Credit - Dumb buffers

"When the weather changes, nobody believes the laws of physics have changed. Similarly, I don't believe that when the stock market goes into terrible gyrations its rules have changed."

- Benoit Mandelbrot 

A buffer is a part of the buffers-and-chain coupling system used on the railway systems of many countries, among them most of those in Europe, for attaching railway vehicles to one another. Buffers in the very earliest days of railways were rigid (dumb buffers). 

You might wonder where we might be going with this week's railway analogy, but, looking at the recent senate hearings following last year JP Morgan's 6 billion dollar losses, discussions surrounding banks and equity capital have resurfaced as of late. Arguably one of the most pertinent read we have come across was from Bloomberg's editors - JPMorgan’s $6 Billion Loss Shouldn’t Be a National Matter:

"To make the whole system more resilient, banks need to get a larger share of their funding in the form of equity from shareholders, as opposed to loans from depositors and other creditors. We have advocated $1 in equity for each $5 in assets, a level that would absorb a 20 percent drop in the value of a bank’s investments, compared with JPMorgan’s 3.1 percent. The latest global banking rules require only $1 in equity for each $33 in assets, and use a lenient approach for measuring the ratio.
Higher equity requirements reduce taxpayer support to banks in a different way, by making them less likely to require bailouts. The added discipline would also put natural pressure on banks to shrink: Once shareholders fully realized how poorly the largest banks perform in the absence of subsidies, they would have more incentive to demand that they be broken up into smaller, more profitable units." - source Bloomberg

Dumb buffers were the source of many staff accidents and damaged loads and vehicles. The Board of Trade required all new construction in England and Wales from 1889 to have spring buffers, but in Scotland the railway companies continued to accept new wagons with dumb buffers until 1 October 1903. From 31 December 1913 all dumb buffered vehicles were banned from the main line, but the Scottish owners gained an extension to 1915. In fact, the disruption of the Great War meant that dumb buffers persisted in Scotland until at least 1920-21. 

One can argue that the latest global banking rules requiring only $1 in equity for each $33 in assets is akin to the famous dumb buffers that plagued Scottish railways for an extended period of time, which might be leading to many "derailments" for banks in particular and for the economy in general as witnessed with the financial crisis of 2008:

The aftermath of the Gare Montparnasse accident

Similar to Bloomberg editors and Simon Johnson, MIT professor and former chief economist at the IMF, we have long advocated larger equity buffers for banks in order to reduce the systemic risk banks pose to the real economy as a whole. Back in October 2011, in relation to discussions surrounding Capital Regulation, contrary to many beliefs, we argued as well that Bank Equity is not expensive. It is a myth. A study realized by Stanford University by Anat R. Admati is a must read. a summary of the presentation made to the Bank of England by the co-author is available here:

"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive"

A summary of a presentation to the Bank of England is available below which highlights Professor's Admati's key findings.

http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

Some countries such as Denmark have started asking for higher extra capital. For instance, Denmark's systematically important financial institutions will have to hold 2.5% to 5% of extra capital as recommended by Denmark's Sifi committee. Its recommendations will have to be passed into law by the Danish parliament.

While the European Union us trying to press ahead with global banks standards by March 22nd, if the measures are not in place by month end, it would mean additional delays in implementing the January 2014 target for Basel III accord, which could potentially shorten the transition period and put some additional strain on lenders to adjust by the start of 2014 or delay the implementation until January 2015.

In this week conversation, we would like to focus our attention to this very important subject of bank regulation and capital adequacy, given both the European Union and the US have struggled to agree on legislation to apply the international standards on capital, known as Basel III, which were published in 2010 in conjunction with the Dodd-Frank act, following the demise of Lehman Brothers Holdings Inc.

