Tag: BIS

Reforms On Incentives To Centrally Clear Over-the-counter Derivatives

The Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) has published their final report on Incentives to centrally clear over-the-counter (OTC) derivatives.

The total value of OTC derivatives was recently reported at US$595 Trillion, a massive number. The approach is been to allow the growth of these instruments, but to encourage central clearing rather than bi-lateral dealer arrangements to give greater visibility to the exposures involved.  They propose capital incentives for centrally cleared transactions.

We discussed this in a recent video. This is a highly speculative market, and whilst shining more light on them may help, the more fundamental question which should be asked is why allow these to exist at all. The financial markets would be safer if they were limited to only underlying transactions, not speculative positions.   At the moment, there is a risk that the derivatives markets could swamp, and bring down the normal banking system in a crisis, and that risk remains un-quantifiable.  Another reason for structural separation.

 

The central clearing of standardised OTC derivatives is a pillar of the G20 Leaders’ commitment to reform OTC derivatives markets in response to the global financial crisis. A number of post-crisis reforms are, directly or indirectly, relevant to incentives to centrally clear. The report by the Derivatives Assessment Team (DAT) evaluates how these reforms interact and how they could affect incentives.

The findings of this evaluation report will inform relevant standard-setting bodies and, if warranted, could provide a basis for fine-tuning post-crisis reforms, bearing in mind the original objectives of the reforms. This does not imply a scaling back of those reforms or an undermining of members’ commitment to implement them.

The report, one of the first two evaluations under the FSB framework for the post-implementation evaluation of the effects of G20 financial regulatory reforms, confirms the findings of the consultative document that:

  • The changes observed in OTC derivatives markets are consistent with the G20 Leaders’ objective of promoting central clearing as part of mitigating systemic risk and making derivatives markets safer.
  • The relevant post-crisis reforms, in particular the capital, margin and clearing reforms, taken together, appear to create an overall incentive, at least for dealers and larger and more active clients, to centrally clear OTC derivatives.
  • Non-regulatory factors, such as market liquidity, counterparty credit risk management and netting efficiencies, are also important and can interact with regulatory factors to affect incentives to centrally clear.
  • Some categories of clients have less strong incentives to use central clearing, and may have a lower degree of access to central clearing.
  • The provision of client clearing services is concentrated in a relatively small number of bank-affiliated clearing firms and this concentration may have implications for financial stability.
  • Some aspects of regulatory reform may not incentivise provision of client clearing services.

The analysis suggests that, overall, the reforms are achieving their goals of promoting central clearing, especially for the most systemic market participants. This is consistent with the goal of reducing complexity and improving transparency and standardisation in the OTC derivatives markets. Beyond the systemic core of the derivatives network of central counterparties (CCPs), dealers/clearing service providers and larger, more active clients, the incentives are less strong.

The DAT’s work suggests that the treatment of initial margin in the leverage ratio can be a disincentive for banks to offer or expand client clearing services. Bearing in mind the original objectives of the reform, additional analysis would be useful to further assess these effects.

In this regard, the Basel Committee on Banking Supervision issued on 18 October a public consultation setting out options for adjusting, or not, the leverage ratio treatment of client cleared derivatives.

The report also discusses the effects of  clearing mandates and margin requirements for non-centrally cleared derivatives (particularly initial margin) in supporting incentives to centrally clear; and the treatment of client cleared trades in the framework for global systemically important banks.

The final responsibility for deciding whether and how to amend a particular standard or policy remains with the body that is responsible for issuing that standard or policy.

The BCBS, CPMI, FSB and IOSCO today also published an overview of responses to the consultation on this evaluation, which summarises the issues raised in the public consultation launched in August and sets out the main changes that have been made in the report to address them. The individual responses to the public consultation are available on the FSB website.

The five areas of post-crisis reforms to OTC derivatives markets agreed by the G20 are: trade reporting of OTC derivatives; central clearing of standardised OTC derivatives; exchange or electronic platform trading, where appropriate, of standardised OTC derivatives; higher capital requirements for non-centrally cleared derivatives; and initial and variation margin requirements for non-centrally cleared derivatives.

Shock Announcement Collapses Confidence And Trust In Australia’s Financial System

Economist John Adams and I discuss the renewal of Wayne Byres’ tenure at APRA. What does it signal via-a-vis The Royal Commission?


The John Adams And Martin North DFA Page

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The Rise of the Zombies

We discuss the latest BIS report on “zombie firms” and their impact on productivity, banks and risks in the financial system.

