FT Alphaville is one of my go to sources for information and insight. The Alphaville post flagged below discusses the discussion paper recently released by the Bank of England on the pros and cons of a Central Bank Digital Currency. It is obviously a technical issue but worth at least scanning if you have any interest in banking and ways in which the concept of “money” may be evolving.
This post will focus on stress testing in response to some recent papers the RBNZ released (July 2018) describing both its approach to stress testing and the outcomes from the 2017 stress test of the major banks and a speech by Wayne Byres (APRA) which offered some detail of the Australian side of the joint stress testing undertaken by APRA and the RBNZ. I intend to make some observations related to this specific stress testing exercise but also some broader points about the ways that stress testing is currently conducted. The overriding point is that the cyclical scenarios employed to calibrate capital buffers seem to focus on “what” happened with less consideration given to “why” the historical episodes of financial stress the scenarios mimic were so severe.
There will be technical detail in this post but the question, simply put, is to what extent do really bad things happen to good banking systems? Paraphrased in more technical language, are we calibrating for scenarios based on the impact of some random exogenous shock on a sound banking system, or does the scenario implicitly assume some systemic endogenous factors at play that made the financial system less resilient in the lead up to the shock? Endogenous factors may be embedded in the balance sheets of the banks (e.g. poor credit quality amplified by excessive credit growth) or perhaps they are a feature of the economic system (e.g. a fixed exchange rate regime such as confronted many European economies during the GFC) that may or may not be universally relevant. I am focusing on the RBNZ stress test to explore these points mostly because they offered the most detail but I believe their approach is very similar to APRA’s and the observations apply generally to macro economic stress testing.
No prizes for guessing that I will be arguing that the kinds of really severe downturns typically used to calibrate capital buffers are usually associated with conditions where endogenous forces within the banking system are a key element in explaining the extent of the asset price declines and weak recoveries and that the severity of some historical scenarios was arguably exacerbated by unhelpful exchange rate, monetary or fiscal policy settings. This is not to say that we should not be using very severe downturns to calibrate the resilience of capital buffers. My argument is simply that recognising this factor will help make more sense of how to reconcile the supervisory approach with internal stress testing and how best to respond to the consequences of such scenarios.
The RBNZ approach to stress testing
The RBNZ characterises its approach to be at the less intensive end of the spectrum of supervisory practice so “stress tests are used to provide insights into the adequacy of bank capital buffers and can highlight vulnerabilities at the bank wide level or in its various loan portfolios” but “… the use of individual bank results in setting capital buffers and promoting market discipline is relatively limited“. The RBNZ stress tests fall into three categories 1) cyclical scenarios, 2) exploratory stress tests and 3) targeted tests.
This post will focus on the cyclical scenario which was the focus of the RBNZ’s 2017 stress test and the place where the question of what happened and why it happened is most at risk of getting lost amongst the desire to make the test tough, coupled with the often daunting task of just running the test and getting some results.
The RBNZ states that the aim of a cyclical scenario is to help “… understand the resilience of participating banks to a macroeconomic downturn” so these scenarios “… mimic some of the worst downturns in advanced economies since World War 2, and typically feature sharp declines in economic activity and property prices, and stressed funding markets”. The repetition of the benchmark cyclical downturn scenario over time also allows the RBNZ “to track the resilience of the financial system over time (although the scenario will
It is hard to argue with calibrating the resilience of the banking system to a very high standard of safety. That said, the concern I have with cyclical scenarios drawn from worst case historical events is that the approach tends to skip over the question of why the downturn of such severity occurred.
The RBNZ commentary does recognise the “… need to take account of the nature of the specific stress scenario” and for the cyclical scenario to “evolve based on new research and insights, such as the extent of over-valuation evident in property markets” and the possibility that “domestic monetary policy and a falling exchange rate would provide a significant buffer … that was unavailable during many of these stress episodes in countries without floating exchange rates“. “Exploratory” and “Targeted” stress testing may also be focussed on the endogenous risks embedded in the banking system without explicitly using that terminology.
So if the RBNZ, and APRA, are implicitly aware of the endogenous/exogenous risk distinction, then maybe I am just being pedantic but I would argue that greater clarity on this aspect of stress testing helps in a number of areas:
- It can help to explain why there is often a gap between:The severity of outcomes modelled internally (where the bank will probably assume their portfolios has robust credit quality and none of the systemic weaknesses that were responsible for past episodes of severe financial weakness implicit in the downturn scenario adopted by the supervisors), andThe severity the regulator expects (possibly based on a skeptical view of the extent to which bank management has balanced risk and return with the reward of higher growth and market share).
