Better Grades in Banking Through Better Banking or Better Special Effects?

[Saluki]

I was going to post something on the Citi post, but this is relevant to most banks, not just Citi, so maybe it deserves its own post since I don't see the particular topic being discussed.  It's difficult to believe that all the big banks are spending so much on lobbying, including ads on streaming platforms targeted to consumers, to try to block enactment of Basel endgame, yet they are doing better than before on their stress tests. They are trying to prevent Basel endgame because holding more capital will lower your returns on invested capital. So how are they more secure, without holding more of their own capital in the firm? I don't think they are.  It looks like smoke and mirrors, also know as portfolio compression. 

 

They claim that they are using AI to find ways to comply with new regulations at the lowest cost. My guess is that its one of the companies that goes through your order book and then comes up with a massive swap for hundreds of exposures to different counterparties and then does one large trade which seems to net out a lot of positions, and reduce the number of counterparties so that your positions look less risky. It's like portfolio margining on steroids. 

 

The problem is that with hundreds of smaller trades, if you or your counterparty runs into trouble, it's easy to peel off some that risk and sell it off.  Asian equities? African currency? Oil? No problem. But if you have cleaned up the dregs in your book with a massive bespoke trade with a counterparty who runs into trouble, who will be willing to buy that Swiss army knife trade with so many legs that it would be hard to value, let alone hedge? 

 

The vanilla exposures are already cleared through a clearing house somewhere, and the stuff that's leftover is stuff that isn't easily cleared. (Cross-currency swaps to hedge loans in African currencies that you can't spell?).  Not naming any bank in particular, but if Lehman was still around and they got in trouble.  Who would buy these one off weird trades that exist to clean up your net capital, not to perform some useful function that some other bank would want? Would that have made it harder in 2008?  Now replace Lehman with another bank or insurance company who is still around.  

 

I don't like companies with lots of debt in general, and I have work conflicts that keep my away from investing in many banks, but if I didn't, it's something that I would give serious thought to. 

[schin]

Yes, I think counterparty risk is a huge risk with swaps, options, CDO, etc.  They're just embedded leverage. I do not know who the CEO gamblers in Wall Street nowadays... I feel Jaime Dimon, Brian M, Christian Sewing as super conservative and not coming from a marketing/sales background.

 

I'm reading books about DB, ABN Amro, BAC's histories and it seems when an overly ambitious IBanker runs the show bad things happen. If the CEO comes from the retail banking or risk management side of things, it's run more conservatively and things don't blow up. When they want to scale or be a Global XYZ or they need to make 15%+ ROIC.... risks are taken and leverage is added. 

 

I believe banks are prone to boom and bust cycles. It's when there is growth at all costs is when things go bad. I worry this whole ESG trend will go towards that.

 

As for AI, it's going to be a black box... so, it's like the conventional wisdom in 2008 that housing prices have never gone down... and then,  Housing boom burst... and breaks the 1000 year old rule.

 

AI is going to lead into overconfidence. And it'll create this "mark-to-model" versus "mark-to-market" problem..... AI is not going to save the world....  If it's trained on aggressive techniques, it'll over leverage.  Think Long-Term Capital and all these flash crashes on steroids. 

[dwy000]

1 hour ago, Saluki said:

I was going to post something on the Citi post, but this is relevant to most banks, not just Citi, so maybe it deserves its own post since I don't see the particular topic being discussed.  It's difficult to believe that all the big banks are spending so much on lobbying, including ads on streaming platforms targeted to consumers, to try to block enactment of Basel endgame, yet they are doing better than before on their stress tests. They are trying to prevent Basel endgame because holding more capital will lower your returns on invested capital. So how are they more secure, without holding more of their own capital in the firm? I don't think they are.  It looks like smoke and mirrors, also know as portfolio compression. 

 

They claim that they are using AI to find ways to comply with new regulations at the lowest cost. My guess is that its one of the companies that goes through your order book and then comes up with a massive swap for hundreds of exposures to different counterparties and then does one large trade which seems to net out a lot of positions, and reduce the number of counterparties so that your positions look less risky. It's like portfolio margining on steroids. 

 

The problem is that with hundreds of smaller trades, if you or your counterparty runs into trouble, it's easy to peel off some that risk and sell it off.  Asian equities? African currency? Oil? No problem. But if you have cleaned up the dregs in your book with a massive bespoke trade with a counterparty who runs into trouble, who will be willing to buy that Swiss army knife trade with so many legs that it would be hard to value, let alone hedge? 

 

The vanilla exposures are already cleared through a clearing house somewhere, and the stuff that's leftover is stuff that isn't easily cleared. (Cross-currency swaps to hedge loans in African currencies that you can't spell?).  Not naming any bank in particular, but if Lehman was still around and they got in trouble.  Who would buy these one off weird trades that exist to clean up your net capital, not to perform some useful function that some other bank would want? Would that have made it harder in 2008?  Now replace Lehman with another bank or insurance company who is still around.  

 

I don't like companies with lots of debt in general, and I have work conflicts that keep my away from investing in many banks, but if I didn't, it's something that I would give serious thought to. 

The Basel stuff and subdivision trades wouldn't do a lot to improve capital ratios.  There are a couple of things to keep in mind on that concept.  The most important is that on virtually all derivative transactions today the transactions are done under an ISDA and net collateralized, generally with cash or tbills.  This is especially true with hedge funds and financial counterparties.  Your exposure therefor becomes the movement in the underlying only for the time it takes to call for a collateral top up.

 

The reality is that most banks no longer are at risk of failure from a couple of counterpaties defaulting, the real risk is liquidity (they lose funding) usually from overexposure to market movements (like SVB and others two years ago). In fact, most banks will hedge out most of the large counterparty risk with CDS.

 

What I really worry the overreach of Basel does is encourage them to move all of the riskiest exposures off of the banks' balance sheets and into unregulated shadow banking market (for example thru CDS).  It would make the financial system more risky and volatile not less because there's no transparency and no limitations. 

[LC]

AI is a cost reduction tool - it is not even a risk management tool. 

 

Stress tests are responses to macro factors: how will portfolios/positions look in a recession/depression environment.

GDP, HPI goes down by 8%: What happens to your consumer book? 

Treasury yields go up 4%: What happens to your loan portfolio? 

 

You have to look at the variables the regulators are flexing, and the response on the bank's capital ratios.

But ultimately this is a reflection of the bank's business:

One bank may have a large CRE book, another may have a large unsecured consumer loan book. Different books of business will respond differently to macro factors. It's up to each investor to assess & get comfortable. 

 

Regarding Basel, and regulations in general:

Nobody is telling banks how much risk to take, but regulators do put a price (capital) on risk.

The higher the cost, the less risk banks will take. Or, they will do something creative to take that risk. 

 

Frankly I am of the opinion that banks are in a strong position. 

The entire globe went thru a year long shutdown of human and economic activity, and I didn't see a real major bank issue. 

Edited July 1 by LC