The Bank for International Settlements recently released a new report “The rise of zombie firms: causes and consequences”.  They define zombie firms, as firms that are unable to cover debt servicing costs from current profits over an extended period. They used firm-level data on listed firms in 14 advanced economies, to highlight a ratcheting-up in the prevalence of zombies since the late 1980s.  They say this increase is linked to reduced financial pressure, which in turn seems to reflect in part the effects of lower interest rates.  But such zombies weigh on economic performance because they are less productive and because their presence lowers investment in and employment at more productive firms.  And as interest rates rise, many will fail.

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Derivatives Reach New Record US$595 Trillion

The Bank For International Settlements has released their OTC derivatives statistics to June 2018. They report that the notional value of outstanding OTC derivatives increased from $532 trillion at end-2017 to $595 trillion at end-June 2018. This increase in activity was driven largely by US dollar interest rate contracts, especially short-term contracts.

That said, the gross market value of OTC derivatives continued to decline, nearing $10 trillion at end-June 2018 from $11 trillion at end-2017 – compared with the peak of $35 trillion observed in 2008. This decline reflected in part ongoing structural changes in OTC derivatives markets.

The proportion of outstanding OTC derivatives that dealers cleared through central counterparties (CCPs) held steady, at around 76% for interest rate derivatives and 54% for credit default swaps (CDS).

Gross market values declined despite an increase in notional amounts

Outstanding OTC derivatives, USD trillions

Graph 1: Outstanding OTC derivatives, USD trillions (interactive graph).
Source: BIS OTC derivatives statistics (Table D5.1).

Activity in OTC derivatives markets increased in the first half of 2018, driven mainly by short-term interest rate contracts. The notional amount of outstanding OTC derivatives contracts – which determines contractual payments – increased to $595 trillion at end-June 2018, its highest level since 2015 (Graph 1, red line). Nevertheless, the gross market value of outstanding derivatives contracts – which provides a more meaningful measure of amounts at risk – continued to decline, to $10 trillion, its lowest level since 2007 (blue line). Gross credit exposures, which adjust gross market values for legally enforceable bilateral netting agreements, remained stable at $2.6 trillion at end-June 2018 (yellow line).

US dollar contracts drove the increase in notionals

Outstanding notional amounts of OTC interest rate derivatives, USD trillions

Graph 2: Outstanding notional amounts of OTC interest rate derivatives, USD trillions (interactive graph).
Source: BIS OTC derivatives statistics (Table D7)

The increase in notional amounts outstanding was driven mainly by OTC interest rate derivatives, in particular for US dollar-denominated contracts, which rose from $157 trillion at end-2017 to $193 trillion at end-June 2018 (Graph 2, red line). An increase in US dollar activity was also seen in exchange-traded derivatives markets, where the average daily turnover of futures and options on dollar interest rates climbed to a record high of $9.6 trillion in the month of February. This increased activity may reflect changing expectations about the path of future US dollar interest rates during the period. The notional amounts outstanding of euro-denominated interest rate derivatives also went up over this period, but more modestly, from $122 trillion to $129 trillion (blue line).

The increase in OTC interest rate derivatives activity was concentrated in the short-term segment. The notional amount of outstanding contracts with a remaining maturity up to and including one year rose from $191 trillion to $231 trillion between end-2017 and end-June 2018. The increase for contracts with a remaining maturity between one and five years was less pronounced, from $140 trillion to $155 trillion, and longer-term contracts (with a remaining maturity over five years) held roughly constant, at around $94 trillion.

Turning to OTC foreign exchange (FX) derivatives markets, notional amounts rose to a record high of $96 trillion at end-June 2018, up from $87 trillion at end-December 2017. This was also driven by activity in short-term instruments. In contrast to other OTC derivatives, most FX derivatives require counterparties to repay the notional amount at maturity and thus can be viewed as a form of collateralised borrowing, with the associated foreign currency repayment and liquidity risks.

Market value of interest rate and credit derivatives declined further

Outstanding gross market values, trillions USD

Graph 3: Outstanding gross market values, trillions USD (interactive graph).
Source: BIS OTC derivatives statistics (Table D5.1).

Despite the increase in notional amounts in the first half of 2018, the gross market values of outstanding OTC derivatives continued to decline. Gross market values for all OTC derivatives stood at $10.3 trillion at end-June 2018, down from $11.0 trillion at end-2017 (Graph 3, red line). Over that same period, the gross market value of interest rate derivatives declined by $1 trillion, ending at $6.6 trillion (purple line). Other segments of OTC derivatives markets saw smaller movements, with FX derivatives increasing from $2.3 trillion to $2.6 trillion (yellow line) and credit derivatives decreasing from $0.3 trillion to $0.2 trillion (blue line).

