Archive | April 2017

Intragroup funding: don’t build the wall

Three years ago, I wrote about the importance of intragroup funding, liquidity and capital flows within a banking group composed of multiple entities – often cross-border, as it is common nowadays. This series of posts started by outlining recent empirical evidence, which suggested that intragroup funding – or, as academics called it, ‘internal capital markets’ – benefited banking groups by allowing the efficient transfer of liquidity where and when it was needed within the multinational bank’s legal entity structure, thereby averting crises or at least dampening its effects, and solidifying the group as a whole.

Follow-up posts described historical experiences and compared the relative stability of the US and Canadian 19th century branching systems: Canadian banks demonstrated a much higher level of financial resilience thanks to their ability to open branches nationwide, compared to the great instability and recurrent crises experienced by large US state banks – whose ability to open branches in other states or districts was severely constrained by law – and later ‘unit’ banks, which were not allowed to open branches altogether. The series also included the example of a modern banking model that combined characteristics of both the fragmented 19th century US and great resilience, thanks to its peculiar liability-sharing, funds transfer mechanism and cross-control structure: the German Sparkassen Finanzgruppe (saving banks group; see post here).

Of course, throughout this series I kept pointing out that all empirical and historical evidence actually went against the current regulatory mindset of fragmenting and siloing banking. Since the financial crisis, regulators have fallen into a very damaging fallacy of composition: their belief that making each separate entity of larger integrated banking groups stronger and raising barriers between them will strengthen the system as whole is deeply flawed.

Intragroup funding

Last month, a new paper confirming the critical aspect of intragroup liquidity transfers for financial stability was published (Changing business model in international funding, by Gambacorta, van Rixtel and Schiaffi). This paper investigates whether banks altered their funding profile when the financial crisis struck and money markets froze. More specifically, they looked at changes in the nature (retail, wholesale, intragroup…) and origins (domestic, foreign) of the liabilities at holding and parent company level, as well as at branches and subsidiary levels. And unsurprisingly:

Our main conclusions are as follows. Following the first episodes of turbulence in the interbank market (after 2007:Q2), globally active banks increased their reliance on funding from branches and subsidiaries abroad, and cut back on funding obtained directly by headquarters (cross-border funding). In particular, banks reduced cross-border funding from unrelated banks – eg those that are not part of the same banking group – and from non-bank entities. At the same time, they increased intragroup cross-border liabilities in an attempt to make more efficient use of their internal capital markets.

The authors make a great job at summarising the current literature on the topic: there is overwhelming evidence that banks rely on ‘internal capital markets’ to absorb external liquidity shocks. Yet, the authors also highlight that there have been a few drivers of declining intragroup flows, of which the siloing of liquidity and capital by new regulation has been the main one:

Of these drivers, regulatory reform has been the main catalyst of the profound changes observed in global banking and its funding structures in recent years. This includes most prominently Basel III and structural banking reforms, such as the “ringfencing” of domestic operations and “subsidiarisation”, which requires banks to operate as subsidiaries overseas, with their own capital and liquidity buffers, and funding dedicated to different entities. Moreover, several jurisdictions have implemented enhanced oversight and prudential measures, including local capital, liquidity and funding requirements and restrictions on intragroup financial transfers, promoting “self-sufficiency” and effectively reducing the scope of global banking groups’ internal capital markets (Goldberg and Gupta, 2013). In effect, these regulations restrict the foreign activities of domestic banks and the local activities of foreign banks (“localisation”; Morgan Stanley and Oliver Wyman, 2013).

They point out that

“ring-fencing” and “subsidiarisation” may constrain the efficient allocation of capital and liquidity within a globally active banking group and the functioning of its internal capital markets; in fact, these proposals have led to concerns that structural banking reforms may potentially trap capital and liquidity in local pools.

As I mentioned several years ago in my previous series on the topic, this is a real concern. Driven by their fallacy of composition, and with no empirical evidence to justify their reforms, regulators are weakening the system as a whole, repeating the mistakes of the US of the past. Moreover, disjointed discretionary regulatory actions are likely to make things worse when the next crisis strikes: domestically-focused regulators are likely to attempt to protect their own national banking system, preventing domestic subsidiaries from transferring much-needed liquidity to their parents abroad, resulting in a weakened international financial system.

The long-term consequences of trapping capital and liquidity where they are not of any need is unknown. But, constrained by the new rules, the profit-maximising private enterprises that banks are may well decide that putting those funds to use is better than leaving them idle, even if they would have been even more profitably used elsewhere. In turn, this would distort the allocation of capital in the economy, with potentially dramatic economic outcomes.

Worryingly, it has been recently reported that regulatory agencies had in mind an even more drastic idea: the elimination through subsidiarisation of most, if not all, international branches, trapping further capital and funding within entities that never needed to hold such funds in the past. Whether this measure is implemented in the end remains to be seen but one thing is certain: political agendas lead to the total disregard of empirical and historical evidence. In banking as in politics, the new ideological fracture seems to be ‘open’ vs. ‘closed’.

