Capital Management Forum 2016 8 th & 9 th March 2016 Brandon - PowerPoint PPT Presentation

Capital Management Forum 2016 8 th & 9 th March 2016 Brandon Davies

} There are many measures of Bank Capital } Regulatory Capital – WRAs } Regulatory Capital – Leverage } Economic Capital – Risk Based Measures } Book Capital – Accounting Capital } Market Capital – What is the company worth? } So why do so many banks trade so far below book value? } The average price to book for banks in January 2015 was 1:1 by 11/2/2016 it was 0.645:1 } At the extreme Deutsche Bank trading at 30% of book, 0.3:1

} 11/2/16 FTSE down 118 into the close - @ 5549 } Street Account Summary - Sector Highlights: Dow (-2.19%), S&P (-1.86%), Nasdaq (-1.57%), Russell (-2.01%) } Financials the worst performer with the S&P Financials Index (-3.1%) } Banks in the crosshairs again with the BKX (-3.5%). } Weaker results from SocGen and Riksbank’s move to push rates further into negative territory getting latest blame. } Broader concerns about central banks’ embrace of negative rates, lower for longer US rates and growth and credit quality worries some of the other recent overhangs. } Big decliners include BAC (-5.8%), C (-5.4%), RF (-4.4%) and KEY (-4.1%).

} BKX - BKX (-3.5%). } KBW Bank Index Options. This is a modified cap- weighted index consisting of 24 exchange-listed National Market System stocks, representing national money center banks and leading regional institutions. } Acronyms & weightings are on this link - } https://www.invesco.com/portal/site/us/ financialprofessional/etfs/holdings/?ticker=KBWB } BAC - Bank of America } C - Citigroup } RF - Regions Financial Corp } KEY - KeyCorp

} So what is the real reason for the fact that the market is supposing many banks market values are worth only a fraction of the amount of capital they actually hold? } After the rolling series of financial crises that began when Lehman Brothers filed for Chapter 11 bankruptcy on 15 th September 2008. Contagion spread across the financial system. } This is often characterised as a overwhelming crisis but that is not, in my view, correct.

} Network theory, the non-linear behaviour of the financial system in situations of stress, is increasingly being put in the spotlight by researchers looking at systemic risks across markets. } Financial network systems are complex and the interconnections between them are in many instances not well understood but the importance of network theory can be appreciated from the simple diagrams below.

} Diagram 1 shows two independent market systems with no connections. An institution collapses and there is no contagion in this scenario. } On the other hand, Diagram 2 shows what happens in the same circumstances but in this diagram there are just two interconnections between institutions in each market system. The same institution defaults but this now results in all the institutions in both systems collapsing.

} Handle with th care } So, do we understand how our financial markets are connected? Can we know what effect current changes in regulation are likely to have on the number and extent of these connections? The answer is, of course, no, but understanding this does matter greatly. } When we look at the Lehman Brothers collapse and the seemingly endless reverberations of this on the global economy, it is very clear that the effects are not a direct result of a massive shock, as if Lehman were some Fukushima-like event that overwhelmed the global financial systems defenses. It is rather that the network effects of interconnected markets amplified the initial shock and created new shocks that the global financial system was unprepared for.

} If this is correct, then we need to be far more vigilant when looking for catastrophic events, as the initial event may well not look catastrophic at all. It is not the event itself that we should focus on, but rather the feedback and feed-forward repercussions and the so called spillover effects of the event within, and across, different financial markets; something that no individual institution, central bank or otherwise, is well set up to understand. } We also need to be very careful in assessing the effects of actions that drain liquidity from markets, as this will drive correlations more closely together. If it becomes difficult to sell one asset class in a crisis, the inevitable result is that other asset classes are sold, spreading contagion across seemingly independent financial systems . Volatile and highly correlated asset markets are exactly where liquidity strains are likely to show.

} So is there about to be a re-run of the 2008/09 banking crisis?

On the face of it all looks good but beware of the forms of capital raising some might be of dubious worth, such as deferred tax assets

The EU area Banks have been particularly hard hit by changes in the RWA requirements for trading book assets, moreover the leverage ratio hits EU capital markets as they are more focused on sovereign risk assets rather than corporate obligations or securitisations.

Leverage has reduced significantly and more than have RWAs it is probable therefore that lower RWA assets have been significantly reduced. Are we moving from liquidity transformation to credit arbitrage strategies?

At the level of their Investment Bank balance sheets, cuts in RWAs have been proportionately greater than those for overall assets, suggesting IB balance sheets are now less risky and banking groups less dependent on IB income.

Against their currently declared targets for re positioning the balance sheets of their IBs it appears that much of the adjustment has already been made, though to date the returns from these adjusted balance sheets are insufficient to cover the cost of their capital.

} Is it simply that the market is pricing in:- } A weaker Net Interest Margin? } A lower rate of loan growth? } A worsening credit outlook? } A lack of belief that cost cuts will be achieved? } Or are they pricing in all of the above but as a result of a renewed banking crisis? } The key to the difference is that a widespread crisis is likely to result in and from a liquidity crisis

The ECB as a source of funding for Euro area banks has fallen by EUR700bn From EUR1,260bn at the end of 2012 to EUR534bn in Feb 2016

On the face of it the liquidity position of European banks, which have born the brunt of falls in their equity prices has improved significantly since the peak of their problems in 2012. Greek banks do look to be a problem, however, in that their reliance on the ECB having fallen to the end of 2014 has risen since.

As a percentage of banking assets, outside of Greece there is no sign of a strain on European banks funding

During the 2008 and 2012 crises in bank funding the strain showed in interbank funding markets, this is not the case now, though changes to the markets mean unsecured inter-bank lending is now a much smaller market.

No sign of a run on the banks

} Liquidity provided by the ECB is now down by EUR 700bn from its 2012 peak, and all emergency liquidity support remains in place. } There is no sign of strain in interbank markets either in EUR or USD. } Deposit growth is strong, even in Greece and Italy. } Capital has risen by EUR800bn of which EUR665bn is high quality. } Future issues should be idiosyncratic rather than systemic, look for more differentiation on strategy and on financial robustness.

} The Sunday Times 14/2/2016 reports ts th that t Eu European banks have been blocked from raising billions in new long-te term loans prompti ting fears th that t centr tral banks may need to to ste tep in with th em emerg ergen ency fin cy finan ance. ce. } It t cite tes a source, who says th that t th the BoE E has alerte ted th the EC ECB to to th the th threat t of a funding crisis and is monito toring th the situ tuati tion closely. } The arti ticle note tes th that t executi tive of th three Briti tish banks have to told th them th that t th the markets ts have effecti tively been shut t to to th them over th the past t fortn tnight t due to to concerns over falling bank share prices, ta talk of negati tive rate tes and a general slowdown in th the world econ econom omy. y. } It t highlights ts th that t th the executi tives emphasized th that t th there was no danger of a funding crisis unless th the freeze last t several month ths, but t investo tors are demanding higher and higher inte terest t rate tes to to compensate te th them for futu ture risks, which is unsusta tainable. } It t points ts out t th that t th the BoE E and EC ECB could ste tep in if th the freeze persiste ted by acti tivati ting repo schemes put t in place in th the 2008 crisis, where centr tral banks would provide cash in retu turn for lenders pledging assets ts as collate teral.

} Market liquidity across all asset classes has significantly reduced. } European Investment Banks have cut their inventories of securities by some USD2tn over the last four years. } Note there is thus a lot less to Repo, would the ECB have to buy Bank debt outright should support be needed? } Who panics first panics best? } Be prepared for a volatile ride!

QUESTIONS?