Yet Another Warning from the IMF - This Time on "Shadow Banking"

This time about a growing "shadow banking" system. In this Telegraph article, IMF Deputy Chief Zhu Min speaking at the World Economic Forum in Davos says banking risks have shifted to "shadow banking". What is shadow banking? What risks does it pose? Let's look at it.

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We see the term shadow banking pop up pretty often these days. Ever wonder what shadow banking is? Investopedia defines it this way (click here for full explanation):

DEFINITION OF 'SHADOW BANKING SYSTEM'

The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.

So who might some of these financial lenders "not subject to regulatory oversight" be? Investopedia explains that as well:

INVESTOPEDIA EXPLAINS 'SHADOW BANKING SYSTEM'

Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives and other unlisted instruments. Examples of unregulated activities by regulated institutions include credit default swaps. 

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OK, that tells us what shadow banking is. But what risks does it pose to us?
The Telegraph article says this:

"Non-financial corporations have raised $1.3 trillion (£860bn) through shadow banking in the US alone," he told the Telegraph."

"The IMF estimates that contingent liabilities of these shadow forms of lending have reached $15 trillion in the US, using a "broad" measure of activities that captures new forms of risk. This is higher than in China. It is roughly 180pc of banking assets and is rising rapidly towards its pre-Lehman peak. It is particularly worrying since it was a "run" on the interlinked world of structured finance that caused the global crisis to metastasise in 2008."

"Zhu Min said the oil price crash is "terrific news" for consumers but warned that its effects are double-edged and raise a whole new set of risks. It may set off a fiscal crisis in producer countries and a debt-repayment crunch for oil companies with $1 trillion of bonds."

"The concerns were echoed by David Rubenstein, head of the Carlyle Group, who said the slide in oil prices to $50 a barrel is likely to set off a chain of defaults by Russian companies that owe $650bn of external debt."

"They can't service the debt. And who owns that debt? It is nearly all held by European banks. They are going to be hurt, and I suspect that currency turbulence in Europe is going to hurt them too," he said."
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My added comments: 

This article touches on a key risk that we have talked about here many times. This Telegraph article does a good job of explaining what the risk is, why everyone needs to understand it, and how to be aware of what it could lead to.

In plain terms, this article says we have an IMF estimated $15 Trillion (in the US alone) of risk floating around out in this unregulated "shadow banking" system. And this is probably a drop in the bucket of the true undisclosed derivative related investments and debts in the world. The BIS statistics show that worldwide there were an estimated 691 hundred trillion of various forms of derivatives out there as of June 2014. Some are regulated and disclosed to the public and some aren't. Even the IMF and BIS cannot really be sure what the true risk is out there. The system is too big and complex to track it all.

The reason we need to understand these numbers is because none of us has any idea what the true risk to the overall system is related to these obligations. In theory, banks and financial institutions who deal in these higher risk investments offset their positions (hedge) so that their net exposure to losses is a much smaller number than the full value of the contract. However, there is a problem that can arise suddenly at any time. If one too big to fail entity messes up and goes under due to a mistake in their hedging program and has too little reserve capital, it can make the full value of these highly leveraged obligations come due. Not the much smaller "net" position. 

As a simple example, let's say Bank A has a $100 billion long derivative position on the Euro with  Bank B and a $98 billion short position on the Euro with Bank C. Supposedly, the "net" risk of loss to Bank A would be $2 billion (the net of their hedged long and short positions). But what if the Euro drops too far too fast (as just happened against the Swiss franc). This causes Bank C to go under. Bank C cannot pay Bank A the $98 billion they owe them on their Euro short position? (the BIS has issued a warning that many banks are using models that are too optimistic for these types of investments)

In that case, Bank A sees their $100 billion long position collapse in value very quickly. They cannot collect anything on their hedged short position with Bank C (who went bankrupt and cannot pay). Now Bank A goes under too. The true risk to Bank A is much more than the net $2 billion everyone thought they had. The $2 billion risk assumed everyone stays solvent and can pay what they owe.

This is how these unregulated derivative contracts could create a daisy chain of failures that puts the whole system at risk very quickly. Using the link above to the BIS stats, they show 691 trillion in total derivatives as of June 2014. If 3% of those were to go bad, that is over $20 trillion. 

Given the above, just keep in mind that both the IMF and BIS have issued warnings about this problem. The IMF is doing it again here in this Telegraph article. Jim Rickards has stated the overall system is unstable. He predicts at some point we will get a crisis much bigger than the 2008 crisis (he says at least 6 times as big in a recent article). He uses this forecast as the basis for his prediction that the next crisis will be too big for the US Fed to handle, and that the IMF will take over to deal with the crisis.

