Banking system resilience is a sham

Introduction

Financial regulators and governments have made much of their success in restoring the global financial system to a state of stability after the Global Financial Crisis and the Eurozone crisis, lasting from 2007 to 2013.

Unfortunately it is a sham. Bank capital has scarcely increased in monetary terms. The trick has been to shrink banks’ business volume from its nominal amount to a ‘risk-weighted’ amount, and to measure the capital against this smaller amount. Whenever the smaller amount has been put to the test, the capital has proven inadequate to the risks being run and the bank has failed.

Risk-weighting – the heart of the sham

The banking system’s supposed high levels of capital are expressed as a percentage of a business volume significantly shrunken from its nominal to its ‘risk-weighted’ value. The ratio of capital-to-business volume then rises, making banks’ capital appear adequate. The methodologies and databases behind ‘risk-weighting’ have been approved by auditors, financial regulators, global oversight bodies et al.

The disparity between the nominal and the risk-weighted value is stark for supposedly low-risk business: holdings of government debt, real estate lending, and derivatives business where the risk is meant to be covered by cash or quoted assets.

We can tick off each recent disaster as an example of one of those.

USA

Both Silicon Valley Bank¹ and First Republic Bank² failed due to their huge holdings of US government debt. Depositors made mass withdrawals – a bank run – and both banks collapsed.

Government debt is risk-weighted at 0%. These banks had to hold no capital at all against the risk that the US government would default.

The Federal Reserve’s ‘Bank Term Funding Programme’ was created to preclude runs on other banks.³ It lends against the US government debt and similar assets that banks own, keeping the show on the road – for now.

The Federal Reserve claims that the programme was ‘created to support American businesses and households’, whereas its primary purpose is ‘to help assure banks have the ability to meet the needs of all their depositors’ i.e. to avoid bank runs. The programme closed on March 11^th 2024. Its loans have a maximum maturity of one year. We have a wait of eight months to see whether the show lurches back off the road.

Secured real estate lending qualifies for advantageous risk-weighting, allowing a small capital base to support a very high volume of mortgages. Fitch Ratings has warned of losses from lending into multi-family properties where the rent is controlled.⁴ The two biggest actors in this market segment – United Wholesale Mortgages and Rocket Mortgages – were also the two biggest mortgage lenders in the USA in 2023, extending between them 582,000 out of the 1,183,000 loans made by the top ten lenders – 49%.⁵ This sounds like a recurrence of ‘Ninja’ mortgages – borrowers with No Income, No Job – which were repackaged into Residential Mortgage-Backed Securities, and crashed in 2007-8.

China

The bankruptcy proceedings around the two housing development companies – Evergrande⁶ and Country Garden⁷ – are well known. The property market continues to slide, with Chinese house prices falling at a fast pace.⁸

Five of the twenty-nine institutions named by the Financial Stability Board as Global Systemically Important Banks are Chinese, including China Construction Bank.⁹ We cannot know if these banks are solid, even if their ratio of capital to risk-weighted business is 1-1.5% higher than that of banks who are not seen as systemically important.

Continental Europe

The collapse of Credit Suisse was an example of the failure of risk-weighting when applied to derivatives business, including where the bank supposedly had tangible security against the risk-weighted value.¹⁰

The EU’s actions have been limited to a proposal to extend the scope of the European Stability Mechanism (the main bailout facility for the euro) to backstop the Single Resolution Fund, which backstops the salvaging of failed banks.¹¹ Italy has blocked this move.¹²

The EU’s housing market does not appear to be as stretched as those of the USA, China and the UK. The EU’s problem is government debt, particularly that of France,¹³ a country that seems to be heading towards deep social tensions and serious political instability.

UK

The UK’s situation is of high house prices and stretched affordability,¹⁴ with domestic mortgage lending in the biggest banks separated into a supposedly safe bank, called a ‘ringfenced bank’, funded by the deposits of UK families and businesses. This arrangement was designed to make those deposits more secure.

The current trend is firstly a consolidation of medium-sized players – Nationwide Building Society is acquiring Virgin Money,¹⁵ and the Coventry Building Society is acquiring the Cooperative Bank¹⁶. Secondly new entrants are exiting: Sainsbury’s Bank is selling out to Natwest,¹⁷ and Tesco Bank is being acquired by Barclays.¹⁸ These trends show the failure of efforts to spread the UK’s current account, payments, cards and mortgage businesses over a larger number of actors, to dilute the concentration of business and of systemic risk in five or six major banks.

Summary and conclusions

Storm clouds are gathering unevenly around the world in government debt and real estate. Banks are as weakly capitalized as they were before the Global Financial Crisis, a fact obscured by the risk-weighting process. Risk-weighting allows business volume to be shrunk the most dramatically in the exact two asset classes around which the storm clouds are gathering. A capital ratio of ‘14% of risk-weighted assets’ is of little comfort when the business volume has been shrunk by 70%. If measured with reference to the initial business volume, the ratio should actually be 4.2%. Even that formulation allows that derivatives business is not expressed at its nominal value, but firstly as a lower ‘value-at-risk’, and then as an even lower ‘risk-weighted asset’. The only thing that does not get shrunk is the losses.

1 https://www.investopedia.com/what-happened-to-silicon-valley-bank-7368676 accessed on 28 June 2024