So far, the Basel rules negotiations also have been stalled on how much additional capital should be required for systemically important financial institutions as reported by Rebecca Christie and Caroline Connan in their Bloomberg article from the 26th of February entitled - Barnier Says EU Needs Basel Deal to Lift Uncertainty for Banks:

"Lawmakers are pushing the EU to include in the capital rules a requirement for country-by-country reports on profits, losses and taxes, according to the document. Nations have been reluctant to expand the scope of the capital rules, preferring to tackle the topic in separate accounting legislation.

The Basel Committee on Banking Supervision brings together banking regulators from 27 nations including to the U.S., U.K., and China to coordinate their prudential rule-making.

The Basel III measures, which must be written into national laws, would more than triple the core capital lenders must hold and set standards for how lenders should manage risks. Representatives of Karas and the Irish presidency in Brussels declined to comment on the paper." - source Bloomberg.

On top of that, regulators from the Basel Group have clearly put Bank's debt addiction on scrutiny this year as reported by Ben Moshinsky and Jim Brunsden in Bloomberg on the 12 th of March - Bank's Debt Addiction Said to Face Scrutiny at Basel Meetings:

"Regulators are preparing to fight lenders over the details of the so-called leverage ratio as they seek to toughen rules on the minimum amount of capital they must use to back their investments. The Basel group, which brings together supervisors from 27 nations, will meet in the Swiss city tomorrow, according to the people, who asked not to be identified because the meetings are confidential.

 Concerns over how banks calculate reserves has led U.K. bank regulator Adair Turner and U.S. Federal Deposit Insurance Corp. board member Jeremiah Norton to call for tougher leverage ratios. Global supervisors in 2010 included a draft leverage ratio in an overhaul of rules, known as Basel III, drawn up in response to the financial crisis that followed the collapse of Lehman Brothers Holdings Inc.

“Early on, banks did not see it as such a big danger, or as a priority for lobbying, because it looked less likely to be implemented in the EU than other parts of Basel III,” Philippe Lamberts, the lawmaker leading the work on the Basel III rules for the European Parliament’s Green group, said in a telephone interview.

Leverage ratios force banks to hold capital equivalent to a percentage of the value of their assets. Such measures are simpler than standard capital requirements as they don’t give banks any scope to take into account the riskiness of their investments when calculating the reserves they must hold." - source Bloomberg

Back in September 2011, we quoted Dr Jochen Felsenheimer from asset management company "assénagon" now called "XAIA", we would like to quote him again looking at the current context:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. 

Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? Because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity." - Anat R. Admati.

For instance, since 2009, banks have indeed been very creative in the methodology used to beef up their Core Tier 1 ratio using a new generation of Hybrids securities called CoCo (Contingent Convertible Capital). CoCos, convert to equity or are written off once an issuer’s capital ratios fall below a preset level. This market for these new securities, already amounts to +10 billion dollars. This contingent convertible security pays a higher coupon and automatically convert into equities or suffer a full or partial write-down when the bank's capital ratio falls below a pre-defined trigger. 

The beauty for the issuer is that the CoCo automatically boosts its Core Tier 1 capital ratio in times of stress rather than being forced into a dilutive right issue during difficult market conditions. Owning a CoCo, according to a recent BNP Paribas note is very similar to selling a Down-and-In put option on the issuing

bank’s shares with a knock-in barrier linked to a balance sheet capital ratio as opposed to stock price level.

The issuing bank is effectively buying skew and convexity (crash protection) from the investor, who is exposing himself to losses in stress scenarios. 

It is not a free lunch although a coupon in the region of 7% to 8% is outright appealing in this low rate / low yield environment.

The benefits of such transactions for the issuer of CoCo notes is that not only it enables the issuer to maintain a particular minimum capital level, it also pleases the regulator and allows issuers which have been previously bailed out in Europe, to continue repayment of the aid received. For instance, KBC bank issued in January 1 billion dollar worth of CoCos, allowing them to continue the repayment schedule on time and, following a stress test, the National Bank of Belgium had required an additional 2 billion euros of Core Tier 1 capital to be raised. KBC completed in December 2012 a 1.25 billion euro equity offering and 750 million euros worth of CoCos.

