a model’s prediction of a bank’s LLPs and the bank’s reported LLPs—and uses this gap as a measure of the degree to which the bank manipulates its financial statements. While all models have errors, one reason the gap between a model’s predicted LLP and a bank’s reported LLP could grow is if the bank’s managers are manipulating reported earnings, as such manipulations are not included in a given model.

With both measures of opacity, we find that a regulatory-induced increase in bank competition spurs a sharp reduction in bank opacity. The economic benefits to individual firms are substantial. After a state deregulates restrictions on the ability of bank holding companies in another state to enter and compete, we find that bank opacity falls by about half.

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Payday Lending: A Grab Bag of Regulations—and Perceptions

By Moutusi Sau 

Payday loans serve a population that has long been underserved by traditional lenders. A typical payday loan is structured as a short-term transfer of funds, usually for two weeks, providing a quick solution for borrowers who are falling behind on their bills. The borrower provides the lender with a postdated personal check and the authorization to electronically debit that amount from his or her account. If the borrower fails to repay on time, the lender may debit the amount, plus fines.

This industry has attracted controversy lately, accused by some of predatory practices based on outsize interest rates and the areas in which its clients are concentrated. A small minority of borrowers who regularly roll over their loans generate the majority of profits for these lenders. The loans’ rollover feature adds to the high fees that eventually lead to high rates for the consumer. Take, for example, the rates charged in two states: In Indiana, the allowable fee of $15 for a 14-day, $100 loan is equivalent to an annual rate of 390 percent. In Missouri, a $75 fee on the same loan translates into an annualized rate of 1,950 percent. Such wide variation has caught the eyes of state regulators, who have imposed a variety of curbs, from outright bans to caps on loan size.

However, proponents of payday lending assert that the industry aids a community that would otherwise have no access to finance. In addition, payday lenders justify their elevated interest rates by pointing to their small scale and heavy rent obligations as a proportion of revenue, which they pass on to the consumer. Their bank and credit union competitors, on the other hand, do not face this problem, as they have multiple branches and diversified revenue streams.

In the absence of federal guidelines for the industry, we see wide disparities in regulatory action across states. To address the concerns of all sides, the Consumer Financial Protection Bureau (CFPB) had proposed new rules for comment in March, but no final rules have been issued yet. Some of the proposed rules require payday lenders to verify borrowers’ ability to repay their loans and provide repayment options. The CFPB is also trying to make the market attractive for traditional lenders by shifting it toward installment loans with smaller payments. Under the proposed framework, loans would be limited to 5 percent of the borrower’s monthly income and terms would be limited to six months.

Given the wide variation in views of payday lending, it is worthwhile to undertake a landscape study to determine the extent of restrictions and the effects of regulatory curbs. We have posted a dataset on globalbanking.org that examines constraints on payday lenders and correlations between the number of their stores and state regulatory restrictions. The dataset also examines demographic and economic characteristics of neighborhoods to address the concern that these lenders disproportionately target lower-income groups.

Link to the interactive chart

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The Casualties of Correspondent Banking

By Katie Lebling

As access to international finance and banking have increased with globalization, so too has the need to address the risks of cross-border transactions by bad actors. U.S. regulations on money laundering, financing of terrorism and sanctions all have been used as mechanisms to mitigate these risks, but in some cases they are producing dire unintended consequences for innocent individuals and populations.

Banks use a system of correspondent banking to gain access to markets in which they don’t have branches. Under this system, credit institutions in foreign countries act as agents for banks, accepting deposits and conducting transactions, such as loans or remittances from expatriate workers, on their behalf. This system facilitates the cross-border transactions necessary for international trade and inclusion in the global financial system. Correspondent banking, however, has come under closer scrutiny as countering terrorism has become a focal point of U.S. policy.

While regulations have existed for decades to counter money laundering and other financial crimes, U.S. government agencies were granted greater authority following the 9/11 attacks. In recent years, there has been an increase in the number of fines and criminal prosecutions for money laundering and terrorist financing. Many large banks, including HSBC, Standard Chartered, and Barclays have been handed significant fines. Last year, BNP Paribas was fined a record $9 billion for violating U.S. sanctions against Sudan, Cuba, and Iran.

Taken together, this regulatory tightening places greater scrutiny on correspondent banks as the potential facilitators of illegal transactions. Given that most international transactions are in dollars, are regulated by the U.S. Office of Foreign Assets Control, and eventually find a way back to U.S. clearing banks, it is United States policy that essentially determines the fate of correspondent banking.  

With stricter regulations and higher fines, many banks have been forced to re-examine their cost-benefit calculation of maintaining correspondent banking relationships. Ultimately, many have abandoned the practice entirely, cutting correspondent ties in some countries due to low profit and increased perceived risk through a process known as “de-risking.” Rather than mitigate risk, this decision eliminates it entirely. At the same time, de-risking can also leave populations, sectors, or countries, like Somalia and Pakistan, with little to no access to international financial services.

Although de-risking has a number of effects on access for individuals and companies, remittances have become one focal point. Restrictive policies are especially detrimental for countries that are highly dependent on remittances and are also perceived as high risk. According to the World Bank, remittances to the developing world are expected to reach $440 billion this year, which is around three times the expected amount of Official Development Assistance going to these countries.[i],[ii] China and India lead the way in total remittance inflows (see the accompanying chart). If money sent from the U.S. were to end up in the hands of bad actors, intermediary banks could be held responsible, despite their best efforts to conform to regulations. Further, charities, peacekeepers, and even U.S. embassies are feeling the consequences as it becomes more difficult to complete international financial transactions in certain countries.