This Telegraph article shows how all this could actually happen, why the IMF and BIS keep warning about it, and why we cover it here. If it does happen, the world and the present monetary system will change and everyone will be impacted. The crisis would come very quickly without any warning.

Does that mean we should worry constantly about all this? No!  We don't know what the true risk really is and we can't do anything to prevent a crisis like this if it ever does happen. A better response is to understand the risk is out there and incorporate that risk into your financial planning. Once you devise a personal plan to deal with this risk that fits your situation, don't waste time worrying. Just stay informed and alert and go about your business. We will try to help with the staying informed part here.

Added note 8-6-15: A full list of systemic risk warnings can be found on this blog page 

Chrsitine Lagarde: Accomodative Monetary Policy still needed while "Growth Remains Anemic"

IMF Chief Christine Lagarde issued these comments at year end 2014 as quoted in this Reuters article. These new comments suggest that the IMF still thinks global growth is weak. Also, she warns that despite increased regulation in the banking industry, a "shadow banking" industry still exists and that "more effort was needed to fill the shortfall of data on the financial sector". Below some quotes from the article and then a comment. Please read the full article linked above.

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"Accommodative monetary policy will remain necessary for as long as global growth remains weak, IMF managing director Christine Lagarde said in a newspaper article published on Wednesday."

"Accommodative monetary policy will continue to be necessary while growth remains anemic, although we must pay very close attention to the risk of potential spillover," Lagarde wrote in an opinion piece for Italian business daily Il Sole 24 Ore."

"Lagarde said progress had been made in regulating financial services but that countries must now pursue reforms and improve banking supervision."

"She called for tighter control over "shadow banking", or non-bank credit and off-balance sheet bank lending, and said more effort was needed to "fill the shortfall" of data on the financial sector and allow for better regulation."

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My added comments:

This brief statement tells you a lot. The IMF sees world growth as "anemic". Also, they are still concerned about potential problems in the banking system from "shadow banking". This is defined as "non-bank credit and off-balance sheet bank lending".

Consider that for a moment in light of the trillions of derivative products out there in the global system. When you have "shadow banking" and "off-balance sheet bank lending" that means NO ONE knows what all the true risks are out there in the global banking system. You can't assess the risk of something not reported or disclosed to the public.

Why such bank lending and transactions are permitted to be done "off- balance sheet" is a reasonable question to ask. Especially if they can threaten the stability of the entire banking system as many believe.

Coming Later Today - The Mainstream Forecast for 2015

Input from Readers

With not much new to report here, I did get some reader emails suggesting various articles that might be of interest to readers here. So below I have pasted in the links to those articles with a brief excerpt from each just below the link.

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The Guardian - How Big Tech is Dragging Us Towards the Next Crash


"In every major economic downturn in US history, the ‘villains’ have been the ‘heroes’ during the preceding boom,” said the late, great management guru Peter Drucker. I cannot help but wonder if that might be the case over the next few years, as the United States (and possibly the world) heads toward its next big slowdown. Downturns historically come about once every decade, and it has been more than that since the 2008 financial crisis. Back then, banks were the “too-big-to-fail” institutions responsible for our falling stock portfolios, home prices and salaries. Technology companies, by contrast, have led the market upswing over the past decade. But this time around, it is the big tech firms that could play the spoiler role."

Click here to read the full article in The Guardian

The Maghreb Times - Tunisia is First Country to Issue a Central Bank Digital Currency

"Tunisia has announced the launch of its digital currency, the ‘E-dinar.’ With this, the tiny North African country claims to be the first country to launch a central bank digital currency (CBDC)."

Click here to read the full article in The Maghreb Times

The Block - China's President wants Country to  Be Blockchain Leader

"China's President Xi Jinping said on Thursday that the country's communist party should regard blockchain as a core technology for important innovative breakthroughs and should commit to accelerating the development of the technology, according to a report from Xinhua.net."

Click here to read the full article in The Blockcrypto.com

BIS Report on Chinese "Shadow Banking"

Abstract

"Banks' shadow, or money creation by banks beyond traditional loans, plays an important role in China's money-creation process, posing a number of challenges to monetary policy operations and financial risk management. This paper analyzes the money-creation mechanisms of China's shadow banking sector in detail, provides accurate measurements, investigates its effects on financial risk, and surveys recent regulation. To strengthen supervision, China's regulators should closely track the evolution of various shadow banking channels, both on- and off-balance sheet. Specific macroprudential regulation tools, such as asset reserves and risk reserves, should be applied separately to banks' shadow and traditional shadow banking."