While Europe is falling behind in relation to the implementation of Basel III, Switzerland has started implementing it as of January 2013 as indicated in a recent note by BNP Paribas on KBC's specific CoCo from January 2013:

"It is worth pointing out that due to the implementation of Basel 3 in Switzerland starting January 2013 as planned (as opposed to the delay in Basel 3 implementation in Europe, due to delay in completion of CRD4), the relevant ratio in ascertaining the likelihood of trigger is now the Core Equity Tier 1, rather than Core Tier 1 as it was under Basel 2.5. While this comes as no surprise and should have been fully expected it does make quite a bit of difference. For instance, at its Q3 12 UBS reported Basel 2.5 Core Tier 1 ratio of 18.1%, whereas the pro-forma phased in Basel 3 CET1 ratio was 13.6%." - source BNP Paribas

The fixation bankers have with equity buffers mean that they prefer issuing hybrids securities such as CoCos rather than equity in order to maintain their leverage and generate ROE. As indicated by Dr Jochen Felsenheimer, in case of trouble, the insurer is the taxpayer. CoCos are deemed to be "capital" and automatically improve the capital ratios, pleasing regulators in the process, and avoiding an automatic dilution of existing shareholders via capital increases through right issues. They are not equivalent to "equity", they are debt instruments, paying no doubt, a higher coupon, given the risk taken by the low subordination and risk of capital wipe-out faced by the bondholders.

As a reminder, under the draft Basel III plan in 2010, banks would have to hold so-called Tier 1 capital equivalent to 3 percent of their assets, so capping a lender’s debt at no more than 33 times those reserves, which, we think is way too low.

Last week events surrounding German Bank Commerzbank's capital increase is a reminder of not only the lack of sufficient equity buffer in the banking space but is also indicative of the material impact internal models of RWA (Risks Weighted Assets) can have to boost capital ratios as highlighted again in Bloomberg's article from the 12th of March - Bank's Debt Addiction Said to Face Scrutiny at Basel Meetings:

"The temptation for banks to boost their reserves through changes to risk calculations, rather than real steps to raise capital, could be countered by a strong leverage ratio, said Lamberts, the European lawmaker. One example of this is how German lender Commerzbank AG sought to meet EU capital rules in part by adjusting its risk calculations, rather than simply raising fresh reserves, Lamberts said.

“Details that are coming to light about how banks misuse their internal models, for example when Commerzbank said it would make up half of a capital shortfall through changes to its models, show the need for this kind of rule,” he said.

Commerzbank was one of more than 60 lenders told by the European Banking Authority to hold capital equivalent to 9 percent of its risk-weighted assets." - source Bloomberg

On March 2013, Commerzbank AG, Germany's second largest bank announced it would sell 2.5 billion euros of shares to repay the government and insurer Allianz SE. Commerzbank received a 18.2 billion euros bailout in 2009 and the German government had owned 25% of the bank prior to the announcement.

Of course the 15% dilution announcement led to the share sliding 14% in Frankfurt on the 13th of March - source Bloomberg:

 The share declined 14% valuing the bank at around 7 billion euros.

Commerzbank's shares, the intraday proverbial "sucker punch" - source Bloomberg:

This news made us chuckle given that the CEO Martin Blessing, will be using the capital raised to repay 1.6 billion euros owned to the government and 750 million euros to German insurer Allianz, as well as increasing its Core Tier 1 capital to 8.6% under full Basel III capital from 7.6%. 

Why did we chuckle, you might ask? Well, because Commerzbank's largest shareholder SoFFin (Special Financial Market Stabilization Fund), converted already its silent participation in June 2012 to approximately 58.85 million Commerzbank shares,  increasing in effect the capital of Commerzbank to maintain its equity interest ratio in Commerzbank to 25% plus one share. With the 15% dilution, this participation will be now diluted to 20%, meaning in effect a loss for the German taxpayers.

Oh well...

