So much going on in banking; so many lessons and precedents. The way in which Credit Suisse’s Additional Tier 1 securities were applied (and equally as importantly) the way the market reacts is one I think is definitely worth watching.
It was easy to miss this detail given how much has been going on but John Authers (Bloomberg Opinion) neatly sums it up …
Holders of “Additional-Tier 1 (AT-1)” bonds have been wiped out. Credit Suisse’s roughly 16 billion Swiss francs ($17.3 billion) worth of risky notes are now worthless. The deal will trigger a complete writedown of these bonds to increase the new bank’s core capital — meaning that these creditors have had a worse deal than shareholders, who at least now have some stock in UBS.
Bloomberg Opinion “And then there was one”, Points of Return, John Authers 29 March 2023
The relative treatment of shareholders and AT Creditors was, for me at least, a surprise. In the conventional capital stack, shareholders absorb losses before all stakeholders. I did a post here setting out my understanding of loss absorption under bail-in. Christopher Joye helpfully explained that the Swiss seem to do bail in differently …
In contrast to many other bank hybrids, including those issued by Aussie banks, CS bank hybrids cannot, and do not, convert into equity in this scenario (ie, Aussie bank hybrids are converted into equity before a write-off). Instead, the CS hybrids must legally go directly to write-off. They further do not permit any partial write-off: the only option is for the regulator to fully write-off these securities.
“UBS buys Credit Suisse in CHF3 billion deal, bonds fully protected as AT1s are zeroed” Christopher Joye, Livewire 20 March 2023
John Authers offers some more context …
“Additional Tier 1” capital was a category introduced under the Basel III banking accords that followed the GFC, with the intention of providing banks with more security. Holders of the bonds were to be behind other creditors in the event of problems. In the first big test of just how far behind they are, we now know that AT1 bondholders come behind even shareholders.
…. he goes on to note that, while limiting moral hazard requires that someone be at the pointy end of loss absorption, the Swiss precedent poses the big question – who wants to buy Swiss style Additional Tier 1 knowing what they know now …
This follows the logic of the post-crisis approach, and it limits moral hazard. The question is whether anyone will want to hold AT1 bonds after this. The market response will be fascinating, and it remains possible that the regulators have avoided repeating one mistake only to make a new one.
The Swiss logic of favouring shareholders is not obvious to me so maybe I am missing something. It might offer some short term advantage but I am with John Authers on this one. Who signs up for this deal next time. We are definitely living in interesting times.
The two terms are frequently used interchangeably but I am in the camp that being pedantic is useful in this particular case. In that context hat tip to Matt Levin at Bloomberg for another well worth reading opinion column exploring what is going on with FTX
You can find his column here. There is a Bloomberg paywall but you can also access Matt’s material by signing up to his daily newsletter (highly recommended). The whole piece is worth reading but two short extracts below captures the main points.
First up solvency …
One other point here is that if this is the story, then it is not a liquidity crisis but a solvency one. That is, the problem is not a timing mismatch, in which FTX’s customers asked for their cash back but FTX did not have enough ready cash because it had long-term but money-good loans out. The problem is that FTX took its customers’ money and traded it for a pile of magic beans, and now the beans are worthless and there’s a huge hole in the balance sheet.
And some dark magic …
If you think of the token as “more or less stock,” and you think of a crypto exchange as a securities broker-dealer, this is completely insane. If you go to an investment bank and say “lend me $1 billion, and I will post $2 billion of your stock as collateral,” you are messing with very dark magic and they will say no.[9] The problem with this is that it is wrong-way risk. (It is also, at least sometimes, illegal.) If people start to worry about the investment bank’s financial health, its stock will go down, which means that its collateral will be less valuable, which means that its financial health will get worse, which means that its stock will go down, etc. It is a death spiral. In general it should not be possible to bankrupt an investment bank by shorting its stock. If one of the bank’s main assets is its own stock — is a leveraged bet on its own stock — then it is easy to bankrupt it by shorting its stock.
If you want to dig deeper into the solvency versus liquidity question I had a go at the issue here
This article in Wired offers a useful summary of how some motivated individuals are attempting to use the transparency of the system to control bad actors.