Notably, the growing lack of access to international finance in some countries could be instrumental in creating the poverty, exclusion and, possibly, crime that the initial regulations were meant to prevent. This unintended outcome is more likely in poor countries and those in conflict — countries that rely most heavily on correspondent banks because of their weak domestic financial systems.

For a more in-depth report on the issue see this article from the Milken Institute’s Review: Casualties of War

Link to the interactive chart

[i] http://oecdinsights.org/2015/04/13/how-the-world-reacted-to-the-latest-aid-data/

 [ii] http://www.worldbank.org/en/news/press-release/2015/04/13/remittances-growth-to-slow-sharply-in-2015-as-europe-and-russia-stay-weak-pick-up-expected-next-year

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Do Stock Markets Provide a ‘Spare Tire’ When Banks Go Flat?

By  Ross Levine  

October 21, 2015

Do stock markets act as a “spare tire” during banking crises, easing the economic pain when banking systems go flat?

In 1999, Alan Greenspan, then chairman of the Federal Reserve, argued that stock markets can mitigate the negative effects of banking crises. Using the analogy of a “spare tire,” he said banking crises would be less severe in countries that have a legal infrastructure that enables stock markets to provide financing when banks can’t lend. If firms can substitute equity sales for bank loans, then the crises will be less harmful to profit and employment. Although official entities and others have discussed the argument, nobody had systematically assessed the role of stock markets during banking crises until I and two co-authors did so.

In a paper, forthcoming in the Journal of Financial Economics, (“Spare Tire? Stock Markets, Banking Crises, and Economic Recoveries.”) Chen Lin, of Hong Kong University, and Wensi Xie, of the Chinese University of Hong Kong, and I test Greenspan’s hypothesis. (See an abbreviated version here on the Institute's site.)

The spare tire view makes three core predictions:

First, it stresses that the effects of a banking crisis on company performance are ameliorated if firms can issue equity at low cost when loans are difficult to obtain. Put differently, if a banking crisis shuts off bank lending and firms do not have an alternative source of financing, they suffer more than they do when market financing is available.

Second, in a crisis, the benefits of market financing accrue primarily to the firms that depend heavily on bank loans. Firms that do not rely on banks are less likely to be harmed.

Third, the spare tire view stresses the ability of the stock market to provide financing during a crisis, not the size of the market before the crisis. Although banks might normally be the preferred source of financing, the spare tire view holds that when they go “flat,” equity issuances can be substituted, at least partially. For the stock market to play this role, the appropriate legal infrastructure must be established before the crisis hits. This allows the market to respond when the banking system falters. It is the pre-crisis legal infrastructure — not necessarily the pre-crisis size of the stock market — that enables the market to act as a spare tire. To push the analogy further, it is not the use of the spare tire before the regular tire goes flat that mitigates the adverse effects of getting a flat; it is having a sound spare in the trunk.

We assessed these predictions by examining what happened to equity issuances, profitability and employment across almost 3,600 firms in 36 countries from 1990 through 2011. The findings are consistent with the predictions.

First, in countries with laws that protect minority shareholders, companies raise money through equity offerings, had smaller drops in profitability and fire fewer workers during systemic banking crises. The effects are large. In countries that have comparatively sound stock markets, the adverse impact of a systemic banking crisis on profitability and employment is one-third less than in countries with weaker markets.

Second, the beneficial effects of the stock market during a banking crisis accrue primarily to firms that depend heavily on banks. Third, the results are consistent with the spare tire view that it is the pre-crisis legal infrastructure — not the size or liquidity of the stock market before the crisis — that shapes the ability of a market to act as a spare tire.

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Markets Are Poorly Served by Fed Communication Strategy

By Moutusi Sau and Katie Lebling

October 21, 2015

Next week, bankers and policymakers will watch as the Federal Open Market Committee (FOMC) meets to consider the health of the economy and prospects for an eventual interest rate increase, which would be the first since 2008. Barring a change in communications strategy, their views and policy guidelines will be revealed in a statement of such complexity that it calls for post-graduate reading and analytical skills.

As the policymaking arm of the Federal Reserve, the FOMC directs monetary policy through changes in interest rates and money supply, decisions that are communicated through the release of official statements and minutes following each of its meetings. Statements are released on the same day the meeting ends and the minutes are made public 21 days later.[1] Both documents are intensely scrutinized by analysts and investors, and especially so since the beginning of unconventional monetary policy in late 2008.

Over time, FOMC statements have grown longer and more complex, increasing from around 200 words each during the 1990s to nearly 1,000 words apiece last year. The effect of this shift has both positive and negative aspects. On the one hand, financial markets benefit from greater access to information about policy decisions and the economic outlook. However, there is also a greater risk of unsettling markets as a result of the statements’ complexity and lack of clarity.

Under current Fed Chair Janet Yellen, statement length has dropped somewhat, but remains significantly longer than a decade ago. Statement complexity, as measured by grade-level readability, also remains high. A report published by the St. Louis Fed last year concluded that FOMC statements call for a reading level typically associated with three years of graduate study.[2] Taken together, some argue that the Fed’s efforts toward transparency have, in many cases, made understanding the policy more difficult.

In the post-financial crisis world, the release of FOMC statements have become market events as investors search for clarity with regard to the direction of monetary policy decision-making. However, greater complexity and the rise in word count combined with use of “Fedspeak” have added to the uncertainty, which is especially strong with the impending rate rise. A notable example of ineffective Fed communication is the taper tantrum of 2013.