But this painful adjustment for Commerzbank will not be the last one, given we have already established the link between credit and shipping and in particular the exposure of German's second largest bank to shipping woes back in August 2012:

"Commerzbank – the world’s second-biggest provider of ship finance, and reluctant owner of a flotilla of foreclosed ships – said it is shutting down its €20bn (£15.7bn) ship funding operations entirely to “minimise risk and capital lock-up” under tougher EU banking rules."

In April in 2011, in our conversation "Shipping is a leading credit indicator", we indicated:

"Commerzbank’s 2008 takeover of Dresdner Bank AG increased its stake in shipping lender Deutsche Schiffsbank to 92 percent, doubling the size of its maritime-loan portfolio, just before the industry entered its biggest crisis since World War II." - source Bloomberg.

One can wonder what will be the recovery value for its maritime-loan portfolio looking at the boom and bust which occurred in the shipping space - source Bloomberg:

"The marine shipping industry is highly cyclical and susceptible to periods of boom and bust. Cycles are driven by overbuilding during times of growth to take advantage of strong markets. Shipping companies do not have enough lead time to alter orders when economic activity begins to slow, which has a significant effect on freight rates." - source Bloomberg.

Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book:

"Prices of seaborne vessels have crashed since peaking in 4Q08 and have been steadily declining since 4Q09, as excess capacity slowed the new build backlog, along with cheaper builds in China and tight credit markets. Chinese shipbuilders have been using price in attempt to win market share. Price pressure has come on less sophisticated dry-bulk ships relative to LNG tankers." - source Bloomberg

On the subject of banks capital shortfalls and the need to deleverage, and RWAs in particular, Nomura's note from the 11th of March 2013 entitled EU banks - Reconciling weak macro with momentum made some interesting points:

"To illustrate the point on headline capital ratios, the last published EBA Basel 3 monitoring exercise showed that at end-2011, European banks required EUR 225bn of equity capital to meet the minimum CET1 requirement of 7.0% of RWAs (inclusive of GSIB buffers where required). The report implied that the risk-weighted capital ratio rather than the unweighted leverage ratio was more of a bind on banks’ capital needs (given that the bar for unweighted leverage at 3.0% is set rather low, in our view). While we do not expect an official update on the 2012 capital position before September 2013, the EBA did separately disclose that as a result of capital raised for the 2012 stress test as well as other capital measures, European banks increased their capital positions by more than EUR 200bn in 1H 2012 (mostly through measures that directly increase capital rather than reduced assets). Based on the 2011 run-rate of net profit, in 2H 2012 around another EUR 40bn could have been added to banks’ capital bases.

Given that some banks will choose to build additional capital buffers, we do not expect the next monitoring exercise to show zero capital shortfall at end-2012 (several of the large often wholesale banks such as Deutsche Bank still had a gap at end-2012). However, we expect the reported capital shortfall to be substantially reduced for end-2012.

We are aware in 2013 that regulators are looking to improve harmonisation of the measurement of RWAs, moving away from internal models. In some cases, the banks have been well prepared (such as in Sweden) while in others it will delay the timeline to full Basel 3 compliance (such as in the UK). In general, we find that it is the wholesale banks with the lowest RWA/total asset ratios that might have the most need for additional capital actions or balance sheet shrinkage to meet regulatory goals. 

However, our main concerns for the banks are less about the measurement of RWAs and more about the fact that in some economies (such as Spain), the historical cost carrying value of banks’ assets is too high compared with their market value considering the fall in real estate prices in those economies. These unrecognised bad assets (along with deteriorating GDP and rising unemployment) require banks to divert profits to loan loss reserves rather than new lending." - source Nomura.

