another FT article aroused my interest this week: it says banks are complaining about Basel III having a detrimental effect on equity derivatives trading. Since tighter funding rules would make transactions, such as equity swaps, more expensive they are trying to water down the proposal. From a letter sent to the Basel committee:
“By unnecessarily increasing the funding cost for banking organisations’ equity market intermediation activities, the revised NSFR would also potentially force such activities into the largely unregulated shadow banking system, increasing systemic risk.”
There you have it: shadow banks, systemic risk – all things, bank lobbyists know, regulators are trying to avoid like the plague. After all, it has been “proven” that shadow banks and systemic risk caused the last crisis. Of course, the shadow banks would never have existed, had not the banks themselves turned a blind eye and funded them generously, but that’s another story…
But back to the article. As it is not very specific, I can only guess what it is about (hint: it’s certainly not about shadow banking or systemic risk fears by altruistic bank CEOs)
A short primer on Basel III
Under Basel III Banks are required to meet certain thresholds that measure the liquidity position of a certain institution. One ratio, the Liquidity Coverage Ratio (LCR), aims at measuring the short Term (up to 30 days) liquidity position of a bank, whereas the Net Stable Funding Ratio (NSFR) tries to capture a bank’s structural funding profile. Since I believe that the banks are worried about the LCR I will focus on this one for now. So how are these ratios defined and what do equity derivatives have to with them?
Basel III ranks assets according to their liquidity characteristics, weights them (similar to Risk weights) and sums them up to arrive at the numerator of the LCR Ratio. Same with the liability side: banks have to calculate their outflows in a stress scenario over a 30-day horizon. The estimated figure becomes the denominator. Divide numerator by denominator whereby Basel III prescribes a LCR Ratio > 1, i.e. banks are expected to cover their estimated outflows in a stress scenario for 30 days, without outside assistance.
( Zerohedge has posted a new article on the workings of Basel III LCR-ratio)
Fine, but what does this exercise have to do with equity derivatives?
Well, if a bank is long or short any derivative you are subject to margining. As with simple margin loans, with swaps or futures you only need a fraction of the money of the notional amount to enter the position, but you need to come up with additional cash as the position moves against you. If you cannot come up with the cash? Well, that’s how AIG failed. So far there has been no regulatory rule telling banks how much cash to hold (in addition to the initial margin required by my counterpart) against these positions for regulatory purposes – they could do as they please (there were rules for the credit risk associated with derivatives, though). Under Basel III, however, banks will be required to specify their potential outflows from such positions for a 30 day horizon under stress and it seems this is causing headaches.
Enter equity swaps
Most banks hold interest rate derivatives in order to steer their balance sheet’s interest rate risk. despite the fact that notional amounts can be very high, the fact remains that the duration of these derivatives usually is in the single digits, i.e. not that large. Further, interest rate movements in the age of the central banker tend to be well contained, i.e. an increase in rates of, say, 100 bp. can convincingly (in the eye of risk managers or regulators, that is) be seen as a shock – hence the cash outflows, in case of an adversarial movement are more or less within a single digit percentage of the notional. Also, banks have been using interest rate derivatives for a long time, their treasuries have in all likelihood already experienced one big rate move or the other, i.e. they should have enough experience with that.
Equity swaps are a different issue altogether: obviously since shocks in equity markets involve much larger percentage changes – i would say anything less than 30 percent is not conservative enough – potential cash outflows are also larger, ceteris paribus. Add to this the fact that, since the financial crisis, equity swaps have grown massively, in line with the growth of synthetic ETFs, and you see how this could potentially lead to nasty outcomes.
The “idle” reserves myth
Although it has toned down a bit, there has been an intense discussion about the huge liquidity reserves that banks hold at the Fed ever since the Fed has started with QE 3. Keynesians have argued that this huge reserve stockpile is the main reason behind the low velocity of money and the main driver of deflationary forces. Since deflation is bad, it is to be avoided at all cost. Consequently, banks need to be incentivized (=forced) to lend out the money to “starving” businesses in order to kick-start the economy.
Instead, people like James Grant and David Stockman have pointed out that the reserves are not lying “idle” but instead are being used to margin derivatives trades of all sorts and consequently do exert influence on market prices, i.e. the “idle” reserves are an important driver of the current rally. The FT article would suggest they were right and Keynesians, in turn, wrong.
Banks complaining means they are probably overextended
To sum it up: the fact that some banks complain loudly about the impact of Basel III on their equity derivative business means three things:
- this is an important revenue driver, i.e. shutting down would hurt the bottom line
- complying with Basel III, i.e. putting in proper stress assumptions, would be to costly and kill the business
- not putting in proper stress assumptions means banks do not want to account for this risk properly (which sooner or later will hit the bank anyway)
The above points taken together indicate that a substantial amount of bank profits comes from an activity that can only continue in these dimensions if one turns a blind eye to liquidity risk – sounds familiar. Apart from liquidity risk, I would bet that banks are also long equity markets in one way or other, as this activity has been profitable on the back of a huge market advance. Banks certainly claim that they are hedging market risk (they are only “intermediating”), but as Jim Chanos once famously said in his Enron testimony:
“It is an axiom in securities trading that, no matter how well “hedged” a firm claims to be, trading operations always seem to do better in bull markets and to struggle in bear markets.”
In other words: some large banks are overextended liquidity and, very likely, market risk – potentially in systemic proportions (those reserves at the Fed are huge, after all). To what extent, we will only start finding out once equity markets start falling…