It is short and worth reading in conjunction with this paper titled “Statement on DeFi Risks, Regulations, and Opportunities Commissioner Caroline A. Crenshaw that sets out a US regulator’s perspective on the question of how DeFi should be regulated. This extract from the paper covers the main thrust of her argument in favours of formal regulation
While DeFi has produced impressive alternative methods of composing, recording, and processing transactions, it has not rewritten all of economics or human nature. Certain truths apply with as much force in DeFi as they do in traditional finance:
– Unless required, there will be projects that do not invest in compliance or adequate internal controls;
– when the potential financial rewards are great enough, some individuals will victimize others, and the likelihood of this occurring tends to increase as the likelihood of getting caught and severity of potential sanctions decrease; and
– absent mandatory disclosure requirements,[10] information asymmetries will likely advantage rich investors and insiders at the expense of the smallest investors and those with the least access to information.
Accordingly, DeFi participants’ current “buyer beware” approach is not an adequate foundation on which to build reimagined financial markets. Without a common set of conduct expectations, and a functional system to enforce those principles, markets tend toward corruption, marked by fraud, self-dealing, cartel-like activity, and information asymmetries. Over time that reduces investor confidence and investor participation.
Conversely, well-regulated markets tend to flourish
“Statement of DeFi Risks, Regulations and Opportunities” by Commissioner Caroline A Crenshaw, The International Journal of Blockchain Law, Vol. 1, Nov. 2021.
Interesting post by JP Koning exploring the current debate about the value of Bitcoin and its energy demand.
There are two extreme theories about cryptocurrency energy consumption, both of them bitterly opposed to each other. The first I’ll call the big waste theory. Cryptocurrencies such as Bitcoin and Ethereum serve no useful purpose. Yet they are sucking up huge amounts of useful electricity. Let’s ban them.
The second theory is the vital cog theory. Cryptocurrencies are a useful bit of global financial infrastructure. And so the huge amounts of energy that they are consuming is beneficial. Let’s not impede them.
“The overconsumption theory of bitcoin (and decentralization in general)”, JP Koning, May 2021
Koning offers an alternative “overconsumptionist theory” – worth reading
In this post, I lay out some problems that I have encountered in attempting to reconcile what it will mean for a D-SIB ADI to be “Unquestionably Strong” under the proposed new framework that APRA outlined in its December 2020 Discussion Paper (“A more flexible and resilient capital framework for ADIs”). Spoiler alert – I think the capital buffers adding up to a 10.5% CET1 prudential requirement may need to be recalibrated once all of the proposed changes to risk weights are tied down. I also include some questions regarding the impact of the RBNZ’s requirement for substantially higher capital requirements for NZ domiciled banks.
The backstory
The idea that Australian Authorised Deposit Taking Institutions (“ADIs” but more commonly referred to as “banks”) needed to be “Unquestionably Strong” originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian ADIs should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcementsupported by a longer information paper.
For most people, this all condensed into a very simple message, the systemically important Australian ADIs needed to maintain a Common Equity Tier 1 (CET1) ratio of at least 10.5%. The smaller ADIs have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger systemically important ADIs.
In the background, an equally important discussion has been playing out regarding the extent to which the Unquestionably Strong framework should take account of the “comparability” and “transparency” of that measure of strength and the ways in which “flexibility” and “resilience” could be added to the mix. This discussion kicked off in earnest with a March 2018 APRA discussion paper (which I covered here) and has come to a conclusion with the December 2020 release of the APRA Discussion Paper explored in the post above.
December 2020 – “Unquestionably Strong” meets “A more flexible and resilient capital framework for ADIs”
I have written a couple of posts on APRA’s December 2020 Discussion Paper but have thus far focussed on the details of the proposed changes to risk weights and capital buffers (here, here and here). This was partly because there was a lot to digest in these proposals but also because I simply found the discussion of how the proposed new framework reconciled to the Unquestionably Strong benchmark to be a bit confusing.
What follows is my current understanding of what the DP says and where we are headed.
On one level, the answer is quite simple – Exhibit A from the Discussion Paper (page 17) …
APRA DP “A more flexible and resilient capital framework for ADIs” page 17
For systemically important ADI (D-SIB ADIs), the Unquestionably Strong 10.5% CET1 benchmark will be enshrined in a series of expanded capital buffers that will come into force on 1 January 2023 and add up to 10.5%.
However, we also know that APRA has at the same time outlined a range of enhancements to risk weights that are expected to have the effect of reducing aggregate Risk Weighted Assets and thereby result in higher capital adequacy ratios.