- The types of recovery actions that can be deployed and the amounts of capital they contribute to the rebuilding process are also very much shaped by the nature of the scenario (scenarios shaped by endogenous factors embedded in the banks’ balance sheets or business models require much more substantial responses that are more costly though the cost can be a secondary issue when the scale of the challenge is so large).
- Supervisors rightly focus on the need for banks to maintain the supply of credit to the economy but endogenous scenarios may actually require that some customers de-gear themselves and become less reliant on bank credit.
The RBNZ discussion of the 2017 stress test of the major banks focussed on the Phase 2 results and noted that:
- The four participating banks started the stress test with an aggregate CET1 ratio of 10.3% and an aggregate buffer ratio of 5.4%
- The impact of the combined macro economic downturn and the operational risk event saw the aggregate CET1 ratio decline by 3.4 percentage points to 6.9% in the third year; driven in order of importance by:
- Credit losses (including the large counter party loss) – 6.6 ppts
- Growth in RWA – 1.4 ppts
- Dividends and other capital deductions – 1.4 ppts
- The operational risk event for misconduct risk – 0.7 ppts
- Underlying profits which offset the gross decline in the CET1 ratio by 6.7 ppts to arrive at the net decline of 3.4 ppts
- Mitigating actions improved the aggregate CET1 ratio by 1.1 ppts by year three to 8%; these actions included 1) reductions in lending, 2) additional interest rate repricing and 3) operating expense reductions.
There is not a lot of detail on individual bank outcomes. In the combined scenario, individual bank CET1 ratios declined to between 6.4% to 7.4% versus the 6.9% aggregate result. The individual buffer ratios fell to between 1.2 and 1.4% at their low points (no aggregate minimum buffer was reported).
Some observations on the outcomes of the RBNZ 2017 stress test
The fact that the major banks can maintain significant buffers above minimum capital requirements during quite severe stress scenarios offers a degree of comfort, especially when you factor in the absence of mitigating responses. Minor quibble here, but it is worth noting that the aggregate data the RBNZ uses to discuss the stress testing results does not map neatly to the minimum requirements and capital buffers applied at the individual bank level. A 5.4 ppt buffer over the 4.5% CET1 buffer equates to 9.9%, not 10.3%. Looking at Figure 1 in the “outcomes” paper also shows that there was a narrower range in the CCB at its low point than there was for the CET1 ratio so part of the CCB decline observed in the stress test may be attributable to shortfalls at either the Tier 1 or Total Capital Ratio levels rather than CET1. Small point, but it does matter when interpreting what the results mean for the target capital structure and how to respond.
The RBNZ is clearly correct to question the reliability of mitigating actions and the potential for some actions, such as tightening of lending standards, to generate negative feedback effects on asset prices and economic activity. However, it is equally open to question whether the market confidence that banks rely on to fund themselves and otherwise conduct business would remain resilient in the face of a three-year continuous decline in capital ratios. So I do not think we can take too much confidence in the pre mitigation outcomes alone; the mitigating responses matter just as much.
I have always thought of the capital buffer as simply “buying time” for management to recognise the problem and craft a response that addresses the core problems in the business while creating positive momentum in capital formation. The critical question in stress testing is how much time will the markets grant before they start to hold back from dealing with your bank. Markets do not necessarily expect a magic bullet, but they do expect to see positive momentum and a coherent narrative. It would also be useful to distinguish between a core set of actions that could reasonably be relied on and other actions that are less reliable or come at a higher cost to the business.
It is hard to comment on the specific mitigating actions since the paper only reports an aggregate benefit of 1.1 ppts over the 3 years but I can make the following general observations:
- Reductions in lending: The potential for reduced lending to generate negative feedback effects on asset prices and economic activity is a very valid concern but I do struggle to reconcile a 35% decline in house prices with a scenario in which the loans the banking system has outstanding to this sector do not appear to have declined.
- I can’t see any specific numbers in the RBNZ paper but that is the inference I draw if the overall loan book has not declined, which seems to be implied by the statement that the 20% RWA growth over the first three years of the scenario was primarily due to higher risk weights.
- Loan principal is progressively being repaid on performing loans but this balance sheet shrinkage is amplified in the scenario by elevated defaults, while the rate of new lending which would otherwise be the driver of growth in outstanding must be slowing if house prices are falling by such a large amount. In addition, the reduced volume of new loans being written are I assume for lower amounts than was the case prior to the decline in house prices.
