From the Outside

Westpac considers its options in NZ

Westpac today (24 March 2021) announced that it is “… assessing the appropriate structure for its New Zealand business and whether a demerger would be in the best interests of shareholders. Westpac is in the very early stage of this assessment and no decisions have been made.”

There are obviously a lot of moving parts here but one important consideration is the interaction between the substantial increase in capital requirements mandated by the RBNZ and APRA’s proposed change in the way that these investments must be funded by the Australian parent.

The rest of this post offers a short summary of how these investments are currently treated under the Australian capital adequacy standard (APS 111) and APRA’s proposed changes.

As a rule, APRA’s general capital treatment of equity exposures requires that they be fully deducted from CET1 Capital in order to avoid double counting of capital. The existing rules (APS 111) however provides a long-standing variation to this general rule when measuring Level 1 capital adequacy. This variation allows an ADI at Level 1 to risk weight (after first deducting any intangibles component) its equity investments in banking and insurance subsidiaries. The risk weight is 300 percent if the subsidiary is listed or 400 per cent if it is unlisted.

APRA recognises that this improves the L1 ratios by around 100bp versus what would be the case if a full CET1 deduction were applied but was comfortable with that outcome based on exposure levels that preceded the RBNZ change in policy.

The RBNZ’s move towards higher CET1 requirements however undermines this status quo and potentially sees a greater share of the overall pool of equity in the group migrate from Australia to NZ. APRA recognises of course that the RBNZ can do whatever it deems best for NZ depositors but APRA equally has to ensure that the NZ benefits do not come at the expense of Australian depositors (and other creditors).

To address this issue, APRA has proposed to amend APS 111 to limit the extent to which an ADI may use debt to fund investments in banking and insurance subsidiaries.

ADIs, at Level 1, will be required to deduct these equity investments from CET1 Capital, but only to the extent the investment in the subsidiary is in excess of 10 per cent of CET1 Capital.
An ADI may risk weight the investment, after deduction of any intangibles component, at 250 per cent to the extent the investment is below this 10 per cent threshold.
The amount of the exposure that is risk weighted would be included as part of the related party limits detailed in the recently finalised APS 222.

As APRA is more concerned about large concentrated exposures, it proposed to limit the amount of the exposure to an individual subsidiary that can be leveraged to 10 per cent of an ADI’s CET1 Capital. This means capital requirements are increasing for large concentrated exposures, as amounts over the 10 per cent threshold would be required to be met dollar-for-dollar by the ADI parent company.

You can find my original post here which offers more background and may be useful if you are not familiar with the technicalities of Level 1 and Level 2 capital adequacy. At the time the change was proposed, APRA indicated that it would release more detail during 2020 with the aim of implementing the change on 1 January 2021. Covid 19 obviously derailed that original timeline but I assume APRA will provide an update sometime soon.

Tony – From the Outside

Antifragile

Interesting review of Nassim Taleb’s “Antifragile” by Scott Alexander on his “Astral Codex Ten” blog

— Read on astralcodexten.substack.com/p/book-review-antifragile

Fed money printing and inflation

I will always worry about inflation but I found a post by Morgan Housel offering an interesting counter perspective on what the Fed is doing with the money supply

“The risk of rising inflation over the next few years is probably the highest it’s been in decades. Inflation happens when too much money chases too few goods, and Covid-19 closed a lot of businesses and gave people an unprecedented amount of money. The stars align.
That out of the way, let me cool things down: The Fed is printing a lot of money, but not nearly as much as it looks.”

The short version is that the dramatic increase in recent times can be attributed to a redefinition of savings accounts in the US – link to the post here. The inflation question is obviously way more complex than this simple data point but the post is short and worth reading.

Tony – From the Outside

In Search of a Post-Pandemic Modeling Paradigm – Risk Weighted

Nice post from Tony Hughes discussing the difference between modelling intended to forecast a most likely outcome and modelling tail risk …

“A forecasting mindset yields very tight models, whereas a tail risk mindset demands a far more liberal approach to model specification.”

— Read on riskweighted.com/2021/03/03/in-search-of-a-post-pandemic-modeling-paradigm/

Another reason why monetary authorities might not like stablecoins

Marc Rubinstein’s post (here) on Facebook’s attempt to create an alternative payment mechanism offers a useful summary of the state of play for anyone who has not had the time, nor the inclination, to follow the detail. It includes a short summary of its history, where the initiative currently stands and where it might be headed.