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My added comments: A thank you to readers for their input and forwarding the links to these articles. Always appreciate the help.

Added note: I like to include these kinds of stories when I see people doing good things to help out a neighbor. This one happened to take place right nearby us, but got some national attention. Enjoy:

https://twitter.com/LateNightSeth/status/1194668749967831040

Repost of Systemic Risk Articles

Recently, we have written some blog posts that relate to the topic of systemic risks to the financial system and the banking system. These articles all contain links back to warnings and reports on this topic from the leading global institutions in the system itself like the IMF and the BIS. 

Because we get new readers here regularly and because the information in these articles is so important, below we are reposting links to these articles all in one place. We will probably repost this information from time to time because it's so important and because the source of the information is from the leading banking institutions in the world.

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Yet Another Warning from the IMF - This time on Shadow Banking

"IMF Deputy Chief Zhu Min speaking at the World Economic Forum in Davos says banking risks have shifted to "shadow banking". What is shadow banking? What risks does it pose? Let's look at it."

Bank for International Settlements (BIS) Studies Global Credit Risks

In 2013, the (BIS) did a survey to try and get a feel for the current status of credit risk management. The survey participants came from North America, Europe, and Asia. The goal of the survey was to find out the current status of credit risk management and how it may have changed since the 2008 financial crisis. The survey produced four main recommendations. 

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. 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.

Note: This last blog article linked above contains even more links to more warnings we published last year from the IMF and the BIS. The number of warnings and reports is significant even as we note that there is not that much media coverage of these reports.

Crisis Watch Update - The New Gridlock?

Really nothing new to report here. As we have said, if any kind of major crisis like we watch for here does arise, it will likely revolve around the ongoing battle between the Trump Administration and the existing power structure it wants to disrupt. 

In some ways we may have a new form of gridlock. Instead of Republican vs. Democrat we now appear to have the would be Disruptors vs. the Existing Power Structure (which draws from both political parties). So far, neither side appears to have gained much ground. Hence, what I will call "the new gridlock" for now. 

Trump appears to be someone who can pivot on a dime and change teams (talked about working with Democrats as soon as the GOP bill failed) when it suits his purposes to avoid gridlock if he can. But the entrenched factions that exist in the present system may be able to frustrate him as happened with the recent GOP health care bill. More on this thought later. It may provide us a clue as to how Trump might deal with a major financial crisis if faced with one during his term.

Added note: I got the BIS email alert below advising me of new BIS guidelines for banks exposed to risk from so called "Shadow Banking."

BIS Alert - Press Releases

Proposed guidelines for the identification and management of step-in risk 15 March 2017 Press release about the Basel Committee publishing proposed guidelines for the identification and management of step-in risk, 15 March 2017. "The proposed framework will help to mitigate potential problems at shadow banks from spilling over to banks. This work is part of the G20's initiative to strengthen the oversight and regulation of the shadow banking system with the aim of mitigating systemic risks, in particular, those arising from banks' involvement with shadow banking entities." and also another email alert on rules for "globally systemically important banks" here:

BIS Alert - Press Releases

Progress report on banks' implementation of the principles for effective risk data aggregation and reporting issued by the Basel Committee 28 March 2017 Press release about the Basel Committee issuing a progress report on banks' implementation of the principles for effective risk data aggregation and reporting (28 March 2017).

Christine Lagarde: US Economy Returning to Growth, But has 'Pockets of Vulnerability'

The IMF performs an annual analysis of the health of the US economy and then does a report on it. In this IMF Direct blog article, Christine Lagarde provides a summary of the findings this year. 

In general, the IMF sees the US continuing slow growth, but with some risks to financial stability still present. This is consistent with what the IMF has said for some time now. Below are some quotes from the Christine Lagarde blog article and then a few added comments.

----------------------------------------------------------------------------------------------

"IMF staff have just concluded their annual health check of the U.S. economy, and released their concluding statement.

This year we have also undertaken a Financial Sector Assessment Program with the United States. We conduct these once every 5 years for systemically important countries and it is a comprehensive exercise looking at the whole U.S. financial system."

. . . . . 

Economic outlook

"Yet again, the review took place against the background of a shaky first quarter for the U.S. economy. And we revised our growth forecast down to 2.5 percent for 2015. This is largely due to those factors that affected the first quarter."

. . . . . 

"As always, there are risks and uncertainties to the outlook. For example, further delay of the housing recovery and the strong dollar—notwithstanding the latest improvement in the trade balance—could be a drag on future growth. Nevertheless, when we look at the whole picture, we believe that growth in the coming quarters will be 3 percent or higher."