- I am very happy to be set straight on this part of the modelling but the numbers don’t quite add up for me. If I am right then a loan book that is stable or even declining in value may be what is implied by the scenario rather than something that adds further to the stress on capital ratios. At the very least, winding back loan growth assumptions relative to the benign base case seems a reasonable response.
- Repricing: I can’t tell from the RBNZ paper how significant this factor was in contributing to the 1.1 percentage point 3 year improvement in CET1 but I am guessing it was reasonably material. Materiality therefore requires that the numbers be subject to a higher level of scrutiny.
- History does offer a reasonable body of evidence that Australian and NZ banks have had the capacity to reprice loans under stress and in response to higher funding costs. The question is whether the collapse in trust in big banks has undermined the value of the repricing option they have traditionally benefited from.
- I do believe that some of the critiques of bank repricing are not well founded but that does not change the real politic of the likely public and government push back should banks attempt to do so.
- So the answer here is probably yes; the benefits of this particular mitigating action are likely not as reliable as they have been in the past. At the very least, there is likely to be a higher cost to using them.
- The contribution of RWA growth to the decline in the capital ratio noted in the RBNZ paper is also worth calling out. There is not a lot of detail in the paper but it does appear that the 20% increase in RWA over the first three years of the scenario was driven primarily by an increase in the average credit RW from 45% to 54%.
- This seems to imply that there was a significant cycle driven increase in capital requirements over the course of the scenario that was not driven by an increase in loans outstanding.
- I believe that this kind of capital measurement driven impact on capital ratios is fundamentally different from the impact of actual losses and higher new lending but it is treated as equivalent for the purposes of the analysis. This looks to me like a category error; a decline in a capital ratio due to higher risk weights is not the same thing for the purposes of solvency as a loss due to a loan defaulting.
- The solution probably lies in a better designed approach to counter cyclical buffers (see my post here and here for background) and the regulatory treatment of expected loss, but the stress testing analysis suffers by simply noting the outcome without going behind what that component of the decline in capital ratio actually represents.
Deposit growth under a stress scenario
I also struggled with the statement in Section 5 of the RBNZ paper that “Banks expected strong growth in retail deposits, in line with their experience during the Global Financial Crisis.”
- This statement seems to reflect the intuitive view that bank deposits increase under adverse conditions as people sell risky assets and put their money in banks. But we also know that selling a risky asset requires someone else to buy it, so the increase in cash in the account of the seller is offset by the decrease in the account of the buyer. There was an increase in bank deposits during the GFC but the simple sell risky assets and put your money in the bank does not seem to explain why it happened.
- So what do we know about the GFC? Firstly, big banks continued to grow their loan book and we know that bank credit creation leads to deposit creation. The GFC was also a scenario where the collapse of securitisation markets saw lending for residential mortgages migrate back to big bank balance sheets. I think this also creates a net increase in deposits. Banks were also paying down foreign borrowings which I think is also positive for deposit creation via the balance of payments though this channel is murkier. We also observed money migrating from equities to property lending. The selling of the risky assets is net square for deposits by itself but the deposit creation comes as the cash in the hands of the seller gets leveraged up to support new credit creation via the increased property loans which are typically geared much more highly than other types of risk assets. The shift from equity to property also seems to be driven by the typical monetary policy strategy of reducing interest rates.
- So it is not clear to me that the pool of deposits grows under the conditions of the RBNZ scenario. We do have the likelihood that people are selling risky assets but we seem to be missing a number of the elements specific to the GFC that saw new deposits get created in the banking system. The only deposit formation positive I can see is maybe via the balance of payments but, as noted above this, channel is very murky and hard to understand.
- The other interesting question is whether bank deposits continue to be a safe haven for New Zealanders in future crises given that the RBNZ has implemented an Open Banking Resolution regime that exposes bank deposits to the risk of being bailed-in on a pari passu basis with other unsecured bank creditors. This is a unique feature of the NZ financial system which even eschews the limited guarantees of bank deposits that many other systems see as essential to maintaining the confidence of depositors under stress.
I may well be missing something here so I am very happy to hear the other side to any of the observations I have offered above. I am big believer in the value of stress testing which is why I think it is so important to get it right.
Last month I posted a review of Mervyn King’s book “The end of Alchemy”. One of the central ideas in King’s book was that all deposits must be backed 100% by liquid, safe assets. It appears that the Swiss are being asked to vote on a proposal labeled “Sovereign Money Initiative” that may not be exactly the same as King’s idea but comes from the same school of money philosophy.