The continuing decline in gross market values reflected in part ongoing structural changes in OTC derivatives markets. These changes include central clearing and greater possibilities for trade compression – that is, the elimination of economically redundant derivatives positions. In addition, in recent periods an increasing number of banks have been recording variation margin on cleared derivatives as settlement payments rather than as transfers of collateral. The practice of so-called settled-to-market (STM) allows counterparties to take ownership of the collateral that they receive. Consequently, daily payments of variation margin are recorded as settlements of the derivatives transactions rather than as transfers of collateral and the market value of the derivatives is reset daily to zero. STM, which is increasingly adopted for cleared swaps in particular, thus results in lower market values for a given derivative.

Clearing in credit default swap markets was steady at 54%

 Outstanding notional amounts of CDS, USD trillions

Graph 4: Outstanding notional amounts of CDS, USD trillions (interactive graph).
Source: BIS OTC derivatives statistics (Table D10.1).

Notional amounts of CDS continued to decline, owing to decreased activity between reporting dealers. From end-June 2016 to end-June 2018, total notional amounts dropped from $12 trillion to $8 trillion, amounts vis-à-vis reporting dealers declined from $5 trillion to $2 trillion, and amounts vis-à-vis CCPs remained steady around $4.5 trillion (Graph 4). In the first half of 2018, the share of notional amounts cleared with CCPs was stable at 54%, in contrast to the upward trend over the past few years.

In OTC interest rate derivatives markets, the proportion of contracts cleared was also steady in the first half of 2018, at around 76% overall. Across currencies, the proportion ranged from 73% for euro interest rate contracts to 77% for US dollar contracts and 89% for Canadian dollar contracts. In OTC FX derivatives markets, clearing accounted for only 3.0% of dealers’ outstanding contracts at end-June 2018. While low, this was up from 2.4% at end-December 2017.

Basel III Implementation, Slow But Sure: BIS

The Basel Committee released their status update of progress in implementation the requirements under Basel III.  While some progress is being made, there are still gaps.  The Australian implementation still has gaps, especially around aspects of disclosure.

Here is their summary.

In 2012, the Committee started the Regulatory Consistency Assessment Programme (RCAP) to monitor progress in introducing domestic regulations, assessing their consistency and analysing regulatory outcomes.

As part of this programme, the Committee periodically monitors the adoption of Basel standards. The monitoring initially focused on the Basel risk-based capital requirements, and has since expanded to cover all Basel standards. These include the finalised Basel III post-crisis reforms published by the Committee in December 2017, which will take effect from 1 January 2022 and will be phased in over five years. When those reforms were published, the Group of Central Bank Governors and Heads of Supervision, the oversight body of the BCBS, reaffirmed its expectation of full, timely and consistent implementation of all elements of the package.

As of end-September 2018, all 27 member jurisdictions have risk-based capital rules, Liquidity Coverage Ratio (LCR) regulations and capital conservation buffers in force. Twenty-six member jurisdictions also have final rules in force for the countercyclical capital buffer and the domestic systemically important bank (D-SIB) requirement. With regard to the global systemically important bank (G-SIB) requirements published in 2013, all members that are home jurisdictions to G-SIBs have final rules in force.

Since the last report published in April 2018, member jurisdictions have made further progress in implementing standards whose deadline has already passed. These include the leverage ratio based on the existing (2014) exposure definition, which is now partly or fully implemented in 26 member jurisdictions. Moreover, 25 member jurisdictions have issued draft or final rules for the Net Stable Funding Ratio (NSFR), and 20 member jurisdictions have issued draft or final rules for the revised securitisation framework. In case of implementation of the standardised approach for measuring counterparty credit risk exposures (SA-CCR), 24 member jurisdictions have issued draft or final rules. Also, draft or final rules for the capital requirements for bank exposures to central counterparties (CCPs) have been issued by 23 member jurisdictions.

However, in many jurisdictions, rules for these standards are yet to be finalised and come into force. This is notably the case for the NSFR, with only 10 member jurisdictions having final rules in force as of end-September 2018.

There has been also progress in implementation of standards whose deadline is within the next six months. On requirements for total loss-absorbing capacity (TLAC), 15 member jurisdictions have issued draft or final rules. Similarly, 21 member jurisdictions have issued draft or final rules for the large exposure (LEX) framework and for interest rate risk in the banking book (IRRBB).

They publish a country by country assessment, here is the one of Australia.  Still more to do clearly, especially in terms of disclosure.

To “Bail-In” Or To “Bail-Out”, That Is Indeed The Question

We look at reports from the BIS and IMF, and discuss the issues around bail-in, including of deposits.