. . . . . . 

"Over the medium term, as we highlighted last year, there is still much work to be done. Our forecasts of potential growth are now around 2 percent—a far cry from the over 3 percent average growth rates we saw before the Great Recession."

This leads to our policy recommendations in three key areas.

1. Monetary policy

"On monetary policy, as we have noted before, the Fed’s first rate increase in almost 9 years is being carefully prepared and telegraphed. Nevertheless, regardless of the timing, higher U.S. policy rates could still result in significant market volatility with financial stability consequences that go well beyond U.S. borders.

In weighing these risks, we think there is a case for waiting to raise rates until there are more tangible signs of wage or price inflation than are currently evident:    . . . . . . 

2. Financial stability

"Our team has taken a detailed and comprehensive look at the health of the financial sector under our Financial Stability Assessment Program."    

. . . . . 

"It also seems clear that risks have built up during the long period of exceptionally low interest rates. Nevertheless, today, the data point toward a system with pockets of vulnerabilities rather than one with broad-based excesses. But we shouldn’t minimize these risks. These pockets could create serious, macro-relevant sources of financial instability both here and abroad. Some of our concerns include the migration of intermediation to so-called “shadow banks” and the potential for insufficient liquidity in a range of fixed income markets, particularly as these markets come under stress. I know that the U.S. authorities are investing heavily in understanding and assessing these issues."

. . . . .

3. Fiscal Policies

"As we have said before, given our forecast of a steady rise in the public- debt-to-GDP ratio, it remains critically important to adopt and implement a credible medium-term fiscal plan. This requires actions on tax reform, social security reform, and steps to contain healthcare costs."

. . . . . . 

In conclusion:

• We believe near-term U.S. growth prospects are good.
• It is better to wait for stronger signs of inflation pressures and have an interest rate hike in the first half of 2016.
• Even after the initial step to raise rates, a gradual rise in the federal funds rate will likely be appropriate.
• And although important progress has been made to strengthen the U.S. financial system, there is more to be done to address the pockets of vulnerability

Click Here to Read the full article for full context

----------------------------------------------------------------------------------------------------------------------------

My added comments:

I will just add a few comments related to each of the three main areas listed above.

1- Economic Growth - Here the IMF once again revises its growth forecast downward after everyone badly over estimated the first quarter GDP in the US. They still think overall the US will slowly increase growth. But we have to be honest and admit that they and other economists have consistently been too optimistic in their forecasts. The Atlanta Fed forecast model has been the most accurate and it still shows a lower growth forecast than this one by the IMF (although the Atlanta Fed forecast has been increased in the last week). Also, the call by the IMF to wait until 2016 to raise interest rates supports Jim Rickards prediction that this would happen.

2- Financial Stability - Both the IMF and the Bank for International Settlements have issued repeated warnings about systemic risks for quite some time now. We have many of those documented here on the blog. In this article Ms. Lagarde mentions a couple of these risks. Shadow banking and "the potential for insufficient liquidity in a range of fixed income markets, particularly as those markets come under stress". We covered both the shadow banking warning and the liquidity warning here in earlier blog articles. The market liquidity problem has also been mentioned recently in articles by both Nouriel Roubini and Jim Rickards. I had a friend of this blog (who is a very high level banking expert) review the Jim Rickards article on this issue. He informed me that while there are real risks, he believes they are manageable risks. I believe this is the prevalent view within the system. You can see from the Christine Lagarde article that she is aware of the risks. She obviously thinks the risks will be managed because she is not forecasting they will lead to another major crisis.

3- Fiscal Policies - With the current political division and grid lock in the US, I think it is safe to say that none of the recommendations the IMF makes in this area will be adopted in the US any time soon.

Conclusion: This IMF Direct blog article is a good one to illustrate the different views out there on a big question we are following here on the blog. That question is whether or not we will get another big global financial crisis (worse than the 2008 crisis) that many are predicting?

Some credible analysts outside the system think we will get another crisis. Contacts I have within the system agree there are risks present, but believe the risks can be contained and managed. 

Readers should understand that there are some very good people inside the system who understand the systemic risks and understand why some outside the system are worried about them. They do, however, think that the efforts being made to contain the risks and prevent another major crisis will work. I don't find evidence in my research that suggests fear that another major crisis is imminent exists inside the system right now.

