Yielding to a New Regulatory Reality | A Six Part Series
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NO MORE BANK BAILOUTS What New Banking Regulations Mean for Money Market Investors
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“It requires but a moderate knowledge of the banking system now in force to see that, whatever may be its defects, and whatever the errors of the managers doing business under it, it can never inflict the same kind of loss on the country as that which came from the old system.” — The New York Times, January 16, 1877
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Issuing short-term debt is key to a bank’s business model. As a result, banks issue a disproportionate volume of the short-term debt securities on the market, and bank debt is the primary investment in money market funds. The financial crisis of 2007-2009 exposed vulnerabilities in the banking system, which revealed corresponding vulnerabilities in money market funds. Since the crisis, regulators have overhauled the rules governing banks and money market funds, leading to a new era for banks, the money market funds that hold their short-term debt and money fund investors. Our paper “The New World of Cash” explored changes in money market regulations and the impact they have on cash investors. This paper is the first of a six-part series examining the new bank regulations, their influence over the paper banks issue and their implications for money funds and investors. When the global banking system appeared to be on the verge of collapse in 2008 and 2009, governments around the world were forced to provide massive bailouts in order to protect their countries’ economies and citizens. Since that time, policymakers have introduced a wide range of new rules intended to avert a recurrence of that scenario. The regulatory framework changed from one in which governments would be expected to bail out banks to one in which banks would be held accountable for their own safety — known as a “bail-in”.
The driving factor behind banks’ low default figures has been government support. Banks (and their senior creditors) are rescued by governments because they are critical to a wellfunctioning economy. Allowing a bank to file for bankruptcy disrupts payment systems, reduces credit availability and restricts customer access to deposits. These problems can upset financial markets, so governments have stepped in to save banks in times of crisis. As a result, rating agencies and investors have embedded government support assumptions into the ratings and perceptions of bank credit.
BANK STANDALONE CREDIT RATINGS
+ GOVERNMENT SUPPORT UPLIFT
= BANK LONG-TERM/ SHORT-TERM CREDIT RATINGS
The Past Role of Government Support Banking is a high-risk activity that is inherently vulnerable to market cycles, asset bubbles and liquidity shocks. Yet defaults, even during the past five years, have been rare relative to other industries.
The Cost of Bank Bailouts
Fitch defines a bank failure as any debt default, coercive exchange or extraordinary support without which the bank would cease being an entity. It is important to note that a bank can fail without defaulting. For example, while bank failures surged from 2007 to 2009, only 20 percent of failed banks actually defaulted on their debt obligations. In addition, the bank default rate remains well below the corporate default rate, as indicated below.1 Fitch Two-Year Average Default & Failure Rates
1990–2003 (%)
1990–2012 (%)
Corporate Defaults
1.44
1.45
Bank Failures
1.70
3.22
Bank Defaults
0.58
0.53
A government bailout often supports senior creditors at great cost to the country’s financial position. In 42 separate banking crises between 1970 and 2007, the gross cost of direct recapitalization ranged up to 37 percent of gross domestic product (GDP).2 More recently, Ireland spent €64 billion — fully 40 percent of its GDP — recapitalizing its banking system between 2009 and 2011.3 In this case, the government had low levels of public debt going into the crisis but quickly fell victim to budgetary overruns, a sharp deterioration in public finances and a growing capital deficit in the banking system. The government eventually had to seek assistance from the International Monetary Fund and the newly created European Financial Stability Facility in 2010.4 As history indicates, the unknown future cost of a banking system bailout can represent a destabilizing claim on public sector resources.