APRA has also emphasised that the net impact of the changes is intended to be capital neutral; i.e. any D-SIB ADI that meets the Unquestionably Strong benchmark now (i.e. that had a CET1 ratio of at least 10.5% under the current framework) will be Unquestionably Strong under the new framework
However this implies that the expected increase in reported CET1 under the new framework will not represent surplus capital so it looks like Unquestionably Strong will require a CET1 ratio higher than 10.5% once the new framework comes into place.
The only way I can reconcile this is to assume that APRA will be revisiting the calibration of the proposed increased capital buffers once it gets a better handle on how much capital ratios will increase in response to the changes it makes to bring Australian capital ratios closer to those calculated by international peers under the Basel minimum requirements. If this was spelled out in the Discussion Paper I missed it.
What about the impact of RBNZ requiring more capital to be held in New Zealand?
Running alongside the big picture issues summarised above (Unquestionably Strong, Transparency, Comparability, Flexibility, Resilience”, APRA has also been looking at how it should respond to the issues posed by the RBNZ policy applying substantial increases to the capital requirements for banks operating in NZ. I wrote two post on this issue (see here and here) that make the following points
To understand what is going on here you need to understand the difference between “Level 1” and Level 2” Capital Adequacy (part of the price of entry to this discussion is understanding more APRA jargon)
The increased share of the group capital resources required to be maintained in NZ will not have any impact on the Level 2 capital adequacy ratios that are the ones most commonly cited when discussing Australian ADI capital strength
In theory, maintaining the status quo share of group capital resources maintained in Australia would require some increase in the Level 2 CET1 ratio (i.e. the one that is used to express the Unquestionably Strong benchmark)
In practice, the extent to which the Level 2 benchmark is impacted depends on the maternity of the NZ business so it may be that there is nothing to see here
It is hard to tell however partly because there is not a lot of disclosure on the details of the Level 1 capital adequacy ratios (at least not a lot that I could find) and partly because the Level 1 capital measure is (to my mind) not an especially reliable (or indeed intuitive) measure of the capital strength
Summing up
There is I think a general consensus that the Australian D-SIB ADIs all currently exceed the requirements of what it means to be Unquestionably Strong under the current capital adequacy framework
This implies that they have surplus capital that may potentially be returned to shareholders
APRA has laid out what I believe to be pretty sensible and useful enhancements to that framework (the expanded and explicitly more flexible capital buffers in particular)
These changes have however (for me at least) made it less clear what it will mean for an ADI to be Unquestionably Strong post 1 January 2023 when the proposed changes to Risk Weighted Assets come into effect
Any and all contributions to reducing my ignorance and confusion will be gratefully accepted – let me know what I am missing
… but Jemima Kelly at FT Alphaville remains a sceptic. I think the FT headline is a bit harsh (“Tether says its reserves are backed by cash to the tune of . . . 2.9%”). Real banks don’t hold a lot of “cash” either but the securities they hold in their liquid asset portfolios will tend to be a lot better quality than the securities that Tether disclosed.
The role of real banks in the financial system may well be shrinking but the lesson I take from this FT opinion piece is that understanding the difference between these financial innovations and real banks remains a useful insight as we navigate the evolving new financial system.
I don’t profess to be able to explain the value of Dogecoin but Matt Levine offers an interesting perspective curtesy of a research report published by Galaxy Digital Research. Apart from the left field explanation of what underpins Dogecoin’s value, the relatively short report (22 pages) offers a useful recap of the story of how this variation of digital money came to be.
Here is a short extract from the report
“When we set out to write this report, we expected to find what we’ve always known: Dogecoin is a joke, but it’s also a joke… not credible, resilient, or adopted. But as we reviewed the data, we found that, despite its deficiencies, Dogecoin has remarkably strong fundamentals and powerful forces supporting its rise: a genuine origin story, longevity, and a growing community of users who appear determined to meme a Shiba Inu-themed global currency into existence. We don’t expect Dogecoin to become the world’s most valuable cryptocurrency any time soon, but DOGE should not be ignored.”
“Dogecoin: The Most Honest Sh*tcoin” by Alex Thorn, Head of Firmwide Research and Karim Helmy, Research Associate, Galaxy Digital Research, 4 May 2021
Matt’s column has a link to the report itself which is worth a read if you are interested in Dogecoin in particular or the broader topic of digital money.
From the outside 