What caught my attention was his discussion of why central banks do not seem to be keen to support private sector initiatives in this domain. Marc noted that Facebook have elected to base their proposed currency (initially the “Libre” but relabelled a “Diem” in a revised proposal issued in December 2020) on a stable coin approach. There are variety of stable coin mechanisms (fiat-backed, commodity backed, cryptocurrency backed, seignorage-style) but in the case of the Diem, the value of the instrument is proposed to be based on an underlying pool of low risk fiat currency assets.

A stable value is great if the aim for the instrument is to facilitate payments for goods and services but it also creates concerns for policy makers. Marc cites a couple of issues …

But this is where policymakers started to get jumpy. They started to worry that if payments and financial transactions shift over to the Libra, they might lose control over their domestic monetary policy, all the more so if their currency isn’t represented in the basket. They worried too about the governance of the Libra Association and about its compliance framework. Perhaps if any other company had been behind it, they would have dismissed the threat, but they’d learned not to underestimate Facebook.”
“Facebook’s Big Diem”, Marc Rubinstein – https://netinterest.substack.com/p/facebooks-big-diem

One more reason why stable coins might be problematic for policy makers responsible for monetary policy and bank supervision?

Initiatives like Diem obviously represent a source of competition and indeed disruption for conventional banks. As a rule, policy makers tend to welcome competition, notwithstanding the potential for competition to undermine financial stability. However “fiat-backed” stable coin based initiatives also compete indirectly with banks in a less obvious way via their demand for the same pool of risk free assets that banks are required to hold for Basel III prudential liquidity requirements.

So central banks might prefer that the stock of government securities be available to fund the liquidity requirements of the banks they are responsible for, as opposed to alternative money systems that they are not responsible for nor have any direct control over.

I know a bit about banking but not a lot about cryptocurrency so it is entirely possible I am missing something here. If so then feedback welcome.

Tony – From the Outside

The tension between competition and financial stability …

… is a topic on which I have long been planning to write the definitive essay.

Today is not that day.

In the interim, I offer a link to a post by Marc Rubinstein that makes a few points I found worth noting and expanding upon.

Firstly, he starts with the observation that there are very few neat solutions to policy choices – mostly there are just trade-offs. He cites as a case a point the efforts by financial regulators to introduce increased competition over the past forty years as a means to make the financial system cheaper and more efficient. Regulators initially thought that they could rely on market discipline to manage the tension between increased freedom to compete and the risk that this competition would undermine credit standards but this assumption was found wanting and we ended up with the GFC.

When financial regulators think about trade-offs, the one they’ve traditionally wrestled with is the trade-off between financial stability and competition. It arises because banks are special: their resilience doesn’t just impact them and their shareholders; it impacts everybody. As financial crises through the ages have shown, if a bank goes down it can have a huge social cost. And if there’s a force that can chip away at resilience, it’s competition. It may start out innocently enough, but competition often leads towards excessive risk-taking. In an effort to remain competitive, banks can be seduced into relaxing credit standards. Their incentive to monitor loans and maintain long-term relationships with borrowers diminishes, credit gets oversupplied and soon enough you have a problem.
The Policy Triangle, Marc Rubinstein -https://netinterest.substack.com/

We have learned that regulators may try to encourage competition where possible but, when push comes to shove, financial stability remains the prime directive. As a consequence, the incumbent players have to manage the costs of compliance but they also benefit from a privileged position that has been very hard to attack. Multiple new entrants to the Australian banking system learned this lesson the hard way during the 1980s and 1990s.

For a long time the trade-off played out on that simple one dimensional axis of “efficiency and competition” versus “financial stability” but the entry of technology companies into areas of financial services creates additional layers of complexity and new trade-offs to manage. Rubinstein borrows the “Policy Triangle” concept developed by Hyun Song Shin to discuss these issues.

Hyun Song Shin, Economic Adviser and Head of Research, Bank for International Settlements

Firstly, he notes that financial regulators don’t have jurisdiction over technology companies so that complicates the ways in which they engage with these new sources of competition and their impact on the areas of the financial system that regulators do have responsibility for.
Secondly, he discusses the ways in which the innovative use of data by these new players introduces a whole new range of variables into the regulatory equation.

