March 14, 2014

TED spread: Indicating Credit Risk?

The difference between the 3-month LIBOR rate and the 3-month Treasury rate, also called the TED spread, is a commonly used indicator for the perceived credit risk in the general economy. Defining this spread requires an explanation of its parts. As a rule of thumb, the TED spread tends to be wide if banks view loans as risky and investors are nervous. In contrast, it will be small when markets are stable. We will now identify the parts of the TED spread.

We start off by defining the LIBOR rate.  The LIBOR is an interest rate which serves as a benchmark for the interest rates charged by banks when they lend funds to each other. The market where banks lend funds to each other is called the interbank market. So as some might have noticed, the LIBOR is actually an abbreviation. More specifically it stands for the London InterBank Offer Rate. This interest rate is determined by the average of borrowing costs of global banks, discarding upper and lower quartiles. It’s important to realize that banks all around the world use the LIBOR as a base rate for setting their own interest rates on loans. In order to see the importance of the LIBOR, one should know that hundreds of trillions of dollars in securities and loans are linked to the LIBOR. When the LIBOR rises, rates and payments on loans often rise. Similarly, they fall when the LIBOR goes down.

Second, the U.S. Treasury Bill rate can be seen as being risk-free. Thus the size of the TED spread indicates the liquidity premium in the market, as the LIBOR indicates the credit risk of lending to banks. The TED spread can widen due to an increase of the LIBOR or a decrease of the Treasury rate. We already have discussed the widening based on the LIBOR rate. The widening of the TED spread, based on the Treasury rate, occurs because banks want to get first-place collateral in times of crisis. This means that they will like to hold more Treasury bonds, pushing down the Treasury rate. We give a visual representation of the widening of the TED spread during crisis times below. In this graph an overview is given of the TED spread between April 2007 and January 2009, indicating the recent financial crisis.

In the following part we discuss the manipulation of the LIBOR, also called the LIBOR fixing scandal. During the financial crisis, banks manipulated the LIBOR rate in order to show a healthier picture of their credit quality and ability to raise funds. Namely, the true LIBOR rate would reveal problems with respect to the ability to borrow funds from the market. Thus the LIBOR rate was kept at a level that was unrealistically low. In the beginning of the financial crisis, the credit markets for banks started to freeze up. Banks began to suffer losses on their holdings of toxic securities relating to American subprime mortgages. As a consequence, banks were reluctant to lend to one another which led to shortages of funds. So there was little data in submitting LIBOR. This allowed for the opportunity to set LIBOR rates that did not match reality. Several banks were taken under the loop in the investigations but in order to demonstrate the event, we would like to refer to the following graph. This shows the range of different LIBOR rate submissions by banks after the Lehman Brother collapse. As you can see, before this point the rate submissions were very similar. 

The investigations into the fixing of the LIBOR rate by the national authorities led to global penalizations of numerous large and well-known banks. The European Commission, for instance, fined six financial institutions including Deutsche Bank and Citigroup with the highest antitrust penalty and the highest penalty for rigging financial benchmarks ever.
"What is shocking about the Libor and Euribor scandals is … the collusion between banks who are supposed to be competing with each other"


March 11, 2014

Stress Tests : Useful or Misleading?

Since the financial crisis and the collapse of the financial system authorities see stress testing from vital importance for financial institutions to shore up confidence in the financial system. Stress testing is an analysis conducted under unfavorable economic scenarios which is designed to determine whether a bank has enough capital to withstand the impact of adverse developments by examination of their balance sheets. Banks have to understand how robust their positions are to alternatives of macro events and other stresses, no matter how implausible they seem. Their existing risk structures and processes failed to account for the enormous liquidity crunch following the collapse of Lehman Brothers. Stress testing is pointed out as a very important tool to examine the structural challenges banks are facing today and to understand their risk exposures (market risk, credit risk, liquidity risk).

The financial crisis has highlighted the problems of over-reliance on quantitative models. The traditional performance measures (RoE and RoA) needs to be combined with more forward-looking risk tools and techniques. The European authorities, the EBA (European Banking Authority), ECB (European Central Bank) and European Systemic Risk Boards (ESRB) are strengthening bank stress testing procedures and their application. The exercises are used to evaluate bank’s plans to comply with the evolving capitalization requirements under EU’s latest Capital Requirement Directive CRD IV which is the implementation of the global agreed Basel III accords on banking capital and liquidity (8% core Tier 1 capital).

Incorporating banks’ reaction to shocks is a critical input into the design of informative stress tests, especially over long time horizons. This requires modeling solvency and liquidity shocks in a coherent manner because first, when banks react to financial stress, the source of the shock (solvency or liquidity) is not always clear and the measures that banks take in reaction to these shocks have both capital and liquidity aspects that are not easy to disentangle. It is clear that the stress tests scenarios need to encompass a much longer time horizon; incorporate structural shifts (e.g., ongoing deleveraging and changes of bank funding profiles) affecting the balance sheet and income; and emphasize more other metrics, such as profitability, and changes in RWA. Scenarios such as a benchmark scenario, a recession scenario or the impact of a sovereign debt shock to a recession are implemented during stress testing.