It is not clear that there is any popular support for the proposal but it would be a fascinating money experiment if it did get support. Thanks to Brian Reid for flagging this one to me.
This is a big topic, and somewhat irredeemably technical, but I have come to believe that there are some unique features of banks that make them quite different from other companies. Notwithstanding the technical challenges, I think it is important to understand these distinguishing features if we are to have a sensible debate about the optimum financing structure for a bank and the kinds of returns that shareholders should expect on the capital they contribute to that structure.
You could be forgiven for thinking that the Australian debate about optimum capital has been resolved by the “unquestionably strong” benchmark that APRA has set and which all of the major banks have committed to meet. However, agreeing what kind of return is acceptable on unquestionably strong capital remains contentious and we have only just begun to consider how the introduction of a Total Loss Absorbing Capital (TLAC) requirement will impact these considerations.
The three distinctive features of banks I want to explore are:
- The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
- The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
- The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.
It should be noted at the outset that Anat Admati and Martin Hellwig (who are frequently cited as authorities on the issues of bank capital discussed in this post) disagree with most if not all of the arguments I intend to lay out. So, if they are right, then I am wrong. Consequently, I intend to first lay out my understanding of why they disagree and hopefully address the objections they raise. They have published a number of papers and a book on the topic but I will refer to one titled “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as the primary source of the counter arguments that I will be attempting to rebut. They are of course Professors whereas I bring a lowly masters degree and some practical experience to the debate. Each reader will need to decide for themselves which analysis and arguments they find more compelling.
Given the size of the topic and the technical nature of the issues, I also propose to approach this over a series of posts starting with the relationship between bank lending and deposit creation. Subsequent posts will build on this foundation and consider the other distinctive features I have identified before drawing all of the pieces together by exploring some practical implications.
Do banks create “money”? If so, how does that impact the economics of bank funding?
The Bank of England (BoE) released a good paper on the first part of this question titled “Money creation in the modern economy” . The BoE paper does require some banking knowledge but I think demonstrates reasonably clearly that the majority of bank deposits are created by the act of a bank making a new loan, while the repayment of bank loans conversely reduces the pool of deposits. The related but more important question for the purposes of this discussion is whether you believe that bank deposits are a form of money.
Admati and Hellwig identify the argument that “banks are special because they create money” as Flawed Claim #5 on the grounds that treating deposits as money is an abuse of the word “money”. They are not disputing the fact that monetary economists combine cash with demand deposits in one of the definitions of money. As I understand it, the essence of their argument is that deposits are still a debt of the issuing bank while “real” money does not need to be repaid to anyone.
It is true that deposits are a bank debt and that some deposits are repayable on demand. However, I believe the bigger issues bearing on the economics of bank financing stem from the arguments Admati and Hellwig advance to debunk what they label as Flawed Claim #4 that “The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies“.
Their argument appears to focus on using Modigliani and Miller (“M&M”) as an “analytical approach” in which the cost (contractual or expected) of the various forms of financing are connected by a universal law of risk and reward. Their argument is that this universal law (analogous to the fundamental laws of physics) demands that using more or less equity (relative to debt) must translate to a lower or higher risk of insolvency and that rational debt investors will respond by adjusting the risk premium they demand.
I have no issue with the analytical approach or the premise that funding costs should be related to risk. What happens however when one of the primary forms of debt funding is largely protected from the risk of insolvency? In the case of the major Australian banks, deposits account for over half of a bank’s total funding but are largely isolated from the risk of insolvency by a number of features. One is the Banking Act that confers a preferred claim in favour of Australian depositors over the Australian assets of the bank. The other is government guaranteed deposit insurance coverage capped at $250,000 per person per bank. The rationale for these acts of apparent government generosity is a contentious subject in itself but, for the purposes of this post, my working hypothesis is that the preferred claim and deposit insurance are a consequence of the fact that the community treats bank demand deposits as a form of money.
Consequently, the risk that an Australian depositor will face a loss of principal in the already remote event of insolvency is arguably de minimis and the way that demand deposits are priced and the way they are used as a substitute for cash reflects this risk analysis. There remains a related, though separate, risk that a bank may face a liquidity problem but depositors (to the extent they even think about this) will assume that central bank Lender of Last Resort liquidity support covers this.