When explaining its decision-making process, the FOMC has continued to maintain the position that it looks only at broad factors — principally employment and inflation. However, current events often play a significant role as well. In September, the recently exposed fragility of China’s economy and the ripple effects of its vulnerability likely influenced the FOMC, which might have otherwise raised rates. Next week (Oct. 27-28), we will again see markets try to decipher Fed communications and prepare for a possible policy change. Given that recent FOMC statements have caused some amount of market volatility, the Fed would do best to consider revising and streamlining its communications strategy to make its message more easily understood.

[1] The FOMC meeting minutes: An assessment of counting words and the diversity of views. FEDS Notes. Board of Governors of the Federal Reserve System. May 26, 2015.

[2] The Rising Complexity of the FOMC Statement. Economic Synopses. Federal Reserve Board of St. Louis. November 5, 2014.

Link to the interactive chart

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What the VIX Tells Us About Erratic Markets

By Moutusi Sau

September 16, 2015

The U.S. financial markets have been on a wild ride over the past month. Many experts were surprised by the sudden volatility in the middle of summer, when calm usually reigns. While some see the ominous signs of a long-term market correction, others believe this was a temporary event exacerbated by news out of China (read our blog “China’s Devaluation and Skidding Stock Markets”). The Standard & Poor’s 500 Index (SPX) saw a wild week of trading in late August, when stocks plunged 3.9 percent on the 24th and rose 3.9 percent two days later. This erratic activity was captured by an index called the Chicago Board Options Exchange Volatility Index, or VIX, which showed a particularly high level of risk taking that week.

Two big-picture events triggered the massive selloff on August 24. The first was China’s economic weakness, highlighted by missed factory output and investment forecasts, and the devaluation of its currency. The larger emerging markets (EM) slowdown, a negative factor over the course of 2015, had been hitting the markets hard. The second factor, related to the first, was the weakness in commodity prices, especially oil. Amid softening demand and robust supply, oil prices have fallen this summer and hopes for a near-term reversal look bleak. The sudden bearish tone in the markets was unexpected amid strong U.S. economic data, including declining unemployment, and a benign inflation outlook.

Nevertheless, how these news items were translated into market volatility can be traced by the dynamics of the VIX. One might say that the VIX gauges the current anxiety level of the market, measured as a component of option prices. As the options are bid higher, volatility becomes a larger component of the price. The VIX rises when put option buying increases and falls when call buying increases.[1] During the week of August 24, the VIX was at its highest, a level that had not been seen since the financial crisis (see VIX Futures chart). According to Tracy Alloway in BloombergBusiness, the volatility was largely driven by buyside players dabbling in techniques such as volatility overlays, dynamic hedging and risk parity to boost returns in a low-interest-rate environment. In many cases this involved hedge funds and commodity trading advisors rushing to purchase protection for hedging their short positions.

As a result, the Dow Jones Industrial Average seesawed and moved 10,000 points in merely five trading sessions. VIX futures contracts jumped from negative 53 million to 16 million in just one week, another spectacular illustration of the instability. “Driven by a combination of tactical and structural forces, it is indicative of an ongoing shift in markets' operating environment”—that’s how Mohamed El-Erian, chief economic advisor at Allianz, put it in a Financial Times blog.  

The tense trading also may be influencing the interest rate discussions taking place at the Federal Reserve. Many observers had expected the Fed to move at its September meeting but market gyrations may have given it reason to rethink its timing. While it is hard to say whether recent events are a harbinger of a more serious market correction, the new participants and their strategies could bring structural change.

[1] The VIX® Index Calculation, CBOE, VIX White Paper

Link to the interactive chart

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China’s Devaluation and Skidding Stock Markets

By Katie Lebling

September 4, 2015

Against the backdrop of decades of rapid growth driven by exports and investment, China is in the midst of a massive economic transition to a “new normal” of slower, more sustainable growth paired with the goal of creating a more decisive role for markets in the financial sector. As part of this shift, the nation’s central bank—the People’s Bank of China (PBOC)—moved on August 11 to revise the way the Chinese yuan-U.S. dollar exchange rate is calculated. This move triggered a 1.9 percent devaluation of the yuan, marking the currency’s largest depreciation in two decades and igniting panic in global markets.  

The PBOC shifted the yuan-dollar exchange rate from following a narrow band around a daily midpoint calculation to floating in line with the previous day’s close. The yuan sank further over the next two days, at which point the PBOC stepped in to stem mounting worries over a runaway tumble, instructing state-owned banks to buy yuan and sell dollars. This dollar selloff strengthened the yuan, helping to prevent further freefall. Despite tentative stabilization, questions remain regarding the extent of the PBOC’s role in the coming weeks, given its initial stated intention of stepping away from currency intervention.

The PBOC’s devaluation was notable for its timing, coming just after the release of slack July export numbers (falling 8.4 percent year-on-year) and August manufacturing data (sinking to a  six-year low), which heightened concerns over the trajectory of the Chinese economy. This unexpected weakening of the yuan helpfully bolsters Chinese exports at the same time that it serves the stated goal of adhering more closely to market value, which has prompted many to classify it as a measure to prop up the economy. Notably, even with its slide, the yuan remains substantially stronger than its trading partners’ currencies compared to a year ago.

Another motivator for bringing the stage-managed currency closer to its market value is China’s growing interest in adding the yuan to the International Monetary Fund’s Special Drawing Rights basket of reserve currencies, which currently includes the U.S. dollar, the British pound, the euro, and the Japanese yen. In April, the IMF declared the yuan fairly valued, though more recently it criticized the government for aggressively interfering in the currency.

Despite official statements regarding the motivation for this technical devaluation, China’s actions have intensified global economic concerns. Since this policy shift, stock markets in the United States, Europe, and across the developing world have all suffered amid worries of a slowdown in China. This declining confidence comes at a time of anxiety in commodity markets about sagging Chinese demand.