Are stress test possible to boost investors’ confidence? Can the added RQR safety measure save the euro zone and its financial institutions? The European Central bank is expected to release the results of its latest bank stress test in November, which involves reviewing the quality of bank assets and requiring those that fail to recapitalize. Not only conducting an in-depth asset quality review (AQR) but also a recapitalization quality review (RQR) will be necessary to supervise the euro zone’s largest banks. The AQR only reveals limited capital shortfalls, representing a fraction of the sector’s annual profits. An expanded RQR would address wider structural risks inherent in recapitalizing banks. It helps to highlight those banks where conventional recapitalization is impossible, and allow investors and national regulators to prepare for a potential bail-in.

In the stress test, any capital shortfall arising from either the baseline or the adverse scenario relative to agreed benchmarks will require a strengthening of capital buffers and/or other supervisory interventions, as will losses ascertained in the AQR. As the stress test results for the banks that are subject to the comprehensive assessment will incorporate capital requirements that may result from the AQR, the end result will be more demanding than in previous exercises conducted by the European authorities in 2011.

With respect to the selection of portfolios – AQR phase 1 – data for all 128 banks across the EU were submitted to the ECB on schedule in late December, followed by a data quality review undertaken in close cooperation with the NCAs. The collection of data focused on identifying the most risky portfolios for inclusion in the AQR and subject to the minimum criteria that selected portfolios must account for at least 50% of a bank’s risk-weighted assets in each country. Intensive work is currently under way to select, bank-by-bank, the portfolios to be reviewed. For banks operating in multiple countries, only the parent bank will be scrutinized. That process will end in mid-February. 

We have seen that these tests are based on scenarios in which banks in each country fail or pass. Are these scenarios and the required Core Tier 1 Capital ratio of 8% right? Can stress testing conducted by the European authorities cover up the whole weakness in the European Banking system? Is there enough following up, coordination and transparency? Are the results coming from accurate data? Liquidity risk was a kind of sleeping risk we didn’t took into account in the past. Are there other risks that needs to be measured? The U.K.’s Prudential Regulatory Authority has said it is likely that it will also test banks on completely other test metrics such as the leverage ratios as a measure of capital adequacy because banks are using the benchmark risk-adjusted metrics to overstate their financial strength.

March 8, 2014

The Rise of Shadow Banking

Financial crisis of 2008 was a landmark on the history of financial regulations. The collapse of large investment and commercial banks was an alarm for the banking sector. Since then every regulator turned their attention to find a solid structure for the financial sector. We’ve observed a rise in the financial regulations. Starting with Dodd Frank Reform and Volcker Rule in United States, Ring Fencing in United Kingdom and ongoing debates in European Union, there is a strong drift towards more regulated markets and financial institutions. And there is no predictable reason in the near future to change this direction.

Since the global financial crisis, regulators become even more anxious about the high leverage that banking sector employed. Regulatory pressure on bank lending and request for deleveraging is increasing since then.

In order to comply with regulations Banks had to change their models and reshape their balance sheets by reducing their risk weighted assets. Basel 3 is a game changer. RBS’s August 2013 report states that across Europe complying with Basel III rules will require banks to reduce assets by 3.2 trillion Euros.
Central Banks all over the world responded to the financial crisis by loosening the monetary policy. Since 2008, the biggest six central banks have spent 7.5 trillion US Dollars on quantitative easing programs. This increased the market liquidity and promoted lending.

As expected, asset allocations also changed in post crisis era. Equity allocations fell and fixed-income allocations rose. (Mercer 2013 European Asset Allocation Survey)

All these developments cause an unprecedented rise in shadow baking. Traditional banks and non-bank lenders switched hats. The demand for borrowing satisfied more and more by non-bank lenders. A recent research from DC Advisory shows that LBO (leveraged buyout) deals including non-bank lenders has been increased from 17% in 2011 to 46% in 2013.

Some experts claim that shadow baking absorb some of the risks that traditional banks took and constitute a market friendly solution to the “too big to fail” problem. However cases like the fail and following bail out of Long Term Capital Management (LTCM) reinforce the skepticism towards these arguments. On the contrary one might argue that heavily reliance to shadow banking was one of the reasons that triggered the last global financial crisis.

In conclusion, massive quantitative easing kept interest rates all time low and substantially increased the demand for assets with yield. On the other hand new regulations restrained banks appetite for lending. Somebody had to fill the void. Therefore we have seen a boom in shadow banking. 

The effects of this process is still not clear but it is certain that the financial system is increasingly changing and our models can’t keep up the pace to explain the situation.

 References :

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