My own view is that there is an information gap between those inside the system and those outside the system that contributes to the difference of opinion on this very important question. Obviously, those inside the system have access to more information than those of us on the outside. Jim Rickards feels those on the inside are using the wrong models and will miss a coming crisis. We will continue to follow events here and provide the best information and analysis we can, given the information limitations we must work with. If we have readers working inside the system who are willing to comment on this important issue, your comments are welcome and will be reported here (without editing and only with your permission). 

Meanwhile, our advice remains the same. Readers should stay alert and informed. Readers should have a backup plan in mind in case another crisis does emerge, but not waste time worrying about it constantly. We will do our best here to help with the staying informed part.

Coming Up Over the Holiday Weekend

With the Fourth of July weekend coming up we will take a little break here for a few days. In the month of June we had several very popular articles that also covered some very important issues. 

Over the holiday weekend (July 2-5) we will repost a few of those articles. This will give readers who may have missed the articles the first time a chance to read them over the holidays.  Here is one to get things started.

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Christine Lagarde blog article on the US Economy (originally posted 6-15-2015)

The IMF performs an annual analysis of the health of the US economy and then does a report on it. In this IMF Direct blog article, Christine Lagarde provides a summary of the findings this year. 

In general, the IMF sees the US continuing slow growth, but with some risks to financial stability still present. This is consistent with what the IMF has said for some time now. Below are some quotes from the Christine Lagarde blog article and then a few added comments.

----------------------------------------------------------------------------------------------

"IMF staff have just concluded their annual health check of the U.S. economy, and released their concluding statement.

This year we have also undertaken a Financial Sector Assessment Program with the United States. We conduct these once every 5 years for systemically important countries and it is a comprehensive exercise looking at the whole U.S. financial system."

. . . . . 

Economic outlook

"Yet again, the review took place against the background of a shaky first quarter for the U.S. economy. And we revised our growth forecast down to 2.5 percent for 2015. This is largely due to those factors that affected the first quarter."

. . . . . 

"As always, there are risks and uncertainties to the outlook. For example, further delay of the housing recovery and the strong dollar—notwithstanding the latest improvement in the trade balance—could be a drag on future growth. Nevertheless, when we look at the whole picture, we believe that growth in the coming quarters will be 3 percent or higher."

. . . . . . 

"Over the medium term, as we highlighted last year, there is still much work to be done. Our forecasts of potential growth are now around 2 percent—a far cry from the over 3 percent average growth rates we saw before the Great Recession."

This leads to our policy recommendations in three key areas.

1. Monetary policy

"On monetary policy, as we have noted before, the Fed’s first rate increase in almost 9 years is being carefully prepared and telegraphed. Nevertheless, regardless of the timing, higher U.S. policy rates could still result in significant market volatility with financial stability consequences that go well beyond U.S. borders.

In weighing these risks, we think there is a case for waiting to raise rates until there are more tangible signs of wage or price inflation than are currently evident:    . . . . . . 

2. Financial stability

"Our team has taken a detailed and comprehensive look at the health of the financial sector under our Financial Stability Assessment Program."    

. . . . . 

"It also seems clear that risks have built up during the long period of exceptionally low interest rates. Nevertheless, today, the data point toward a system with pockets of vulnerabilities rather than one with broad-based excesses. But we shouldn’t minimize these risks. These pockets could create serious, macro-relevant sources of financial instability both here and abroad. Some of our concerns include the migration of intermediation to so-called “shadow banks” and the potential for insufficient liquidity in a range of fixed income markets, particularly as these markets come under stress. I know that the U.S. authorities are investing heavily in understanding and assessing these issues."

. . . . .

3. Fiscal Policies

"As we have said before, given our forecast of a steady rise in the public- debt-to-GDP ratio, it remains critically important to adopt and implement a credible medium-term fiscal plan. This requires actions on tax reform, social security reform, and steps to contain healthcare costs."

. . . . . . 

In conclusion:

• We believe near-term U.S. growth prospects are good.
• It is better to wait for stronger signs of inflation pressures and have an interest rate hike in the first half of 2016.
• Even after the initial step to raise rates, a gradual rise in the federal funds rate will likely be appropriate.
• And although important progress has been made to strengthen the U.S. financial system, there is more to be done to address the pockets of vulnerability

Click Here to Read the full article for full context

----------------------------------------------------------------------------------------------------------------------------

My added comments:

I will just add a few comments related to each of the three main areas listed above.

1- Economic Growth - Here the IMF once again revises its growth forecast downward after everyone badly over estimated the first quarter GDP in the US. They still think overall the US will slowly increase growth. But we have to be honest and admit that they and other economists have consistently been too optimistic in their forecasts. The Atlanta Fed forecast model has been the most accurate and it still shows a lower growth forecast than this one by the IMF (although the Atlanta Fed forecast has been increased in the last week). Also, the call by the IMF to wait until 2016 to raise interest rates supports Jim Rickards prediction that this would happen.