An examination of the larger picture reveals instability in China’s domestic markets—the August stock market panic followed another bout earlier this summer. After rapid appreciation over the past year, concern arose over the sustainability of the gains. Subsequently, the government tightened regulations on leveraged investing, which sent the market tumbling on the first day of the BRICS Summit in early July. Stability followed that intervention until mid-August, when the market again fell (though it remains up year-on-year, as seen in the charts). On August 23, China’s State Council approved measures allowing the state pension fund to invest up to 30 percent of its assets in domestic stocks, but the move did little to ease concerns.

The PBOC later reduced the one-year benchmark bank lending rate by 25 basis points to 4.6 percent and the required reserve ratio by 50 basis points to 18 percent to counter capital outflows, which were worsened by the yuan devaluation. Markets, however, remained unstable, and volatility continued into September with the release of declining Chinese manufacturing numbers.

Although China’s drastic market shifts caused global jitters, it is important to note that Chinese equities are not accurate barometers of overall economic health — due largely to low participation by the Chinese populace and underdeveloped corporate governance. Indeed, many view this latest panic as a needed correction that doesn’t necessarily indicate underlying weakness. At the same time, state media has increasingly encouraged wider market participation, which now closely ties Communist Party credibility to the stock market’s long-term performance. How and whether the government intervenes in the stock and currency markets in the coming months will provide valuable clues to its level of commitment to putting markets at the center of its financial system.

Link to the interactive chart

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Deposits, Confidence Seep Out of Greek Banks

By John Schellhase

August 10, 2015

The tensions between Greece and its troika of creditors are well-known. But another group of lenders to the Greek financial system has decided to stop handing over its euros—namely, Greek households and businesses. Since the end of last year, they have withdrawn €30 billion (US$33 billion) in deposits from Greece’s banking system, exacerbating the country’s liquidity crisis.

 In the first five months of 2015, as negotiations grinded on at the highest levels of European policymaking, Greek citizens and businesses made withdrawals equivalent to 19 percent of all private deposits from the nation’s banking system. At the end of 2014, private deposits stood at €160 billion, but by May, deposits had fallen below €130 billion. This is the banking system’s lowest level of deposits since the summer of 2004. It is also a €100-billion drop from peak levels in 2009. During one period of fraught negotiations in February of this year, depositors were pulling €800 million from Greek banks every day. Apparently, many Greeks have begun to fear their country may leave the euro zone or enter a Cyprus-esque labyrinth in which a euro inside a Greek bank might soon be worth less than a euro elsewhere on the continent.

Link to the interactive chart

The Greek debt crisis has been an ongoing trauma since 2010, when Athens revealed huge holes in the country’s finances and submitted to a macroeconomic adjustment program from the International Monetary Fund (IMF). Eventually, the so-called troika of the IMF, the European Central Bank (ECB), and the European Commission extended €240 billion of relief to Greece.

 Even after these interventions, as the chart above shows, the Greek debt-to-GDP ratio remains the highest in Europe at 177 percent, ahead of other crisis-hit countries like Italy and Ireland. (The chart includes data for Greece only from 2010, because there is no reliable data before that period.) Despite severe austerity measures—or due to them, as many argue—the economy has continued to shrink, with GDP down 25 percent from 2010 levels. In July, the IMF revised its debt predictions for Greece and now foresees government debt rising to nearly 200 percent of GDP “in the next two years.”

 These revised projections came weeks after Greece failed to make a €1.5-billion payment to the IMF. Afterwards, negotiations entered a new, feverish stage, and Greece’s creditors froze disbursements. Fearing their citizens might also abandon the Greek financial system and continue to pull out hundreds of millions of euros, the national government imposed severe restrictions on how Greeks can access and use their own savings.

 ATM withdrawals were limited to €60 a day, and foreign transactions were virtually forbidden as new capital controls came into place. Even after banks reopened on July 20, most of these restrictions have remained, paralyzing the Greek economy. Unable to pay suppliers, for example, small-business importers have basically had to close their doors while they wait for Athens and the European institutions to settle their differences. Speaking with NPR’s “Planet Money,” one well-informed Greek citizen foresaw food shortages in “about three weeks, three to four weeks if we continue like this.” He added, “After that, if I see that the situation escalates somehow, then I’m going to just get the family and get out of the country.”

 In July, the European institutions put forward a new bailout offer of €86 billion to be disbursed over the next three years. But release of the funds depends on Greece meeting a variety of demands, including changes to the VAT system, pension reforms, and the creation of a fund to privatize a targeted €50-billion worth of Greek public assets to be managed “under the supervision of the relevant European Institutions.” The IMF, which would seem to prefer a write-down of Greek debt, has balked at joining the new bailout, and though Prime Minister Alexis Tsipras has pushed through broad reforms, Greece has still not entirely agreed to the program either.

 For now, Athens remains strapped for cash, and Greek citizens can withdraw only €420 a week from their own bank accounts. In 2012, ECB President Mario Draghi famously promised that the ECB would “do whatever it takes to preserve the euro.” In the case of Greece, it is still not clear how much will be enough.

  Photo credit: Sharon Mollerus (Creative Commons 2.0, Generic License)

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BRICS Summit 2015: A New Era for Development Banks

By Moutusi Sau

July 31, 2015

Earlier this month, leaders of Brazil, Russia, India, China and South Africa met in Ufa, Russia for the seventh BRICS Summit. Despite the generally dark mood – the meeting was overshadowed by the sudden drop in Chinese stock markets that same day – the BRICS still managed to come together to establish the New Development Bank (NDB) and the Currency Contingency Arrangement (CCA).

