Thursday, February 19, 2015

New Government Report Looks at Systemic Risk from Biggest Banks

In an earlier blog post, we noted that there is a new government agency report out that looks at the impact and risk of the biggest banks on the whole international financial system. Here is a link directly to that new report. In this post, we will look at this new report more in-depth because it contains important information that we all need to be aware of. Below are some excerpts from the report. I will add some comments in bold type below each excerpt to help try and help clarify the point being made.


"The Basel Committee on Banking Supervision, a group of banking supervisors from 28 jurisdictions, in 2011 created a set of 12 financial indicators to identify global systemically important banks (G-SIBs). These are banks whose failure could pose a threat to the international financial system. The most recent list identified 30 banks across the world as G-SIBs, including eight U.S. bank holding companies."

This is the first key point to make. These banks are so influential that their failure "could pose a threat to the international financial system." The report covers 30 banks worldwide and 8 within the US. They are called G-SIBs (global systemically important banks).

"The largest U.S. bank holding companies reported in August 2014 their systemic importance indicators as of December 31, 2013. This important new data set provides more transparency and is a significant step in quantifying specific aspects of systemic importance. "

This report is based on the latest available data, but still a little bit dated. No doubt some changes have taken place. But all available evidence (see recent BIS study) indicates that the risk from these G-SIBs is just as big as ever if not even greater today.

"Annual systemic risk scores for major banks around the world all use the same indicators. In the United States, each U.S. bank holding company with over $50 billion in assets is required to annually disclose its systemic risk indicators to the Federal Reserve by filing a Form Y-15, or Banking Organization Systemic Risk Report.3 A total of 33 banks — including eight subsidiaries of foreign banks4 — filed the Y-15 for 2013 and the Federal Reserve published the data on its National Information Center website."

"The Basel Committee designates banks with the highest scores as G-SIBs and each must hold an additional capital buffer of up to 3.5 percent of its risk-weighted assets." (note: The US Fed has issued guidelines requiring a capital buffer up to 5 percent for some US banks).  . . . . " The Basel Committee suggests that national regulators phase in G-SIB capital buffers beginning in January 2016."

It's hard for a non banker like me to know if a capital buffer of 3-5 % is high enough or not for these banks. I will just admit that I don't know, but it does not sound like very much of a buffer if a real systemic crisis did happen where many banks come under stress at the same time. This concern (the interconnected nature of these banks) is discussed in this report. Also, the capital buffers apparently don't start to "phase in" until January 2016.

"The systemic risk indicators are grouped into five categories, as shown across the top of Figure 1. Each category has a total weight of 20 percent divided equally among its indicators. A description of the five categories and their indicators follows:"

1) Size  - obviously this is a big key. Big banks get on the list pretty easily.

2) Interconnectedness - "The failure of a bank to meet payment obligations to other banks can accelerate the spread of a financial system shock if the bank is highly interconnected."

3) Substitutability - "A bank is more systemically important if it provides important services that customers would have difficulty replacing if the bank failed."

4) Complexity - "A bank with highly complex operations is more difficult to resolve and has a broader impact if it fails. Complexity is measured by a bank’s notional amount of over-the-counter (OTC) derivatives; total amount of trading and available-for-sale securities; and total illiquid and hard-to-value assets, which are also known as Level 3 assets."

5) Cross Jurisdictional Activity - "Banks with international operations can transmit problems from one region to another during a financial crisis. Global banks are also more difficult to resolve because they require coordination among national regulators. The scale of a bank’s global activity is measured by its total foreign claims and its total cross-jurisdictional liabilities."

In the next paragraph, the report says trying to assess the risks in these five categories "raises significant measurement challenges." In other words, it is not easy to figure out how much risk these banks have, but it is important to try and to set some kind of mandatory capital buffer to absorb losses at these banks. But again, who knows if a 3-5% of risk weighted assets buffer is enough or not? Some of these risks (like some OTC derivatives) are not even disclosed to the public. See IMF warning on "Shadow banking".

The next section of the report goes into detail on each of the five categories listed above. It's too much detail for this article. But one chart in the report really got my attention. It is figure 3 in the report. Below is the text in the report that goes with figure 3 (a chart showing total exposure of the bank vs. its total assets).

"Bank size is an important component of systemic risk. Figure 3 presents two measures of size, total assets and total exposures, the size measure used in the G-SIB methodology that includes derivative positions and securities financing transactions, such as repurchase agreements and securities lending. By either measure, the six largest U.S. banks dominated the others, accounting for nearly 70 percent of total assets and 72 percent of total exposures. The same six had total exposures 44 percent larger than their total assets."

If I read that correctly, the report states that just 6 banks have 70% of total assets and 72% of the total exposure (risk) in the US. Beyond that, the report says "the same six had total exposures 44% larger than their total assets." To use real numbers, if you look at JP Morgan on the chart for example, it shows that JP Morgan has total exposures (risks) that are more than $1 Trillion larger than its total assets. Again, is a 3-5% capital buffer to absorb losses on these exposures really enough in a true crisis situation? 

In the conclusion to the report, this statement is made:

"Some dimensions of systemic importance are not captured by the indicators. One is the extent to which a bank engages in maturity and liquidity transformation. Funding long-term illiquid assets with short-term liabilities can make a bank resolution more difficult. A second dimension is the extent to which a bank’s home sovereign relies on the bank for funding activities and financial services; this type of reliance can contribute to a bank’s systemic importance. A third dimension is that the current substitutability indicators do not directly measure all critical services, such as clearing and settlement operations."

In other words, this report is not able to fully capture all the risks these banks may have or how big their systemic impact might be. It's an effort, but not complete.

Concluding Summary:

By now, it should be clear that we need to take the systemic risk from these big banks seriously. On this blog we have documented warning after warning from both the IMF and the BIS that the conditions for another big financial crisis do exist. Just recently the BIS issued another study on this very topic. This report also shows why experts like Jim Rickards and others are warning that another crisis will eventually happen. 

Obviously, if we do get another big crisis, these big banks will have to have enough "capital buffer" to avoid failure. Looking at this new report, do you think that is the case? 

This is why all this is very important and why everyone needs to stay informed and have a plan in mind in case we do get another crisis. It is crystal clear that the some level of risk exists. The entire system up to and including the IMF and the BIS take it seriously. Experts like Jim Rickards and Nomi Prince take it seriously. So should we.

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