In June, The Atlantic published “The Looming Bank Collapse”, a piece by University of California, Berkeley law professor and ex-Morgan Stanley derivatives structurer Frank Partnoy, which generated significant debate over whether a banking crisis in the same mould as that witnessed during the global financial crisis (GFC) is just around the corner.
In fact, the article suggests that this time around, things could be even more dire than the disaster that unfolded in 2008. “You may think that such a crisis is unlikely, with memories of the 2008 crash still so fresh. But banks learned few lessons from that calamity, and new laws intended to keep them from taking on too much risk have failed to do so,” Partnoy claimed. “As a result, we could be on the precipice of another crash, one different from 2008 less in kind than in degree. This one could be worse.”
But why worse, one might wonder? After all, haven’t banks learned their lessons from the last time? Have regulations not been severely tightened since then? And don’t banks have sufficient capital and liquidity buffers in place now? Well, according to Partnoy, the problem lies with collateralised loan obligations (CLOs). They are similar to collateralised debt obligations (CDOs)—those notorious mortgage-pool instruments issued to subprime homebuyers with low creditworthiness but erroneously given top-notch grades by ratings agencies; however, instead of going to troubled homebuyers, CLOs are given to troubled businesses.
“The CLO market has exploded in the past decade…. It’s a byproduct of the boom in private equity, which layers tons of debt onto its acquisitions,” Whitney Tilson, a former hedge fund manager, recently said. “CLOs should work well for the banks, unless—like with mortgages in 2008—all the loans go bad at the same time.”
CLOs are similar to CDOs in that their objective is to buy loans using money packaged up from various investors, who receive a rate of return for their participation. CDOs were typically sold according to their risk levels, called tranches, with senior tranches considered the safest as they had the first claim on the CDOs’ assets should those risky loans default on their obligations, and junior tranches being the riskiest but offering the highest rates of return to ostensibly reflect that risk.
But during the financial crisis, the CDOs that ended up incurring substantial losses were known as CDO-squared; they did not purchase risky homebuyer loans but rather tranches of other CDOs and credit default swaps (CDSs) that referenced other CDOs. These products severely compounded the risks to investors and ultimately triggered enormous losses. Indeed, it is worth reminding ourselves of just how dubious the data upon which loans were provided to those risky homeowners turned out to be back then, and the critical role that that falsely rated debt played in generating such horrendous losses.
CLOs, which pool loans from businesses similarly for various investor tranches, don’t suffer from this problem. “The typical CLO holds hundreds of loans diversified across dozens of industries,” observed a recent piece by the Wharton School of the University of Pennsylvania. “Exposure to any industry is contractually limited to 15% of the loan pool, while the maximum exposure to a single company is 2%. Thus, defaults must be pervasive across all sectors of the economy to materially affect the collateral pools of CLOs.”
As such, the corporate bonds that back CLOs will typically be sourced from a much greater diversity of industries. This explains why senior tranches of CDOs sold prior to the 2008 crisis led to losses in the hundreds of billions in the ensuing years, but similarly rated tranches of CLOs ended up with no losses. With the maximum exposure to any single industry or company mandated to be low, defaults would have to occur across a number of industries for the collateral pools of CLOs to be significantly affected. But should losses reach the banking sector, which largely represents the senior tranche, they constitute such a small fraction of their Tier 1 capital that they would not cause any serious problems.
In a recent speech, Randal K. Quarles, the vice chair for supervision of the US Board of Governors of the Federal Reserve System (the Fed), reiterated the strong position in which the US banking sector currently finds itself. “Large US banks entered this crisis in strong condition, and the Federal Reserve has taken a number of important steps to help bolster banks’ resilience,” he noted. He also pointed to the measures taken by the Fed to prohibit share repurchases in the third quarter for large banks, whilst also capping dividends as well as implementing the requirement for banks to reassess their capital needs due to the continued uncertainty and resubmit their capital plans. Quarles also confirmed that the Fed has recently released a baseline and two hypothetical recession scenarios that it can use to assess the resilience of the banking sector, and it will release bank-specific results from this assessment before the end of the year.