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Prolonged low interest rates could affect financial stability, central banks find

The BIS is worried by the current low interest rate environment, and in a new report by a committee chaired by Philip Lowe warn of the impact on financial stability across the financial services sector, with pressures on banks via net interest margins, and on insurers and super funds.  They warn that especially in competitive markets, risks rise in this scenario.  Low interest rates may trigger a search for yield by banks, partly in response
to declining profits, exacerbating financial vulnerabilities.

In addition, keeping rates low for longer may create the need to lift rates sharper later with the risks of rising debt costs and the broader economic shock which follows. A salutatory warning!

Interest rates have been low in the aftermath of the Global Financial Crisis, raising concerns about financial stability. In particular, the profitability and strength of financial firms may suffer in an environment of prolonged low interest rates. Additional vulnerabilities may arise if financial firms respond to “low-for-long” interest rates by increasing risk-taking.

The decade following the Great Financial Crisis (GFC) has been marked by historically low interest rates. Yields have begun to recover in some economies, but they are expected to rise only slowly and to stabilise at lower levels than before, weighed down by a combination of cyclical factors (eg lower inflation) and structural factors (eg productivity, demographics). Moreover, observers put some weight on the risk that interest rates may remain at (or fall back to) very low levels, a so-called “low-forlong”
scenario. An environment characterised by “low-for-long” interest rates may dampen the profitability and strength of financial firms and thus become a source of vulnerability for the financial system. In addition, low rates could change firms’ incentives to take risks, which could engender additional financial sector vulnerabilities.

In light of these concerns, the Committee on the Global Financial System (CGFS) mandated a Working Group co-chaired by Ulrich Bindseil (European Central Bank) and Steven B Kamin (Federal Reserve Board of Governors) to identify and provide evidence for the channels through which a “low-for-long” scenario might affect financial stability, focusing on the impact of low rates on banks and on insurance companies and private pension funds (ICPFs).

Now a report by the Committee on the Global Financial System finds that low market interest rates for a long time could have implications for financial stability as well as for the health of individual financial institutions. Philip Lowe, Chair, Committee on the Global Financial System and Governor, Reserve Bank of Australia said:

“The adjustment of financial firms to a low interest rate environment warrants further investigation, especially when low rates are associated with a generalised overvaluation of risky assets. I hope that this reports provides both a sound rationale for ongoing monitoring efforts and a useful starting point for future analysis”.

Financial stability implications of a prolonged period of low interest rates identifies channels through which a “low-for-long” interest rate scenario might affect the health of banks, insurance companies and private pension funds.

For banks, based on econometric evidence, simulation models, and reviews of past stress tests, the Working Group found considerable evidence that low interest rates and shallower yield curves depress net interest margins (NIMs). This effect was more pronounced for banks facing constraints on their ability to reduce deposit rates, for example, because of very low interest rates or strong competitive pressures. low rates might reduce resilience by lowering profitability, and thus the ability of banks to replenish capital after a negative shock, and by encouraging risk-taking. These effects can be expected to be particularly relevant for banks operating in jurisdictions where nominal deposit rates are constrained by the effective lower bound, leading to compressed net interest margins. For banks in emerging market economies (EMEs), such adverse effects might materialise not only as a result of low domestic interest rates but also as a consequence of “spillovers” from low interest rates in advanced economies (AEs), which can encourage capital inflows into EMEs, excessive local credit expansion, and heightened competitive pressures for EME banks.

Lower for longer would be harder on insurers and pension funds than on banks. Even though the CGFS analysis did not show that measures of firms’ financial soundness dropped significantly, prolonged low rates could still involve material risks to financial stability. In particular, a “snapback”, involving an unexpected sudden increase in market rates from currently low levels, could affect banks’ solvency and create liquidity issues for insurers and pension funds.

“A key takeaway is that, while a low-for-long scenario presents considerable solvency risk for insurance companies and pension funds and limited risk for banks, a snapback would alter the balance of vulnerabilities,”

Chair Philip Lowe, said.

“The first line of defence against these risks should be to continue to build resilience in the financial system by encouraging adequate capital, liquidity and risk management. But the report also underscores the need to monitor institutions’ exposures in a comprehensive way, including through stress tests.”

The CGFS is a central bank forum for the monitoring and analysis of broad financial system issues. It supports central banks in the fulfilment of their responsibilities for monetary and financial stability by contributing appropriate policy recommendations.

Red Alert, From The Banker’s Banker

The Bank for International Settlements, Banker’s Bank has released their latest annual report. We looked at the section on how banks are fudging their ratios in our earlier post “Are Some Banks Cooking the Books?” But within its 114 pages, the BIS report also painted a worrying picture of where the global economy stands.