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The End of Bailouts In the aftermath of the global credit crisis and the European Union sovereign debt crisis, global regulators have created (and continue to create) resolution regimes to mitigate the risk of a full-fledged government bailout. These initiatives are supported by regulatory proposals mandating that banks hold elevated levels of loss-absorbing capital.5 While resolution regimes will differ by jurisdiction, the guiding principle is that shareholders, depositors and creditors — not governments — will bear the cost of a bank failure going forward. The process of passing bank failure costs to shareholders, depositors and creditors generally will result in lower credit ratings. A Reshuffling of Bond Safety The United States and Europe have placed the cost for future bail-ins on holders of specific types of debt, while protecting other debt-holders and depositors. For example, in the United States, the Dodd-Frank Act explicitly eliminated government support of banks and directed that the debt of bank holding companies be liquidated to preserve core operating subsidiaries. In Europe, regulators gained the power to take over a failing institution rapidly and, if necessary, to restore viability by imposing losses on subordinated and senior unsecured debt. Europe also has exempted small depositors from funding a bail-in, essentially making them senior to bondholders and institutional depositors. For money funds and their investors, the result has been a reshuffling that has made certain types of bonds safer in the event of a bank failure while putting others at greater risk. In the United States, operating company creditors (though the mechanism has not been tested) are in theory now more secure than holding company creditors. In Europe, some senior creditors face higher probability and potential severity of losses in the event of a failure than they did under previous regulations.6
A RANGE OF REGIMES GLOBALLY The United States and Europe have adopted similar approaches to eliminating bailouts. Other countries have taken different paths. CANADA
Likely to protect short-term creditors
Canadian regulators proposed details of a resolution regime in 2014 and now are in the midst of building it. Although original indications were that debt maturing in less than 400 days would be exempt from bail-in, this remains to be seen. Additional clarity is expected in 2016/2017.7
AUSTRALIA
Supportive of senior creditors
The Australian government has adopted a relatively cautious and noncommittal public stance on creditor bail-in. Regulators may ultimately find a middle ground that could include a requirement for higher levels of capital or creating a class of contractually loss-absorbent debt. Although no rules have been established yet, the initial impression is that the government will remain more supportive of senior creditors than other major jurisdictions.
JAPAN
Rejecting bail-in
Japan’s resolution approach is more favorable to senior creditors than the US or European schemes. Rather than seek to end government bailouts, Japanese regulators have opted to provide pre-emptive support. The new resolution law actually expands the array of entities that can receive assistance. In its October 2014 upgrade of Japanese brokers, Moody’s states, “The authorities take the view, formed in light of their experience during the Japanese financial crisis of the late 1990s, that pre-emptive capital injections are the lowest-cost method for maintaining financial stability.”8 Some senior creditors can still take losses through bankruptcy, which includes asset transfer to a bridge bank. But an industry-backed resolution fund may help absorb losses before they reach senior creditors.9
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Growing Capital Requirements
Figure 1: Basel III Risk-Based Capital Requirements*
In isolation, diminished government support would weigh on credit ratings. Yet policymakers have paired the efforts to remove government protection of the banking system with regulations requiring banks to hold much more capital than they have before. Those higher capital requirements have buoyed bank credit ratings, helping to offset the ratings impact of the elimination of government support.
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Following the financial crisis, officials from the world’s banking system met in Basel, Switzerland to craft a voluntary, global regulatory framework. (Although the rules are technically voluntary, many have been incorporated into laws in individual countries, and banks generally must adhere to them to participate in the global banking system.) This was the third such meeting since 1988, so the agreement that resulted became known as Basel III. It spelled out the following requirements: • All banks must hold common-equity capital — the strongest form of regulatory capital, known as Common Equity Tier 1 (CET1) — of at least 7 percent of their risk-based assets, an increase from 2 percent prior to Basel III. • Banks may need to hold an additional 2.5 percent in common equity in the event of a credit boom, bringing the total to 9.5 percent. • The most systemically important banks must hold up to 2.5 percent in additional common equity. The potential total common equity requirement amounts to 12 percent, six times pre-crisis levels.10 The following chart represents the capital timeline laid out by the Basel Committee. Under Basel III, mandated levels of CET1 compare favorably to losses in the recent crisis. For a sample of large economies, the Bank for International Settlements estimates that pre-tax losses averaged 5 percent of risk-weighted assets. (The highest was 26
Glossary Core Tier I Ratio of a bank's core equity capital to its total risk-weighted asset. Non-Core Tier I Consists of Permanent interest bearing shares (PIBS). Tier II Supplementary bank capital that includes items such as revaluation reserves, undisclosed reserves, hybrid instruments and subordinated term debt.
