The terminal disease afflicting banking
Posted by Izabella Kaminska on Jul 18 10:46.
Finding out that you are dealing with a terminal disease is never easy.
The natural reaction is to seek out a cure, no matter how bleak your chances. You will, for the most part, do almost anything to live. That includes changing your habits, your lifestyle, your friends, your profession or, for that matter, doing things you never previously considered doing. Whatever it takes to get just one more day of life.
We make this point not to be morbid but because there’s a good chance that this sort of mentality is currently afflicting the banking industry. If not for many years already.
We’d like to argue that faced with certain death, banks have adapted. Moved on. Reapplied themselves. Done everything they can to squeeze a little extra life from the system.
We’re talking about developments that touch almost every modern commercial and investment bank — from the growth of shadow banking, to the fragmentation of markets and build up of dark inventory. Algorithmic trading and securitisation to ETFs and Libor manipulation. Rehypothecation, to dealing with the threat of corporate cash-piles.
With hindsight, all of these developments may have been signs of an industry in crisis. Signals of pariah banking and desperation.
But it’s incorrect to blame the banks outright. It’s natural, after all, for anyone facing certain death to try to save themselves. To protect against extinction.
Which is why it’s worth exploring how this may have come about and what it is now leading to.
There’s no doubt, for example, that banks have held the top spot in credit creation for decades, if not centuries. Yet, there’s equally little doubt that banks have spent most of the last quarter of a century branching out into ever more exotic services and roles.
So why has that been?
In order to answer that it’s first important to understand what traditionally drives bank profitability.
As Steve Randy Waldman at Interfluidity points out it’s not, contrary to popular belief, their ability to create credit. Indeed, as we have also argued, any reputable institution or individual has the ability to do that. No, in Waldman’s opinion the power of banks actually lies in their more unique ability “to issue liabilities that are widely accepted as near-perfect substitutes for whatever trades as money despite being highly levered.”
From Waldman:
Bill Gates can issue liabilities that will be accepted as near-perfect substitutes for money, but Gates is not a bank: his liabilities are viewed as creditworthy precisely because he is rich. The value of his assets far exceed his liabilities; he is not a highly levered entity. Goldman Sachs, on the other hand, was a bank even before it received its emergency bank charter from the Federal Reserve. Prior to the financial crisis, despite being exorbitantly levered and having no FDIC guarantee, market participants accepted Goldman Sachs’ liabilities as near substitutes for money and were willing to leave “cash” inexpensively in the firms care. The so-called “shadow banks”, the conduits and SIVs and asset-backed securities, were banks before the financial crisis, because their highly rated paper was treated and traded as a close substitute for cash despite the high leverage of the issuing entities. Shadow banks wrapped guarantees around a wide variety of promises that, after a while, we wished they hadn’t.
So it’s really all about guarantees, and more specifically faith in those guarantees. You give money to a bank on deposit because you trust that it will remain a money-like instrument even though it’s earning you some interest.
Indeed, you get a return without having to compromise the liquidity profile of your holding. You get something seemingly out of nothing.
The rise of shadow banking is thus closely connected to investors becoming ever more satisfied that non-banks can perform a similar role. That, combined with the fact that these shadow banks can also guarantee liquidity without sacrificing basic returns, of course suddenly makes them competitors with banks.
Which brings us to the start of what looks to be a fascinating series from Nicola Cetorelli and his colleagues at the New York Fed’s Liberty Street Economics Blog about the evolution of banks and financial intermediation. Why have investors chosen to empower shadow banks over conventional banks, and how does this compromise the role of banks more generally?
As he notes:
As a result of innovation and legal and regulatory changes, financial intermediation has evolved in a way that invites us to question whether it revolves around banks anymore. The centerpiece of modern intermediation is the advent and growth of asset securitization: loans do not need to reside on the originator’s balance sheet until maturity any longer, but they can instead be packaged into securities and sold to investors.
With securitization, banks’ balance sheets get replaced by a longer and more complex credit intermediation chain (Pozsar, Adrian, Ashcraft, and Boesky 2010). This evolution literally changes the picture of intermediation, as the figure below suggests. From a bank-centered system, we go to one where multiple entities interact with one another along the sequential steps of the chain, and concomitantly we hear increasingly of shadow banking, defined recently by the Financial Stability Board as a system of “credit intermediation involving entities and activities outside the regular banking system.”
In other words shadow banking was essential for facilitating the asset securitisation process, which in itself was necessary to keep banking liabilities stable and returns supported in what was otherwise a falling yield environment.