And in May, the Bank of England (BoE) confirmed that banks should be able to withstand a 30-percent contraction in the economy. “Is everything going to be fine? We don’t know,” said Stephen Jones, former chief executive of UK Finance, the trade association for banks, adding that the Bank of England’s modelling suggests that the system as a whole is solid. “The banks aren’t the problem in this crisis; the impact of the pandemic on the wider economy is the problem.”
But while banks’ capital and liquidity positions are more robust on the whole vis-à-vis 2008, it remains decidedly difficult to ascertain just how much they will eventually rack up in toxic debt as the coronavirus continues to shutter economic activity. As such, the liquidity phase of the crisis will soon give way to the solvency phase as liabilities start to flare up. As Mr. Hyun Song Shin, economic adviser and head of research at the Bank for International Settlements (BIS), recently acknowledged in an op-ed, “Banks will undoubtedly bear the brunt of the wave of bad loans and insolvencies affecting weaker businesses, especially in those sectors the pandemic has hit the hardest.”
And while banking systems in some parts of the world show admirable resilience, there is no guarantee that banking systems in every part of the world will survive this global shock. Those that were already under stress prior to the pandemic will undoubtedly feel an existential threat given the sheer magnitude of the unfolding economic contraction. Lebanon, a country that has been suffering from a deep economic and financial crisis since last year, is among the clearest examples in this regard. Banks had already exerted capital controls on depositors prior to the pandemic taking hold, freezing savers from their dollar deposits and blocking most transfers abroad. And the country is now suffering under the weight of an indebted state that defaulted on its foreign-currency debt obligations in March as well as soaring poverty levels that have exceeded 50 percent in recent times.
As such, banks are now potentially staring down the barrel of a wave of collapses should conditions continue to deteriorate. Indeed, Riad Salameh, governor of Lebanon’s central bank, warned in late August that banks must increase their capital by at least 20 percent by the end of February 2021 or exit the market. Salameh did, however, confirm that deposits would be preserved in such a scenario as the exiting bank would not be put into a bankruptcy situation, but, rather, its shares would be handed over to the central bank.
However, as the coronavirus continues to unleash damage across much of the world, it remains too early to tell whether banks are in existential danger. According to JPMorgan Chase, global gross domestic product (GDP) has dropped by more than 15 percent during the first half of the year, a whopping four times more than in 2008. The International Monetary Fund (IMF) believes that SME (small and medium-sized enterprises) bankruptcies “could triple from an average of 4 percent before the pandemic to 12 percent in 2020, threatening to add to unemployment and harm bank balance sheets”. And concerns continue to mount about just how many people will be permanently laid off. “Some companies think their business model has been permanently damaged by this,” noted John Wraith, UBS economist and head of UK and European rates strategy. “Many casualties won’t bounce back even if there is a medical breakthrough.”
All of this means that at some point, the level of banks’ nonperforming loans could very well reach a critical stage that forces them to scale back lending and induce a credit crunch, similar to 2008. And while regulators continue to show faith in the resilience of the world’s biggest banks, smaller lenders are on decidedly shakier ground.
“I fear that indeed there will be a deceleration of credit supply, which by itself will contribute to a very sluggish recovery,” warned Vítor Constâncio, former European Central Bank (ECB) vice president, who believes that the European Union (EU) might even have to lift its rules preventing using taxpayer money to fund bank bailouts and that a credit crunch may end up emerging in the second half of 2021. As such, while a pronounced wave of banking collapses may not ultimately transpire with the same force that was observed in 2008, banks remain vulnerable to a sharp deterioration in their overall health. And with no end in sight for the coronavirus, just how pronounced that deterioration will ultimately be remains far from certain at this stage.
1 comment
Great article. Thank you. There is no way that banks will escape a credit crunch considering the size of GDP contraction this year, and uncertainty of recovery and contraction in consumer spending and thus consumer deleveraging…especially, amongst GSBIs.