Moving back to our discussion around bank regulation and capital adequacy, we need to ask ourselves what have been accomplished since the demise of Lehman in 2008? Not enough, as indicated by the Bloomberg editors on the 10th of March in their article - Getting the Banks Around the World to Play by the Same Rules:

"Since that 2008 pact, progress has been made on the road to convergence. One example: Starting on March 11, Wall Street’s largest banks, including Goldman Sachs Group Inc. and JPMorgan Chase & Co., must process derivatives trades through clearinghouses, an accomplishment of the 2010 Dodd-Frank financial reform law, itself part of the U.S.’s commitment to convergence. By holding collateral and standing between buyers and sellers, clearinghouses can prevent one participant’s default from infecting all the others. In another step forward, the EU decided in December to create a single bank regulator. 

In Reverse 

But the dream of convergence remains, well, a dream. Conflicting national and regional laws, regulations and accounting standards have blocked the world from getting on the same page on financial reform. This, in turn, has jeopardized the ability of regulators to work across borders to address the next crisis. Shutting down a large failing bank that, say, loses all its capital because of a trading strategy gone haywire isn’t possible without universal rules for resolving sick banks. Moreover, financial companies will be able to take advantage of regulatory arbitrage -- shifting operations to countries with the loosest rules.

What happened? Let’s take a tour.

 In the U.S., regulators have been lobbied to a standstill. They have yet to name a single nonbank financial company or industry as systemically risky, despite the immense size and vital roles played by money-market funds, hedge funds, insurers and nonbank lenders. 

The Commodity Futures Trading Commission is backing away from some of its early positions on derivatives, moves that could have broken the big-bank stranglehold over the swaps business. The agency looks likely to revoke a proposal that would have required large investors to solicit quotes from at least five dealers, as a way to promote pre-trade price transparency. 

Regulatory agencies have also stalled over the Volcker rule, named after former Federal Reserve Chairman Paul A. Volcker. The measure is supposed to limit speculative trading by federally insured banks. For more than a year, five agencies have been debating with large banks and among themselves about where to draw the line between trading and making markets for clients, which the law exempts from the Volcker rule. On Capitol Hill, meanwhile, lawmakers from both parties and both chambers want to repeal parts of Dodd-Frank, including the requirement that banks move derivatives trading to separate affiliates with their own capital. 

Nasty Split

In Europe, the situation is no more auspicious. A nasty split has opened between the Continent and the U.K. The European Parliament and national governments have moved in recent weeks to tax financial transactions and cap bankers’ bonuses. This has (rightly) rubbed the British the wrong way, as their model of finance -- the Anglo-Saxon model -- is less regulated, more centered on trading and pays bigger bonuses than its counterparts in, say, France or Germany. 

Another rift is between Europe and the U.S. -- this one over capital requirements. New rules being written in Basel, Switzerland, have been watered down after much bickering. The level is now set at 7 percent of risk-weighted assets, up from 2 percent. Still, it falls short of the 10 percent initially sought by the U.S., and way short of the 20 percent of total assets that some economists and academics recommend. France and Germany led the opposition, seeking to protect the interests of their biggest lenders, which would have needed to raise more capital than foreign competitors, Bloomberg News has reported. Not only is the global financial system no safer now than it was in 2008, it’s also clear that the project of convergence is badly stalled. Is the world really prepared to let the great convergence turn into the great divergence?" - source Bloomberg.

On a final note the principal reason for banks to hold a larger equity buffer is to be able to face risks such  as real estate bubbles. For instance both Credit Suisse and UBS have been asked to hold more capital to that effect as reported by Bloomberg:

"The 1.2 swiss-franc-to-euro cap and low interest rates have prevented the Swiss National Bank from tightening monetary policy to avert soaring real estate prices. To mitigate the risk of a property bubble, the authorities plan to curb lending growth by requiring banks to hold an extra 1% of capital on residential mortgages, starting 4Q13. UBS and Credit Suisse had 252 billion francs of mortgages outstanding at end-November." - source Bloomberg.

"What we define as a bubble is any kind of debt-fueled asset inflation where the cash flow generated by the asset itself - a rental property, office building, condo - does not cover the debt incurred to buy the asset. So you depend on a greater fool, if you will, to come in and buy at a higher price." - James Chanos 

Stay tuned!