Ever since the first BRIC Summit, in Yekaterinburg, Russia in 2009, the bloc has come a long way. The groundwork to form a development bank was laid down in fourth BRICS Summit in 2012 in New Delhi. The NDB was formally inaugurated just last week, on July 21, and will start accepting project proposals next year. The bank will be based in Shanghai. The NDB has been publicized as a rival to the World Bank, and the CCA has been mentioned in the press as a competitor to the IMF. However, Jim Yong Kim, president of the World Bank, has suggested that he intends to work together with the NDB to share knowledge and co-finance infrastructure projects. This development is interesting because the formation of the NDB was spurred by the discontent of the developing nations over the delay in implementation of proposed 2010 reforms in the Bretton Woods agreement. The proposed changes would reform the quota structure as per the GDP of the nation, helping equalize opportunities for smaller economies. Emerging countries, including the BRICS, have long felt they lacked a voice in the decisions made by the IMF and the World Bank.

Interestingly, the inauguration of the NDB was made less newsworthy by the opening, a few months ago, of Asian Infrastructure Investment Bank (AIIB). The AIIB, which is primarily a Chinese-run bank (China has a subscribed capital of $29.8 billion[i] in a total capital base of $100 billion) and has already garnered support from 57 member countries, including the UK and Germany. The AIIB has also pledged to work together with the NDB, although they will be lending mostly in the same space. The biggest news is that the NDB and AIIB have announced that they will be issuing their first loan in yuan. This will be a significant shift away from the dollar – a big first step for the BRICS toward fulfilling their goal to promote their intra-trade in local currencies.

Link to the interactive chart

Despite the increase in clout and increasing collaboration between the BRICS countries, several analysts have questioned the countries’ ability to act collectively as a group. The foremost question is the oversized role of China in the bloc. China’s GDP is 61 percent of the GDP of the BRICS overall. China has 77 percent of foreign exchange reserves amongst all the BRICS nations. Bilateral trade agreements between China and other four BRICS nations account for 85 percent of total intra-BRICS trade. Overall, The BRICS nations have not had a great year, with the exception of India. The remaining BRICS are freighted with a lackluster GDP growth trajectory this year. Russia has been facing increasing pressure from the West due to sanctions imposed since last year. At the moment, South Africa is probably more of a benefactor than a real contributor in this bloc. Another often mentioned pillar of intra-BRICS trade agreement also looks lopsided. Of the total $376 billion invested in Africa last year, $222 billion came from China, while Russia contributed only $12.5 billion.[ii]

However, even as skeptics are quick to point out shortcomings, there is no denying that the BRICS were the fastest growing bloc, and their combined GDP exceeded the United States’ GDP last year. Goldman Sachs has estimated that by 2030, 85 percent of the world’s middle class will be living in BRICS. However, with the recent events, such as the huge declines in China’s stock market, questions remain. Those markets continue to fall, despite state intervention. It will be interesting to watch the BRICS’ collective growth alongside the increasing footprint of China in the world market as it hosts both the AIIB and the NDB, two of the newest banks in the developmental space.

[i] How China Plans to Run AIIB: Leaner, With Veto

[ii] Insight and Strategy - Africa's re-pivoting trade portrait: 2014

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Fed Stress Test: Success for  Most of the Big Banks

By Moutusi Sau

March 26, 2015

The Federal Reserve announced its annual stress test results for the banking system recently. The financial markets watch the results very carefully for any deficiencies or changes in the outcome. Overall the test revealed that the banks are in much better shape than in previous years. The test showed that of the 31 firms examined, representing 80 percent of domestic banking assets, most of the banks are in good shape, and their capital plans were approved this year.

The results of the test’s two parts were announced a week apart this year. The results of the first part, which are more quantitative in nature, were released March 5, and all 31 banks passed. The Comprehensive Capital Analysis and Review (CCAR) test, whose results were released a week later, evaluated capital planning process and capital adequacy of financial institutions and was more qualitatively focused. Only 28 banks passed this round. The CCAR results are more closely watched, since they help shareholders predict whether they will be rewarded by the raising of dividends or the buyback of shares. The capital plans for Bank of America were approved conditionally upon the presentation of the final capital planning process by the end of September.

The Fed rejected the plans of Santander Bank and Deutsche Bank, however. This is the first year of tests for Deutsche Bank conducted by the Federal Reserve, and they were expected to fail before the results were announced. Interestingly, Deutsche Bank and Santander passed the European Central Bank stress test conducted in November with very good margins. The official statement from the Fed reads into the fact that Deutsche Bank was “adequately capitalized” but had problems in its “risk management.” Santander failed this test for the second year in a row.

A new set of “severely adverse scenarios” was introduced as part of the test this year. The worst-case figures are used for more prominent variables, such as unemployment rate, real GDP growth rate and Dow Jones Total Stock Market Index. Another notable change to this year’s test was the introduction of the common equity Tier 1 capital ratio. This measures the bank’s financial strength, comparing core equity capital with risk-weighted assets.

The results were a mixed bag. The five regulatory ratios that were used to measure the performance were Tier 1 common, Tier 1 risk-based capital, total risk-based capital, Tier 1 leverage, and the newly introduced common equity Tier 1 capital ratio. This is the first year in which all the banks managed to pass the Tier 1 common ratio requirement. However, three of the top five banks failed other regulatory requirements, showing that the “severely adverse scenarios” focused primarily on corporate defaults. This affected the big banks more than others because they focus more on trading and capital markets. This also explains the lower Tier 1 common ratios for most of the big banks compared with their smaller regional banking peers. However, Citigroup turned out to be a silver lining this year. After failing the test last year, it was under close watch by shareholders. It passed the test this time and announced a dividend payout and share buyback after the results were released.