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2.5
12 2.5 8 4 4
0
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4
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2
2
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2
2010
2011
2012
n Core Tier I n Non-Core Tier I n Tier II
2
2.5
2.5
2
2 1.5
2.5 2 1.5
2.5
2
1.5
1.5
0.63
1.25
1.88
2.50
3.5
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4.5
4.5
4.5
4.5
4.5
2013
2014
2015
2016
2017
2018
2019
3.5 1
1.5
1.5
n Capital Conservation Buffer n Anti-Cyclical Buffer n G-SIB Buffer
* This timetable follows the schedule as laid out by BCBS. However, the implementation timetables for any specific jurisdiction could differ from the above as national regulators draft their respective versions of Basel III’s capital rules. Source: Roever, Alexander, Ho, Teresa and Iborg, John, “US Fixed Income Regulatory Update for 4Q14: Regulations affecting the US Fixed Income Markets,” JPMorgan Chase, January 2015.
percent).11 Still, the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, has put forth a proposal for total loss absorbing capacity (TLAC) that goes above and beyond these thresholds; if implemented, the required TLAC level may be 3.1 times greater than the average historical losses of the largest failed US financial institutions.12 Even then, TLAC would imply the write-down of certain debt obligations. Taken together, while new regulations require banks to hold significant levels of capital to absorb losses and avoid a government bailout — with potentially greater levels to come — some scenarios could still create losses for creditors.
Anti-Cyclical Buffer Aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate G-SIB Buffer Those institutions deemed as systemically important must hold additional loss absorption capacity tailored to the impact of their default, rising from 1% to 2.5% of risk-weighted assets (with an empty bucket of 3.5% to discourage further systemicness), to be met with common equity.
Capital Conservation Buffer Designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred.
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THE IMPACT OF BAIL-IN ON CREDIT RATINGS Bank credit ratings historically have been boosted by high government support assumptions. In fact, Moody’s estimates that 40 percent of its bank ratings contained more than one notch of government support as of March 17, 2015.1 The agencies are now reducing these assumptions based on resolution regimes. While downgrades are expected, potential rating actions are mitigated by the agencies’ formal recognition that senior secured creditors benefit from the establishment of a large (and growing) buffer of subordinated debt. As a result, the rating changes have minor implications for money market funds. Like the changes brought about by new US and EU regulations, shifts in the rating agencies’ methodologies could reshuffle the relative security of particular types of short-term issues. MOODY’S
STANDARD & POOR’S
FITCH
Moody’s is revamping its entire bank rating methodology. The agency is reducing government support assumptions and incorporating a new “loss given default” (LGD) feature into its ratings. The impact is likely to be generally favorable for senior secured debt instruments, recognizing that they benefit from high levels of subordination and that early intervention via resolution regimes has the potential to maximize recovery value for senior secured creditors.
Standard & Poor’s also is modifying its bank rating methodology to reduce levels of government support, but is taking a more incremental approach. Indications at this point suggest that its changes will have a more negative impact on ratings than Moody’s changes will.
Fitch’s last sovereign support review, completed in March 2014, resulted in negative outlooks for 36 European banks. The latest review resulted in several downgrades on May 19, 2015. The impact of the changes were largely minor, in part because the banks that received shortterm downgrades already had lower ratings from the other agencies.
Moody’s new methodology delinks ratings on unsecured debt from ratings on deposits. This change could create some confusion for money market investors, because in some cases short-term debts (for example, commercial paper) will be rated lower than deposits (such as CDs). Moody’s new methodology has had a mainly neutral impact. Ratings in Europe until now have been largely positive, while senior ratings in the United States were reduced for regional banks and increased for systematically important banks.
• In Europe, Standard & Poor’s is currently focused on countries that have implemented early resolution regimes ahead of the EU-wide 2016 deadline. In early February, the agency placed most UK, German and Austrian banks on a negative credit watch.13 • In the US and Canada, government support assumptions will be reassessed once Standard & Poor’s believes that there is sufficient clarity on the features and implementation terms of the respective resolution regimes.
In the US, the impact of rating actions was largely subdued as a stronger view of standalone fundamentals offset the removal of government support. In fact, a number of systemically important banks received upgrades. 1
Source: Moody’s Investors Service The principal methodology used in these ratings was Multilateral Development Banks and Other Supranational Entities published in December 2013. Please see the Credit Policy page on www.moodys. com for a copy of this methodology.
Standard & Poor’s also is incorporating the upward notching of bank ratings where there is an established level of additional loss-absorbing capacity, or ALAC.114 The agency’s review of UK, German and Austrian banks was completed on June 9, 2015.15 In many instances, uplift from ALAC offset the removal of government support assumptions.