2- Financial Stability - Both the IMF and the Bank for International Settlements have issued repeated warnings about systemic risks for quite some time now. We have many of those documented here on the blog. In this article Ms. Lagarde mentions a couple of these risks. Shadow banking and "the potential for insufficient liquidity in a range of fixed income markets, particularly as those markets come under stress". We covered both the shadow banking warning and the liquidity warning here in earlier blog articles. The market liquidity problem has also been mentioned recently in articles by both Nouriel Roubini and Jim Rickards. I had a friend of this blog (who is a very high level banking expert) review the Jim Rickards article on this issue. He informed me that while there are real risks, he believes they are manageable risks. I believe this is the prevalent view within the system. You can see from the Christine Lagarde article that she is aware of the risks. She obviously thinks the risks will be managed because she is not forecasting they will lead to another major crisis.

3- Fiscal Policies - With the current political division and grid lock in the US, I think it is safe to say that none of the recommendations the IMF makes in this area will be adopted in the US any time soon.

Conclusion: This IMF Direct blog article is a good one to illustrate the different views out there on a big question we are following here on the blog. That question is whether or not we will get another big global financial crisis (worse than the 2008 crisis) that many are predicting?

Some credible analysts outside the system think we will get another crisis. Contacts I have within the system agree there are risks present, but believe the risks can be contained and managed. 

Readers should understand that there are some very good people inside the system who understand the systemic risks and understand why some outside the system are worried about them. They do, however, think that the efforts being made to contain the risks and prevent another major crisis will work. I don't find evidence in my research that suggests fear that another major crisis is imminent exists inside the system right now.

My own view is that there is an information gap between those inside the system and those outside the system that contributes to the difference of opinion on this very important question. Obviously, those inside the system have access to more information than those of us on the outside. Jim Rickards feels those on the inside are using the wrong models and will miss a coming crisis. We will continue to follow events here and provide the best information and analysis we can, given the information limitations we must work with. If we have readers working inside the system who are willing to comment on this important issue, your comments are welcome and will be reported here (without editing and only with your permission). 

Meanwhile, our advice remains the same. Readers should stay alert and informed. Readers should have a backup plan in mind in case another crisis does emerge, but not waste time worrying about it constantly. We will do our best here to help with the staying informed part.

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.

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"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.

BIS Speech - Former Italian Minister of Finance - The International Monetary System Strikes Back

The Bank for International Settlements publishes speeches relevant to the monetary system on its web site from time to time. This one is a dinner speech given by a former Minister of Finance from Italy, Fabrizio Saccomanni. In the concluding remarks to this speech, he laments that world leaders often use the phrase "global challenges require global solutions", but do not actually implement global solutions. This speech touches on many issues we have covered here on the blog that relate to the monetary system. 

Below are several quotes from the speech. The speech is fairly long so I can only use some excerpts for this blog post. To get full context, please read the whole speech. Just below each quote, I will add a comment in bold type to try and clarify the point to be made.

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"I am grateful to Jaime Caruana and Claudio Borio for having invited me to this important meeting. After my brief experience as Minister of Finance in Italy, it is nice to be back in the more stable world of central banking where I have spent most of my professional life."

This speech is from a Central Bank lifer to more Central Bank lifers.

"In my remarks today, I will review the three aspects of the current policy debate that I have mentioned. These will be examined separately, but they are components of the same global economic problem and I will make frequent cross-references to highlight the interconnections among them."

1-Monetary spillovers


"In its 84th Annual Report last year, the BIS forcefully made the point that international financial markets have been “under the spell of monetary policy”, showing a keen sensitivity to the impact of monetary policies, actual or expected. It used not to be that way. There were indeed many episodes in the past in which markets were taken by surprise, most famously in 1994, when the unexpected increase in the policy interest rate by the Federal Reserve led to the collapse of the market for government and corporate bonds world-wide, paving the way for the “Tequila crisis” in Mexico. The current spell originates from the conventional and unconventional monetary policies adopted by the major advanced economies since 2008. Policy rates have remained at very low levels for an unprecedentedly long time; long-term interest rates have fallen to historical lows; credit spreads have been compressed across asset classes, including emerging market economies’ (EMEs’) debt securities and high-yield corporate bonds. This has led to a dramatic increase in global liquidity and, in the context of uncertain growth prospects for advanced economies, to large capital inflows to EMEs. The composition of these flows has seen a decline in bank lending and an increase in portfolio flows, which tend to be more volatile. Especially for countries with relatively underdeveloped and shallow financial markets, large capital inflows may feed credit and asset price bubbles. Moreover, by causing the exchange rate to appreciate, inflows may create external imbalances. Contrasting the impact of such inflows may be costly and not necessarily effective. However, these trends can be quickly reversed if markets become convinced that a change in the monetary policy stance of major countries is imminent."