The irony is that for the asset securitisation process to work, it was necessary to pass the precious role of liability generation down the chain to shadow banks. This was the trade-off for the banks. Indeed, the whole process depended on an arm’s length approach to funding via encumbered collateral and asset stocks, so that ‘funders’ could be distanced from direct exposure to banks, while improving returns in a low-yield world, in what was mostly considered a safe manner. (Of course, in the case of hedge funds it was the opportunity to reap larger than expected returns at a fraction of the cost, because much of the risk was actually being borne by the risk-averse component of the shadow banking universe.)
Which makes us wonder if asset securitsation — which really came into its own in the 1980s — wasn’t the first real sign that something very unusual was going on with banking.
The consequences of falling yields were, after all, potentially deadly for banks if mismanaged. Not only did they threaten to erode the margin banks collected via cheap liabilities, they increasingly compromised funding supply altogether. (After all, why bother giving banks your money if you get little or no interest back?) And while we appreciate that correlation does not equal causation, falling yields have definitely coincided with the rise of asset securitisation:
That securitisation came to compensate for falling yields is easily argued. More of a challenge is to say what would have happened had securitisation not stepped into the breach.
Would falling yields have killed off funding supply altogether? Would low-risk investors have embraced risk much earlier on? Would funding demand have whittled off alongside funding supply? Or would for-profit lending have died much in the way it’s dying now? (If not interest-bearing money itself.)
In other words did securitisation simply delay the inevitable by acting as a form of life-extension for the banks by means of bolstering margins through financial engineering fees and market making margins? The trade off came in the transformation of their own liabilities, a process which happened to compromise funding security at the same time. But it was seen as worth it, since the constraint on high-yield asset creation was equally eliminated. The funding advantage they lost, was thus more than compensated for by the ability to skim off the high yielding assets they created — high yield returns which, we should add, they themselves were not responsible for, thanks to all the other moving parts in the securitisation process.
That the financial engineering obscured, or even detached the credit intermediation role from the conventional banking sector, was unfortunately ignored.
As was the fact that the process made banks ever more dependent on shadow banking lines for funding. Though this of course became patently obvious when financial engineering back-fired on everyone in 2007 and shadow banks began pulling funding away from banks left, right and centre.
Yet even as central banks have come to fill the funding void, the disease that afflicts banks lives on. Though, with the funding issue taken care of by central banks, the symptoms are changing. It’s no longer a funding shortage that ails banks, but rather an inability to create enough of the right sort of assets to cover operational costs.
In short, low-risk funding demand is no longer able to accommodate low-risk funding supply. So, even if banks were able to attract shadow banks back into their fold again to the same degree, it’s not clear whether they could originate the type of assets that would keep them satisfied. The liabilities were improperly conceived in the first place. In many cases they were presented as safe, when really they bore risk. Which begs the question: had the risk been visible, would they have been created at all?
This, of course, explains the overhang of risk, which can only be extinguished by risk-averse investors either becoming more risk oriented, and thus open to the prospect of principal losses, or by the risk-taking component of the shadow banking maintaining risk appetite even when true risk is not cunningly transferred elsewhere.
Of course, when central banks originally came to the rescue on the funding side there was a lot of hope riding on the idea that investors would embrace risk in exactly this way. But those hopes are now dwindling. It is increasingly evident that investors are not prepared to direct funds towards existing risky assets or for that matter further risky asset creation. And with more demand for safe assets than borrowing by safe hands, that leaves banks unable to match liabilities against assets, without taking on the additional risk themselves.
Nowhere is that more beautifully illustrated than in the daily value being put at risk over at Goldman Sachs.
As John Kemp notes in a chart on Tuesday:
Simply put, it takes two to tango in a risk market, yet unfortunately for the banks one partner is currently refusing to dance. Since risk is not being funded, banks have no choice but to cut back on their risk taking. This comes despite continued efforts by banks to displace as much risk as possible to the risk-averse shadow banking sector (notably through ever more creative shadow banking vehicles that do their best to disguise the risk transfer, so everything from passive volatility funds to commodity funds and principal protected notes).
But with low-risk investors not biting and hedge funds continuing to dodge real risk unless it’s actually packaged as a sure bet (that would be the ‘hedge’ in hedge fund) , banks are understandably struggling.
It is any wonder that the New York Fed’s Cetorelli now comes to ask this?
In light of this evolution, what role remains for banks? How do they fit into this new way of matching fund supply and fund demand?
We look forward to the rest of the series, and will ourselves look more closely at the other tactics banks have deployed in order to fend off diminishing returns in conventional lending and investment businesses. |