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Thicker capital buffers do not prevent banking crises

Bagehot Capital Quote

I know I complained about the sorry state of academic research on banking in my previous post, but not all research makes me despair. In fact, I have long admired a number of ‘mainstream’ academic researchers, such as Borio, as well as Jordà, Schularick and Taylor. The latter’s research is top-notch and what they built what is surely one the best available historical databases of banking. Thanks to their data collection, they provide academics with resources that go beyond the narrow scope of US banking. Their dataset is available online.

Last September, they published a paper titled Macrofinancial History and the New Business Cycle Facts, which is quite interesting, although not as much as their ground-breaking previous papers. Nevertheless, it is based on excellent datamining and I strongly encourage you to take a look. One of the interesting charts they come up with is the following real house price index aggregated from data in 14 different countries. As we can see, real house prices have remained relatively stable (at least within a range highlighted the black lines I added below) until the 1970s. However they started booming from the 1980s, when Basel artificially lowered real estate lending capital requirements relative to that of other lending types.

Historical Real House Price

But it is their most recent paper that particularly drew my attention. Published just a couple of weeks ago and highlighting Bagehot’s quote at the top of this post, Bank Capital Redux: Solvency, Liquidity, and Crisis argues that, contra the current regulatory logic, higher capital ratios do not prevent financial crises. In their words (my emphasis):

A high capital ratio is a direct measure of a well-funded loss-absorbing buffer. However, more bank capital could reflect more risk-taking on the asset side of the balance sheet. Indeed, we find in fact that there is no statistical evidence of a relationship between higher capital ratios and lower risk of systemic financial crisis. If anything, higher capital is associated with higher risk of financial crisis. Such a finding is consistent with a reverse causality mechanism: the more risks the banking sector takes, the more markets and regulators are going to demand banks to hold higher buffers.

As usual, their data collection is remarkable. This time, they collected Tier 1 capital-equivalent* numbers, as well as other balance sheet items, across 17 countries since the 19th century. Here is the aggregate capital ratio over the period:

Aggregate Capital Ratio

Unlike what most people – and economists – believe, they also demonstrate that capital ratios were on the rise in a number of countries in the years preceding the financial crisis:

Post WW2 Capital Ratios

Their finding is a blow to mainstream regulatory logic: capital ratios are useless at preventing crises and may well be a sign of higher risk-taking.

However, some of their findings do provide some justification for capital regulations. They find that

a more highly levered financial sector at the start of a financial-crisis recession is associated with slower subsequent output growth and a significantly weaker cyclical recovery. Depending on whether bank capital is above or below its historical average, the difference in social output costs are economically sizable.

While the fact that better capitalised banks are more able to lend during the recovery phase of a crisis sounds logical to me, I believe this result requires more in-depth analysis: it is likely that regulators in many countries forced banks to recapitalise after past crises or, as it was the case in the US in the post-WW2 era, that banks were also required to comply with a certain type of leverage ratio. This would have slowed their lending growth and impacted the recovery as they rebuilt their capital base to remain in compliance.

It may also be that, as they highlight in some of their previous research, banks suffered more from real estate lending, which was initially seen as safer and requiring thinner capital buffers, but which ended up damaging their capital position further and for longer periods of time once prices collapsed (relative to financial crises triggered by stock market crashes for instance). Whatever the underlying reason, this finding requires more scrutiny and granular analysis.

They also find

some evidence that higher levels and faster growth of the loan-to-deposit ratio are associated with a higher probability of crisis. The same applies to non-core liabilities: a greater reliance on wholesale funding is also a significant predictor of financial distress. That said, the predictive power of these two alternative funding measures relative to that of credit growth is relatively small.

See below the 17 countries aggregate loans/deposit ratio:

Aggregate Loans to Deposits

This is interesting, as we see that, unlike capital ratios, loans/deposit ratios were quite stable in recent decades relative to long-run average (in particular if we exclude the Great Depression period and its long recovery), around the 100% mark.

However, I will have to disagree with their finding that more ‘wholesale funding’ is a driver behind financial crises, even if there is some truth to it; although I happen to disagree strictly based on the evidence they provide. They base their reasoning on the wrong assumption that all non-deposit liabilities are necessarily other funding sources (see below the breakdown of liability types). This is incorrect: modern large universal banks have very large trading and derivative portfolios, which often account for 20% to 40% of the liability side of their balance sheet (although US banks under US GAAP accounting standards are allowed to net derivatives and therefore report much smaller amounts).

Aggregate Liability Structure

The key to figure out whether a bank is wholesale-funded is simply its loans/deposits ratio. A ratio above 100% indicates that a portion of loans has been funded using non-deposit liabilities. But as we’ve seen above, this ratio has never risen very high in the years preceding the financial crisis and used to be even higher in the 1870s.

Despite those minor disagreements and caveats, their research is of great quality and their dataset an invaluable tool for future analysis.

*Tier 1 capital is a regulatory capital measure introduced by the Basel rulebook

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