|An investor looks at an electronic board showing stock information at a brokerage house in Hangzhou, Zhejiang province, China, after Chinese stocks plunged|
This was the time for regulators to sit in the middle offices of the world’s largest banks and in the executive suites to find out how quickly and accurately banks’ risk monitoring and control systems could present senior executives with data on their exposures across troubled countries, markets and counterparties.
How quickly and accurately could banks discern their direct exposures to countries in aggregate and to specific counterparties most directly affected, the extent of their contingent and off-balance sheet exposures through derivatives and also their secondary exposures to counterparts based in developed markets but at risk from collapses in commodity prices and revenues derived from emerging markets (EMs)?
Time will tell if this correction was just a wobble or the beginning of a more lasting and worrying sell-off across financial markets. Certainly it looks as if volatility is back, a consequence in large part of the withdrawal of banks from their buffering role as market makers.
And while some firms may yet benefit from a rise in volatility, if it induces high levels of customer hedging, risk reduction and bargain hunting, they will be hurt if it leads to a funk period when investors do nothing and bank’s own illiquid assets gap down in price.
The suspicion remains that banks do not do a better job of quantifying and revealing to the market their direct and indirect exposures to broad markets suffering sell-offs or to specific counterparties in a crisis, for the simple reason that their vaunted IT systems aren’t capable of delivering that information to management in a timely manner.
However, if an EM crisis should be upon us, investors in bank debt and equity will continue to press for whatever information they can gather. During the recent equity market sell-off all banks’ share prices were hit, pretty much in line with the market, as if a systemic problem might be brewing.
The first place to look for aggregate data is the Bank for International Settlements and its numbers on banks’ consolidated foreign claims and other potential exposures. This gives us data on foreign claims by banks (on an ultimate risk basis), and also includes contingent liabilities like guarantees or derivatives written.
Matt Spick, banks analyst at Deutsche Bank, spent the last days of August combing through this and finds the good news is that European banks have been shrinking their exposures to EMs as part of an overall deleveraging which has seen cross-border exposures fall by a compound 2% annually since 2010. Relative to the size of the European banking sector overall, the EM exposures are now quite small.
Deutsche Bank identifies, for the universe of banks it covers, $1.7 trillion of EM loans outstanding and estimates an additional $500 billion in off-balance sheet exposure via derivatives and other commitments. And it finds that this exposure is concentrated in a small number of banks.
The ones to worry about are mostly obvious: HSBC and Standard Chartered for exposure to China, Santander and BBVA for exposure to Latin America, Erste and RBI for exposure to central and eastern Europe. Deutsche also names Julius Baer as a surprise addition to the list, given its increasing dependence on Asia as a source of revenues for its wealth management business and an associated pick up in lending there.
Among the US banks, which are more exposed to Latin America than to Asia, the biggest concern is at Citi, although JPMorgan and Bank of America also have much at stake in the foreign exchange markets.
While investors have every reason, in the light of recent history, to be concerned about banks’ capacity to monitor their direct and indirect exposures and to manage them as financial markets appear increasingly illiquid, could the recent sell-off in bank stocks be overstating the risk of damage from an EM crisis?
This month, Euromoney examines how the profitability of large, developed-market banks has fallen, in large part owing to much reduced leverage. At the same time, the cost of equity investors charge to banks suggests they see them as far less risky. The pace of loan growth, which has been agonizingly slow in developed markets and has been in decline in EMs, is a new feature of the industry.
Spick points out that the danger of rapid loan growth of the kind banks indulged in through previous cycles is that, when a crisis hits, it leaves banks with far less seasoned loan portfolios full of recently originated loans. The worst losses almost always come from the last loans advanced before a crisis breaks. The subprime crisis provides a good example of this. Subprime loans originated in 2006 had double the equivalent-stage loss experience of those originated in 2004.
Whatever happens next in EMs, bad debt levels at developed market banks are almost bound to go up from here. Having peaked in 2009 and 2010, bad debts have sunk since to far below the 25-year average and almost to all-time lows. The question becomes how far and how fast they rise.
Regulators have been blamed for stopping developed market banks from lending plentifully into fragile economic recovery. If an EM crisis proves that they have also put on far fewer bad loans and left earnings lower but more stable, investors may thank the regulators yet.