This year’s test has boosted the morale of most of the big banks. The Fed has approved most of their capital plans, an important measure to lift the banks’ return on equity. Despite minor hiccups with the results of some, most of the big banks fared well and are on track to either distribute dividends or buy back shares to boost their shareholder wealth.

Link to the interactive chart

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Spain Looks to Fix its Real Estate Lending

By Donald Markwardt

February 25, 2015

Fixed-rate mortgage offerings by some of Spain’s leading banks are making a splash in the country’s home-loan marketplace. In a country where over 90 percent of consumers have traditionally relied on variable-rate loans, these products are noteworthy because of their fixed-rate and their length (up to 30 years). This is in stark contrast to the U.S., where the practice of locking in rates for 10 years to 30 years is the standard rather than the exception.

Debt overhang and market distortions left over from Spain’s real estate bubble more than five years ago are blamed for most of the country’s recent economic woes, so the introduction of new or innovative mortgage products meant to ratchet up lending volume is likely to be met with suspicion, at best.

Indeed, Spanish mortgage lending has picked up, and total mortgage capital loaned on a year-over-year basis has turned positive for the first time since 2007. The increasing prevalence of fixed-rate mortgages is, at least partly, a response to the increased pressure on bank lending margins, as variable-rate mortgages have come down to as low as 1 percent (plus the variable component Euribor).

But there’s reason to believe these fixed-rate mortgages meet a real consumer need, especially for Spanish homebuyers who were burned when  variable rates (12-month Euribor) spiked from 2.0 percent in 2005 to 5.5 percent in 2008. That jump  significantly increased mortgage payments for homeowners, dramatically cut demand for new home loans, exacerbating the housing collapse. The ability to lock in a fixed mortgage payment over the life of a loan provides risk-averse homeowners a sense of security. The products also make sense for banks, which are using derivatives to hedge their additional exposure to the risk of rising interest rates. These hedges have become substantially cheaper due to market participants discounting the risk of any significant rate rises or inflation risks in the intermediate term, owing to low growth prospects and the ECB’s announcement of its quantitative easing program. Cheaper hedges mean banks can offer fixed-rates, such as 2.5 percent for 10-year fixed or 4 percent for a 30-year mortgage, that are relatively competitive with variable-rate products.

In the end, this doesn’t yet constitute a sea change in Spanish mortgage conventions: Sabadell, one of the country’s largest banks and a leading provider of these new products, expects fixed-rate loans to represent one fifth of its new mortgages in 2015. However, the trend merits watching as Spanish consumers look for safer alternatives in Spain’s post-recession financial landscape.

Link to the interactive chart

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Community Banks: Defying the Trend

By Moutusi Sau

February 10, 2015

Consolidation and regulatory change are reshaping the banking sector. As shown in a chart of the week published in September, the number of banks in the U.S. has declined despite growth in total assets, a trend that highlights the concentration of assets in a few top institutions.

Community banks are doing better than the whole of the industry. Untouched by the consolidation trend, they also are growing in asset size. In addition, they are generating higher interest rate margins than bigger banks.

Community banks are defined by the Federal Deposit Insurance Corp. as banks with assets of $100 million to $10 billion. Growth has been especially strong among smaller community banks. From 1985 to 2013, banks with $100 million to $1 billion in assets grew 27 percent and those with $1 billion to $10 billion increased 4 percent.[1]

This superior performance, in part the result of longer-term lending, continued last year both in loan growth and net interest margins,  according to the FDIC.

As pointed out in our blog post last week, big banks have faced increasing pressure on their interest rate margins in recent years, possibly because of their higher concentration of short-term assets. The steepening yield curve over 2013 was very favorable for institutions that funded at the short-term but invested over medium to long-term. In this climate, community banks benefitted from their high concentration of medium to long-term assets.

Community banks may also have gotten a lift from small businesses. The increased regulation of larger banks since the financial crisis has prompted small businesses to seek new lenders, including community banks. Currently, they provide over 45 percent of the industry’s small-business loans.

They also have had stronger overall loan growth in 2014 compared to the rest of the industry. Loan balances increased by 8 percent over the past year compared to 4.6 percent for the industry overall. As depicted in the chart below, community banks have seen a greater growth in loan balances for the four of the past six quarters.  

Community banks appear to be getting a break from regulatory reforms that were intended to address problems at the big banks, including Dodd-Frank and the Volcker rule. The Federal Reserve and Consumer Financial Protection Bureau recently eased restrictions on lending and acquisitions for smaller banks. And Congress is considering additional relief. Senate Banking Committee Chairman Richard Shelby said today that he wants to advance legislation that will lift the regulatory burden on community banks and credit unions.

“We are long overdue for regulatory relief for small financial institutions,” Shelby said as he opened a hearing on the matter.

A lighter regulatory hand is meant open the door to continued growth for community banks. The question going forward is whether the banks will grow without engaging in risky lending practices that ultimately would harm their customers.

Link to the interactive chart.

[1] Source: https://www.fdic.gov/bank/analytical/quarterly/2014_vol8_2/article.pdf

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U.S. Banks Squeezed by Interest Rate Disparity

By Donald Markwardt

February 2, 2015

While the European Central Bank embarks on its quantitative easing program and lowers bond yields throughout the euro zone, consensus is building across the pond that 2015 could finally be the year interest rates rise in the United States. Fed Fund futures markets and Fedspeak soothsayers agree that the Federal Reserve will, more likely than not, finally raise short-term interest rates by October.

U.S. banks have been preparing for the Fed’s move for some time. The question of whether higher interest rates are good for the banking sector depends on a couple of more specific inquiries: which rates are rising and why?