Jurisdiction

New entrants have been able to make inroads into certain areas of finance, the payments function in particular. Some regulators have supported these areas of innovation but Rubinstein notes that regulators start to clamp down once new entrants start becoming large enough to matter. The response of Chinese authorities to Ant Financial is one example as is the response of financial regulators globally to Facebook’s attempt to create a digital currency. The lessons seems to be that increased regulation and supervision is in store for any new entrant that achieves any material level of scale.

Data

The innovative use of data offers the promise of enhanced competition and improved ways of managing credit risk but this potentially comes at the cost of privacy. Data can also be harnessed by policy makers to gain new real-time insights into what is going on in the economy that can be used to guide financial stability policy settings.

Conclusion

Rubinstein has only scratched the surface of this topic but his post and the links he offers to other contributions to the discussion are I think worth reading. As stated at the outset, I hope to one day codify some thoughts on these topics but that is a work in progress. That post will consider issues like the “prisoner’s dilemma” that are I think an important part of the competition/stability trade-off. It is also important to consider the ways in which banks have come to play a unique role in the economy via the creation of money.

Tony – From the Outside

p.s. There are a few posts I have done on related topics that may be of interest

Do banks need belts and braces? – Bank Underground

Some interesting research via a Bank of England Staff Working Paper that explores the value of using multiple regulatory constraints to measure the risk of failure in banks.

Not surprisingly, they find superior utility in a portfolio of measures (risk weighted capital ratio, leverage ratio and Net Stable Funding Ratio) versus relying on a single measure of risk. This is not just due to better predictions of potential for failure but also because this is achieved at lower threshold ratios than would be the case if any of the measures was the sole basis for indicating heightened risk of failure

— Read on bankunderground.co.uk/2021/02/16/do-banks-need-belts-and-braces/

Tony – From the Outside

The Bitcoin energy use debate

Bitcoin’s energy use has been one of the more interesting, and less explored, avenues of the brave new world the crypto community is building. To date I have mostly seen this play out in very simplistic arguments along the lines that Bitcoin is bad because it uses as much energy as whole countries use. On those terms it certainly sounds bad but I came across a more nuanced discussion of the question in this post on the “Principlesandinterest” blog.

Toby lays out some of the counter arguments used to support Bitcoin and in doing so gets into some of the history of how we value things. While my bias remains that Bitcoin’s energy use is a concern, Toby’s post opened my mind up to some of the broader issues associated with the question. Definitely worth reading if you are interested in the question of cryptocurrency and the nature of money.

Tony – From the Outside

Marc Rubinstein on “The story of clearing”

Marc Roubinstein published an interesting post on his “Net Interest” newsletter delving into the history of clearing houses. His account is set against the background of the $3bn call the National Securities and Clearing Commission made on Robinhood Securities at the height of the recent peak in trading in GameStop. The post is short and worth reading in full but the following extract will give you a flavour …

Power comes in many forms. Last week’s events surrounding GameStop show how power can coalesce in the hands of individual investors when they pool their intellectual and financial resources. But the events also reveal a different manifestation of power: the power to call a high-profile tech company in the middle of the night and demand $3 billion. That’s quite some power!
The entity wielding that power is the NSCC, which – as Vlad Tenev, the CEO of Robinhood spelled out to Elon Musk – stands for the National Securities and Clearing Corporation. The NSCC in turn is a part of the DTCC, which stands for the Depository Trust and Clearing Corporation. And the DTCC is perhaps the most powerful entity you’ve never heard of. It’s the engine of the US securities markets; in 2019 alone, it processed over $2.15 quadrillion worth of securities (yes, quadrillion!) It’s big and ugly enough to be included among a very short list of entities designated by people in Washington as “systemically important financial market utilities”.
To understand what (and who) the DTCC is, we need to delve a little into market structure, and the best way to do that is with some historical perspective.
WTF is DTCC? The Story of Clearing – net interest.substack.com – Marc Rubinstein

If that appeals then read on here ….

Tony – From the Outside

JP Koning – What Tether Means When It Says It’s ‘Regulated’ – CoinDesk

Useful article on Coindesk discussing what underpins the integrity of one of the more popular forms of Stabecoins

“Newcomers to the crypto space are quickly confronted with a popular distinction between regulated stablecoins and unregulated stablecoins. But what is the difference? Tether, the largest of the stablecoins, is often described as unregulated. But Tether executives and supporters disagree with this claim. Who is right?”
— Read on www.coindesk.com/what-tether-means-when-it-says-its-regulated

I don’t profess any real insight or expertise in this space but it does feel to me like a question that any serious student of banking needs to come to terms with.

Tony – From the Outside