In his first area of discussion, he is simply pointing out that since the 2008 financial crisis world financial markets have become addicted to monetary policies (low interest rates, QE, etc). Just the expectation of a monetary policy announcement now moves markets regularly. He says "It used not to be that way."  He notes that large flows of capital around the world, especially into emerging market nations, "may feed credit and asset price bubbles." He goes on to say in this section that the risks from monetary spillovers still exist and could lead to abrupt market corrections. 


2-Financial cycles (i.e. boom & bust)


"These developments in the research on the functioning of global financial markets confirm that procyclicality is a fundamental feature of their behaviour. But what is the main cause of procyclicality? As I have argued in the past (Saccomanni 2008), although global financial intermediaries operate in a highly competitive environment, they have uniform credit allocation strategies, risk management models and reaction functions to macroeconomic developments and credit events. Thus, competition and uniformity of strategies combine, in periods of financial euphoria, when the search for yield is the dominant factor, to generate underpricing of risk, overestimation of market liquidity, information asymmetries and herd  behaviour; in periods of financial panic, when the search for safe assets is predominant, they combine to produce generalised risk aversion, overestimation of counterparty risk and, again, information asymmetries and herd behaviour."

In this second area of discussion he talks about market cycles (boom & bust) and asks: What is the main cause for them? He suggests that that investment managers tend to run in a herd mentality and use similar models to project markets and risks. He says when times are good, they get overconfident and use models that are too rosy. When panic sets in, they use models that overreact and become too risk averse. He says this behavior then amplifies the normal business cycle. He also notes that these days the addiction to monetary policies of central banks can help trigger these cycles.

3-Currency wars

"Monetary policy changes in a key country have an obvious impact on the exchange rate of its currency vis-à-vis other currencies. At the same time, exchange rate movements can have an impact on investors’ strategies and contribute to amplifying the impact of monetary spillovers and to triggering a financial cycle."

In this section he just notes that monetary policies of various countries impact currency exchange rates that can lead to what are now commonly called currency wars. He says this can also amplify the impact of market movements. So he ties all three of these concepts together to say that the stability of the world financial system overall is heavily impacted by these three areas.

"The monetary-financial-exchange rate interactions that I have tried to describe are in fact the manifestations of the shortcomings of the current IMS (International Monetary System). And indeed some sort of a debate on reforming the system, restoring international monetary order, or promoting international monetary coordination has begun, involving both central bankers and academic economists. . . . The overall impression, however, is that there is a deep divergence of views and that little progress is being made towards any form of consensus on what should be done to fix the system."

Now that he has established the "global challenges" to financial stability, he goes on to say that we need "global solutions" to these problems. He says the current international monetary system (IMS) has broken down and needs better coordination from the IMF and the BIS. But he says the overall feeling these days is "that little progress is being make towards any form of consensus on what should be done to fix the system."

A comparison of the G7 and the Asian approaches highlights the crucial dilemma confronting policy-makers when dealing with financial cycles, which Rey (2013) described as follows: “independent monetary policies are possible if, and only if, the capital account is managed, directly or indirectly, regardless of the exchange rate regime”. If international monetary policy coordination is precluded by political considerations and/or the domestic orientation of central bank mandates, then the issue is how to devise an efficient and effective strategy to manage the capital account. It is obvious, at least to me, that this goes beyond the regulatory measures to strengthen the capital base and the liquidity position of banks and financial intermediaries. This process is well underway within the Basel and FSB fora, and it is being implemented in both advanced and emerging economies. But, as Governor Zeti Akhtar Aziz eloquently put it: “Our efforts will not be sufficient to prevent the next mega tidal wave” (Aziz 2014), because, incidentally, shadow banking activity continues to grow unabated. 

This section is more difficult to follow for us non bankers. But basically he seems to be saying that while there is some global effort underway to prepare for the next financial crisis, the efforts are not sufficient "to prevent the next mega tidal wave." Note his reference to "shadow banking" which we covered here earlier. He is preparing us for his argument that more global coordination and cooperation will be required in the next crisis. Next he suggests that these inadequate efforts underway now (which allow each nation to try and solve its own problems) will have to be replaced with a global approach. Here is where he talks about that.