Admati and Hellwig do not, to the best of my knowledge, consider the implications of these features of bank funding. In their defence, I don’t imagine that the Australian banking system was front of mind when they wrote their papers but depositor preference and deposit insurance are not unique Australian innovations. However, once you consider these factors, the conclusion I draw is that the cost of a substantial share of a bank’s debt financing is relatively (if not completely) insensitive to changes in the amount of equity the bank employs in its financing structure.
One consequence is that the higher levels of common equity that Australian banks employ now, compared to the position prior to the GFC, has not resulted in any decline in the cost of deposit funding in the way that M&M say that it should. In fact, the more conservative funding and liquidity requirements introduced under Basel III have required all banks to compete more aggressively for the forms of deposit funding that are deemed by the prudential requirements to be most stable thereby driving up the cost.
The point here is not whether these changes were desirable or not (for the record I have no fundamental issue with the Unquestionably Strong capital benchmark nor with more conservative funding and liquidity requirements). The point is that the cost of deposit funding, in Australian banking at least, has not declined in the way that Admati and Hellwig’s analytical approach and universal law demands that it should.
Summing up, it is possible that other forms of funding have declined in cost as Admati and Hellwig claim should happen, but there is both an analytical rationale and hard evidence that this does not appear to be the case, for Australian bank deposits at least.
The next post will consider the other main (non equity) components of a bank funding structure and explore how their risk/cost has evolved in response both to the lessons that investors and rating agencies took away from the GFC and to the changes in bank regulation introduced by Basel III. A subsequent post will review issues associated with measuring the Expected Loss and hence the true “Through the Cycle” profitability of a bank before I attempt to bring all of the pieces together.
There is a lot of ground to cover yet. At this stage, I have simply attempted to lay out a case for why the cost of bank deposits in Australia has not obeyed the universal analytical law posited by Admati and Hellwig as the logical consequence of a bank holding more equity in its financing structure but if you disagree tell me what I am missing …
Post script: The arguments I have laid out above could be paraphrased as “banks deposits differ from other kinds of debt because banks themselves create deposits by lending” which Admati and Hellwig specifically enumerate as Flawed Claim #6. I don’t think their rebuttal of this argument adds much to what is discussed above but for the sake of completeness I have copied below the relevant extract from their paper where they set out why they believe this specific claim is flawed. Read on if you want more detail or have a particular interest in this topic but I think the main elements of the debate are already covered above. If you think there is something here that is not covered above then let me know.
Flawed Claim 6: Bank deposits differ from other kinds of debt because banks create deposits by lending.
What is wrong with this claim? This claim is often made in opposition to a “loanable funds” view of banks as intermediaries that collect deposits in order to fund their loans. Moreover, this “money creation through lending” is said to be the way money from the central bank gets into the economy.19 The claim rests on a confusion between stocks and flows. Indeed, if a commercial bank makes a loan to a nonfinancial firm or to a private household it provides its borrowers with a claim on a deposit account. Whereas this fact provides a link between the flow of new lending and the flow of new deposits, it is hardly relevant for the bank’s funding policy, which concerns the stocks of different kinds of debt and equity that it has outstanding, which must cover the stocks of claims on borrowers and other assets that the bank holds.
A nonfinancial firm or household that receives a loan from a bank will typically use the associated claim on a deposit account for payments to third parties. The recipients of these payments may want to put some of the money they get into deposits, but they may instead prefer to move the money out of the banking system altogether, e.g., to a money market fund or a stock investment fund. 20
From the perspective of the individual bank, the fact that lending goes along with deposit creation does not change the fact that the bank owes its depositors the full amount they deposited. The key difference between deposits and other kinds of debt is not that deposits are “like money” or that deposits may be created by lending, but rather that the bank provides depositors with services such as payments through checks and credit cards or ATM machines that make funds available continuously. The demand for deposits depends on these services, as well as the interest that the bank may offer, and it may also depend on the risk of the bank becoming insolvent or defaulting.21
The suggestion that bank lending is the only source of deposit creation is plainly false.22 Deposits are created when people bring cash to the bank, and they are destroyed when people withdraw cash. In this case, the reduction in deposits – like any reduction in funding – goes along with a reduction in the bank’s assets, i.e., a shortening of its balance sheet, but this reduction affects the bank’s cash reserves rather than its lending. The impact of such withdrawals on banks and entire banking systems are well known from the Great Depression or from the recent experience of Greece. In Greece in the spring and summer of 2015, depositors also were worried about the prospect that in the event of the country’s exit from the euro, their denomination of their deposits would be changed, whereas a stack of bills under a matrass would not be affected.