The distinction is important because banks rely on borrowing at cheap, short-term rates and lending money for longer periods at higher interest rates, generating a nice net interest margin (NIM). If — as anticipated — longer term rates rise as the Fed raises short-term rates, it bodes well for banks. Under that scenario, banks could reasonably expect an increase in net interest margins by lending at higher rates while experiencing a proportionately smaller increase in borrowing costs due to the fact that a decent portion of their borrowings are from customer accounts (such as checking accounts) that don’t bear interest.

Troublingly, while short-term rates have risen in anticipation of Fed tightening, longer-term yields have reversed course and fallen in recent months. A flattening yield curve can indicate poor long-term growth prospects or recession on the horizon. Indeed, the spread between 10-year and 2-year Treasuries is nearing levels not seen since the global financial crisis:

This relative flattening of the yield curve bodes poorly for bank NIMs, which already registered record lows in the fourth quarter of 2014. Since 2010, net interest margins have come down substantially for U.S. banks, especially among the largest. Wells Fargo’s 12 month trailing NIM dropped from 4.2 percent at the end of 2010 to its lowest-ever recorded, 3 percent, at the end of 2014. JPMorgan’s, in the same period, fell from 3.1 percent to 2.1 percent.

The direction of rates isn’t the only thing affecting bank margins – increasedregulation (Basel III, Volcker Rule) and rising legal compliance expenses haveadded to funding and operational costs – but it is a serious concern for bank executives. Brian Moynihan, chief executive officer at Bank of America, addressed this issue last week at the World Economic Forum. He remarked that if the Federal Reserve raises short-term rates merely “because they have to fight off some unexpected outcome, a spike in inflation, that’s not good.”

A decision to raise rates due to strong U.S. economic growth, on the other hand, would indicate a friendlier and more profitable world for lenders. As 2015 progresses, the shape of the yield curve should provide a decent barometer for banks’ lending prospects going forward. 

View interactive chart.

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Latin America’s Position in Global Leverage

By Stephen Lin  

January 26, 2015

Although the U.S. financial and household sectors have deleveraged after the 2008 crisis, overall global leverage has increased. One interesting corner of this story is the rise in Latin American issuance of international corporate debt. Latin America’s share of global issuance has been surprisingly substantial, and this increased leverage also bears risk. Yet, might LatAm companies have already mitigated these risks?

The growth in LatAm international corporate debt (issued in foreign currency, or FX) is a result of greater financial integration, low interest rates, and low term premia. Financial integration has meant greater access to international capital markets. Being able to borrow in FX, particularly the dollar, has enabled LatAm corporations to take advantage of low rates and thereby make more long-term investments such as capital expenditures.

At the same time, this increased exposure to the dollar, which is experiencing an extended period of strength, raises the cost of dollar-denominated liabilities relative to assets. It also increases interest rate risk: Should U.S. monetary policy tighten, borrowing costs would climb. Further, it could damage companies’ creditworthiness. These risks could spill over into the domestic banks that house LatAm corporate deposits, the global banks and asset managers that have invested in LatAm corporate debt, and the real economy. 

Countries have reserves for dealing with these situations, but how prepared are companies?  Corporations can mitigate these risks in a couple of ways: They can ensure that their FX liabilities are naturally hedged by matching their FX asset returns and revenue, or they can use financial derivatives to hedge FX exposure. Since exact firm-level hedging data are not available, issuer-sector exposure and volume of derivative transactions can serve as proxy indicators.

As it turns out, the largest issuers are companies in financially integrated commodity producing nations[1] such as Brazil, Chile, Colombia, Mexico, Peru, and Uruguay. Their private sectors issue the most debt and have the greatest foreign liabilities. They also have a higher proportion of commodities and energy exporters. Such firms are more accustomed to dealing with FX risk and are therefore more likely to have partially matched their FX assets and liabilities.

Furthermore, the volume of FX and interest rate derivatives transactions has increased in Latin America. Among Brazil, Chile, Colombia, Mexico, and Peru,[2] transactional turnover rose between 2007 and 2013, from $28 billion to $67 billion for OTC FX derivatives and from $3 billion to $6 billion for OTC interest rate derivatives. 

Overseas borrowing and leverage pose risk to financial stability all over the world. However, there are indications that indebted LatAm corporates, especially those in the sectors and countries that are most vulnerable, are a little less vulnerable than they might appear.

View interactive chart.

1. Other groups include non-financially integrated commodity exporters, which consist of Argentina, Bolivia, Ecuador, Paraguay, and Venezuela; and commodity importers, which include Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Jamaica, Nicaragua, and Panama.

2. Excluding Uruguay because its issuance of international debt securities is relatively small.

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Shadow Banking: Non-Bank Financial Intermediaries Grow Despite Scrutiny

By Moutusi Sau

January 9, 2015

Non-bank financial intermediaries (NBFIs), under scrutiny by regulators in the U.S. and abroad, have played an important role in bridging the funding gap created when banks scaled back lending after the 2008 financial crisis.

The Global Shadow Banking Monitoring Report, published annually by the Switzerland-based Financial Stability Board (FSB), sheds light on the growth of the NBFIs worldwide. In the most recent report, published on October 30, the board estimated that assets of non-bank lending institutions reached a record $75.2 trillion, up from $58.5 trillion in 2008. Furthermore, the report highlights several significant trends within the industry.

Asset Classes

The asset classes that grew fastest  in 2013 were “other investment funds” and “trust companies.” While the former expanded 18 percent in 2013, the latter grew at a 42 percent rate.