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Summary and Conclusions Although new regulations and improved capital standards are positive in the short term, history shows that they may not prevent the next bank crisis. In fact, bank reforms often sow the seeds of the next crisis. For example, the favorable capital treatment of credit default swaps (CDS) and residential mortgage–backed securities (RMBS) under Basel II rules greatly contributed to the subprime crisis. The quote at the beginning of this article attests to the faith an earlier generation placed in the National Banking Act of 1877. With the next crisis, senior creditors of western banks will no longer benefit from a government safety net. Investors will need to adjust to a higher likelihood of default, albeit with potentially higher recovery values. Although banks’ larger subordinateddebt and capital bases offset the immediate impact of this negative trend — as does the generally healthier state of the economy — over the long term, investors can no longer assume that the likelihood of government bail-outs makes large banks low-risk credits. Despite global regulatory changes mandating stronger (and in some cases unprecedented) levels of capital and liquidity, bank credit ratings are now much lower than they were pre-crisis. In our view, while stronger regulations could help to mitigate future risks in the banking industry, they do not eliminate the inherent vulnerability of banks to market cycles, asset bubbles and liquidity shocks. Now more than ever — and particularly in light of removed government support — the vigilant monitoring and rigorous analysis of financial counterparties done by State Street Global Advisors’ cash credit team has become an integral part of our investment process.
“Global Bank Rating Performance Study: 1990-2012,” Fitch Ratings, Nov. 27, 2013. Contessi, Silvio and El-Ghazalay, Hoda, “Banking Crises around the World: Different Governments, Different Responses,” Federal Reserve Bank of St. Louis, April 2011. 3 Schoenmaker, Dirk, “Stabilising and Healing the Irish Banking System: Policy Lessons,” Jan. 19, 2015. 4 Honohan, Patrick, “Recapitalisation of failed banks — some lessons from the Irish experience,” Sept. 7, 2012. 5 http://financialstabilityboard.org/wp-content/uploads/TLAC-Condoc-6-Nov-2014FINAL.pdf 6 “EU Bank Recovery and Resolution Directive (BRRD): Frequently Asked Questions”, European Commission, Apr. 15, 2014. 7 Department of Finance Canada, “Taxpayer Protection and Bank Recapitalization Regime: Consultation Paper,” July 2014. 8 “Moody’s upgrades Nomura with stable outlook, concluding review,” Moody’s, Oct. 9, 2014. 9 Obata, Hiroyuki, “Role of DICJ in the Orderly Resolution Framework,” Deposit Insurance Corporation of Japan, June 25, 2014. 10 Ingves, Stefan, “Basel III is simpler and stronger,” The Wall Street Journal, Oct. 15, 2012. 11 “Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach,” Basel Committee on Banking Supervision, October 2010. 12 http://sifma.org/newsroom/2015/ industry_supports_total_loss_absorbency_requirement_ to_help_ensure_gsibs_can_be_resolved_in_an_orderly_manner_without_taxpayer_ assistance/ 13 “S&P Takes Various Rating Actions On Certain U.K., German, Austrian, And Swiss Banks Following Government Support Review” Standard & Poor’s, Feb. 3, 2015. 14 “Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity” Standard & Poor’s, Apr. 27, 2015. 15 “S&P Takes Various Rating Actions On Certain U.K. And German Banks Following Government Support And ALAC Review” Standard & Poor’s, June 9, 2015. 1 2
The following installments in this series describe in detail the three pillars of post-crisis bank regulation — capital, liquidity and funding, and resolution — and the impact they have on money market funds and investors in the United States. View the entire series here
Glossary Senior Creditors a person or organization that is owed money by a bankrupt company and that will be paid back before others. International Monetary Fund (IMF) an international organization created for the purpose of standardizing global financial relations and exchange rates. European Financial Stability Facility An organization created by the European Union to provide assistance to member states with unstable economies. Dodd-Frank Act A massive piece of financial reform legislation passed by the Obama administration in 2010 as a response to the financial crisis of 2008. Subordinated Debt A loan or security that ranks below other loans or securities with regard to claims on assets or earnings.
Senior Unsecured Debt When a company is insolvent and negotiating reorganization under bankruptcy law does not pan out, the firm’s assets are sold off to pay stakeholders’ claims. Some items are always paid first, such as payroll taxes. The remaining money is used to pay creditors and shareholders based on priority. Common-Equity Capital a measure of equity which only takes into account the common stockholders, and disregards the preferred stockholders. Risk-Based Assets bank assets affected by changes in credit quality, interest rates, repricing opportunities, etc. Total Loss Absorbing Aapacity (TLAC) the debt or capital available to absorb losses in banks. Loss Given Default The amount of funds that is lost by a bank or other financial institution when a borrower defaults on a loan.
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