They say, economies are trapped in a series of boom-bust boom-bust cycles which are driving neutral interest rates ever lower and driving debt higher. The bigger the debt the worse the potential impact will be should rates rise (as they are thanks to the FED). Yet in each cycle “natural” interest rates are driven lower  Implicitly the current settings are wrong.

It is as clear an articulation of the underlying issues which are driving us towards the rocks, and at quite a clip. I still hold 2019 as the critical year, my four scenarios still seem about right, with risks biased towards more concerning outcomes.

Claudio Borio, the BIS’s chief economist said  “The end may come to resemble more closely a financial boom gone wrong, just as the latest recession showed, with a vengeance”.

This is a dark warning, coming as it does from the organisation which is effectively the peak body for central bankers around the world.  This is no fringe movement. This is the brain of the banking system speaking!

In fact, the risks in the global monetary system remain from the Lehman crisis in 2008 and aggregate debt ratios are almost 40 percentage points of GDP higher than a decade ago.

The BIS report said: “Global US dollar funding markets are likely to be a key pressure point during any future market stress episode. There are significant roll-over risks, as sizeable parts of banks’ US dollar funding rely on short-term instruments (repos, and currency swaps).”

The BIS says central banks are on the horns of a dilemma. Do you lift rates sharply as the FED has done, or go slowly, both are fraught with difficulty.  They call this the ‘great unwinding’ of the debt laden stimulus, and again it seems we are in uncertain and uncharted territory. As the report says, “A strategy of gradualism is no panacea, as it may encourage further risk-taking”.  The gloom was overdone early last year but now exuberant investors may be making the opposite error, with the world 12 months further into a stretched financial cycle. Has sentiment has swung too far?

The truth is, those hoping to time global asset markets by waiting for the usual signs that the cycle has peaked risk being caught off guard. The deflationary forces of technology and a globalised labour force mean that trouble can creep up on them before inflation emits the usual warning signals.

The bank says under the precious “Phillips Curve” model, wage growth would pick up late in the cycle as the economy reached full employment. Wages would rise and inflation would pick up.  So then the Fed and other central banks would lift rates – boom-bust, and it would usually lead to a recession. But, now globalisation has killed the inflation warning signals. Then you have more than 2 billion people coming on stream into the global economy from China and Eastern Europe has dampened wage growth and as a result a substantial and lasting flare-up of inflation does not seem likely.

Instead the excess stimulus driven by low rates has simply gone into asset bubbles instead. It may look benign if inflation is low but the BIS argues that it is extremely damaging. The cycle ends with a financial crisis. Again.

In fact, my read is that the BIS are saying (in bankers speak perhaps) that the big central banks misread the globalisation era with too much stimulus letting assets booms run, but stepping in with maximum stimulus in busts.

The Fed and others have in effect drawn forward prosperity from the future. It takes ever lower real interest rates with each cycle to hold the system together. At some point interest rates will hit the limit.

So now the way ahead is fraught with danger, as rates are lifted, the risks of a financial crisis follow, and the prospect of a benign set of outcomes is now fading. The BIS says the only way for the world to dig itself out of this hole is to raise productivity from its current anaemic levels. Countries must reform and shift fiscal policy from consumption to investment.

And in a parting shot, the report says, the most destructive course is to undermine free trade itself and impose trade tariffs and other forms of protectionism. “Rolling back globalisation would be as foolhardy as rolling back technological change,” Mr Borio said.

 

Philip Lowe appointed to chair the Committee on the Global Financial System

At their meeting in Basel this weekend, the central bank Governors of the Global Economy Meeting (GEM) appointed Philip Lowe, Governor of the Reserve Bank of Australia (RBA), as Chair of the Committee on the Global Financial System (CGFS).

The appointment of Mr Lowe as Chair of the CGFS is for a term of three years, starting immediately. He succeeds William C Dudley, CGFS Chair since January 2012. Mr Dudley retired from his position as President and Chief Executive Officer of the Federal Reserve Bank of New York on 17 June 2018. The GEM Governors expressed their gratitude to Mr Dudley for his leadership during his time as Chair and wish Mr Lowe every success in his new role.

Mr Lowe has been Governor of the RBA since September 2016.  He joined the Bank in 1980, and previously held the positions of Deputy Governor, Assistant Governor (Economic) and Assistant Governor (Financial System). Mr Lowe is a member of the Financial Stability Board. He also spent two years at the Bank for International Settlements working on financial stability issues.

The CGFS is a central bank forum for the monitoring and analysis of broad financial system issues. It supports central banks in the fulfilment of their responsibilities for monetary and financial stability by contributing appropriate policy recommendations.