“Other investment funds,” with $29.7 trillion in assets, comprise equity and fixed-income funds, among others, but not money market or hedge funds. The category’s growth probably points to a structural shift in the financial landscape. As pointed out by the International Monetary Fund, this class likely grew amid demand from institutional cash pools created in response to limits on deposit insurance.

Trust companies, a small category with $2.13 trillion in assets, have been at the center of controversy in China, where the government has tried to exert greater control over the industry.  Concern centers on the sale of high-yield wealth-management products to well-heeled customers. However, the funds, sometimes based on risky loans, created turmoil in the market and almost caused China Credit Trust Co. to default on a product. About $853 billion worth of trust products in China were about to mature in 2014.

Region-Specific Distribution

Combined, the Euro area, U.S., and United Kingdom represent the bulk of the shadow banking industry, with funds based in those regions holding about 80 percent of all assets in that category as of 2013. In emerging markets, most growth can be attributed to NBFIs operating in China. However, there also has been rapid growth in lending by other financial intermediaries (OFIs)[1].

Although non-banking assets in the U.S. exceed pre-crisis levels, America’s proportion of global OFI assets has declined steadily from 49.9 percent in 2002 to 38.1 percent in 2008 and then 33.5 percent in 2013. Part of this contraction can probably be explained by the reclassification of many financial assets from OFI to deposit-taking bank institutions in 2013.

Lately, the NBFI sector has been under scrutiny because limited data and a lack of transparency often obsure the risks they carry. The FSB has been spearheading regulatory reforms to address the problem. Also, the U.S.  the Securities and Exchange Commission is overseeing asset managers such as BlackRock Inc. in an effort to tighten supervision of the sector. Whether a joint effort between FSB and SEC will succeed in monitoring and controlling risks in the industry remains to be seen.

[1] ‘Other Financial Intermediaries’ comprise all financial institutions that are not classified as banks, insurance companies, pension funds, public financial institutions, central banks, or financial auxiliaries.

View interactive chart.

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Less Liquidity, More Risk in Fixed Income

By Stephen Lin  

December 11, 2014

U.S. fixed-income markets are in transition because of new regulations and Federal Reserve policy. The decline of the broker-dealer market-making model is causing a shortage of liquidity, which would pose risk to investors should the great bull run in bond markets come to an end. Deep, liquid markets are important for financial stability and expand access to capital for individuals and corporations.

Select banks called primary dealers, among them J.P. Morgan, Goldman Sachs, and Citigroup, traditionally played an important role in “making” bond markets by providing liquidity, holding inventory of their own, and acting as the counterparty for trades by quoting bid and offer prices. Because bonds have unique durations, covenants, and rates, and are overall less standardized than equities, they are less frequently traded and have fewer investors, making intermediaries such as dealers necessary. 

Two factors have caused institutional investor bond holdings to rise substantially and dealer inventories to fall. Basel III’s higher capital requirements and supplementary leverage ratios, and Dodd-Frank’s Volcker Rule, have decreased the profitability of dealers who trade and carry bonds on their balance sheets, prompting them to retreat from the traditional dealer model and focus on their core businesses. At the same time, years of quantitative easing by the Fed have caused investors to leave government fixed-income securities for high-yield and investment-grade corporate bonds (and equities) in pursuit of bigger returns.  

The confluence of these factors has constricted the supply of fixed income to investors on the secondary market, while demand has risen. Dealer holdings of bonds have fallen to an all-time low, down 89 percent from their 2007 peak, while mutual fund holdings of bonds more than doubled in the same period. This means the amount of mutual fund credit assets susceptible to declines in liquidity equals nearly $870 billion versus $300 billion during the credit crisis in 2008.

With the inclusion in those assets of exchange-traded funds that track corporate debt, buy side bond holdings further exceed dealer inventories. In part, the huge resurgence in the issuance of traditionally illiquid securities in 2013 (i.e., leveraged loans, CDOs, CLOs, corporate hybrids, and convertible bonds) stems from attempts to satisfy the supply-demand mismatch in fixed-income markets. 

On the surface, market liquidity seems to be healthy, but closer inspection reveals that is not the case. Despite high trading volumes, other aspects of liquidity have suffered: bid-offer spreads that spike when liquidity is needed; less diverse market participation and a concentration in fewer bond categories; weaker dealer participation in Treasury auctions; and thin trading in older and smaller bonds in secondary markets. Because of the issuance boom, investors mainly are buying new bond issues and have not needed to rotate into other portfolios. 

Furthermore, large block trade volume has waned over the past eight years. Block trades worth more than $5 million have decreased, and those in the $1 million to $5 million range have increased. The average trade size has declined due to more dealers splitting up large orders to find buyers and sellers. In retrenching, dealers are focusing on their largest clients, often leaving smaller funds struggling to complete trades affordably and further narrowing market participation and the strategies used for trading. Financial institutions are trying to remedy these issues by developing electronic bond trading platforms to facilitate liquidity.

Illiquid markets present both volatility and risk to investors. Unlike the dealers, institutional investors cannot act as liquidity stabilizers, risk warehouses, or pressure release valves. When the corporate bond bull market ends, investors, not dealers, would bear the brunt of losses as the latter are no longer positioned to take on all the bonds investors would want to offload.

Funds have built up big positions in corporate debt and taken on less liquid securities with higher yields to help meet expected returns or actuarial assumptions. If those funds should need liquidity stemming from a jump in nonperforming loans or market volatility, the door under the Exit sign would quickly become very crowded. Numerous factors could trigger this, including rising interest rates, deflation, an international financial crisis—anything that affects credit or causes defaults to multiply. It would inflict massive stress on those funds and a jarring impact on the economy, undermining the financial futures of pensioners and annuity holders. 

View interactive chart.