"Is this what the world economy really needs? To roll back financial integration and to promote financial fragmentation? And what for? To preserve temporarily the independence of national policies until the next crisis, when all countries will be forced to cooperate under the pressure of events? It seems to be a very shortsighted approach, and it might hamper the growth prospects of the world economy. Rather, I do not see why it should not be possible to improve our ability to prevent and mitigate financial crises by combining the necessary but insufficient house-in-order approach with a realistic reform that would strengthen the instruments and the procedures for managing international financial instability within the institutions that have been created over the years for that very purpose."

The institutions he is talking about are the IMF and the BIS. He says reforms to strengthen them are what is needed. He then offers four reforms to move towards that goal listed just below.

1- A first priority would be to implement the reforms of IMF governance and quotas agreed by the IMFC but still awaiting formal ratification by the US Congress. As this is not considered possible at the present political juncture in the US, the IMF should find alternative ways to achieve the rebalancing of votes and voices in favour of EMEs.

2- Another important step in the same direction would be the inclusion of the Chinese renminbi in the SDR in the context of the basket review scheduled for 2015.  It should be possible to reach a consensus on this reform, which would also enhance the credibility of the SDR by making it more representative of the changed conditions in world currency markets. Whether this step would lead to a new reserve currency regime, as advocated by the Governor of the People’s Bank of China (Zhou 2009), remains to be seen. But I see no harm in trying.

3- A reform of a more general significance would entail the expansion of the global safety nets to an extent sufficient to discourage an excessive accumulation of reserves, which can have a negative impact on economic activity and foreign trade.

4- However, the most necessary and yet more difficult reform is in the area of international policy cooperation. Here again, an important body of background information and analysis has been assembled since the outbreak of the crisis by the G20, the IMF, the World Bank, the BIS and the OECD. But, with a few exceptions, results of these efforts have been modest so far, to say the least . . . .   Sometimes the communication from international cooperation fora tends to broadcast, perhaps not intentionally, a message of the opposite sign, like “it’s every man for himself now”. This is not acceptable, and I fully share the view of the BIS that in a highly integrated global economy “the need for collective action - cooperation - is inescapable. 

Here he makes his call to end the days of "every man for himself" and defer national interests to "the need for collective action-cooperation". In other words, "global challenges call for global solutions" and those solutions should be coming from the IMF and the BIS. He adds that this is actually a political problem:

"The question therefore seems to be more political than technical and, to quote from a perceptive lecture by a former Governor of the Reserve Bank of India, Y.V. Reddy, the real problem is that “short-term motivations at the national level seem to run counter to the longer-term interests of the global economy."

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Concluding comments:

This is obviously a longer article than usual for this blog. However, it ties together many points we have made here that relate directly to coming monetary system change. Here is the bullet point list:

- the current system is unstable and at risk from asset bubbles created in response to various central bank policies around the world 

- these various central bank policies are shaped by the desire to achieve short term results for the various nations and are causing harm to the overall global monetary system. They lead to an "every man" (nation) for himself mentality

- the IMF and BIS have studied all this and have tried to start global solutions by requiring higher capital buffers (Basel regulations) for the worlds banks and investment houses, but their efforts are too meager to prevent the next financial crisis (mega tidal wave)

-when the next crisis comes, nations will be "forced to cooperate under the pressure of events" because the current system is inadequate and too uncoordinated

-only strengthening the existing global institutions (IMF in the lead) will make it possible to coordinate a global solution to the problem. He lists four ways to strengthen global institutions right now

-nations will have to give up the idea that their individual needs are more important than the stability of the overall global monetary system and will have no choice because the global system is so interconnected now

There you have in one speech almost everything we have covered and talked about here for over a year. This is how the world's central bankers are thinking about what needs to happen in the future. Notice how all this ties in very closely to what Jim Rickards has predicted will happen. That is, a new bigger global financial crisis that leads to the IMF stepping in to solve the problem. The IMF using the SDR as a new global reserve currency in some way. This speech lays out that whole idea as possible.

It should be clear now why we are covering all this here on the blog. The world's central bankers are anticipating the potential for another crisis. They expect it to lead to essentially what Jim Rickards has predicted. If that happens, the US dollar will be replaced as sole global reserve currency and everyone who uses the US dollar will be heavily impacted. That's the bottom line for readers here.

Interestingly, this speech expresses a lot of frustration at how none of this is moving forward right now. So, we really don't what may happen if we get another major crisis. But we do know very clearly what a possible plan is. Whether the world will accept it is the unknown.