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July 11, 2023 | We start this issue of The Institutional Risk Analyst by noting the latest comments from the Federal Reserve Board on how to make banks more resilient to the risks that caused the collapse of three good size regional banks, accounting for almost half a trillion in banking assets. As our colleague Dennis Santiago noted on Twitter last week: "Entropy doesn’t care who is right or wrong. The only thing it sees is someone disturbed the equilibrium."
The outsized wave of market volatility unleashed by the Fed has not made the agency any more forthright in its public statements. “Events over the past few months have only reinforced the need for humility and skepticism, and for an approach that makes banks resilient to both familiar and unanticipated risks,” Michael Barr, the Fed’s vice chair for supervision, said in a speech, The Wall Street Journal reports.
The only problem with Barr’s statement is that his solution entirely avoids the problem. The definition of “risk weighted assets,” as defined by US regulators for the purposes of Basel capital rules, does not include government bonds, including Treasury debt and Ginnie Mae mortgage backed securities. Both have zero risk weights, but still caused SVB to fail. Under Basel capital rules, 100% means $8 in capital per every hundred dollars in assets.
Conventional MBS backed by Fannie Mae and Freddie Mac have 20% risk weights. This compares to 50% capital for well-underwritten whole mortgage loans or 100% for corporate credit exposures. Bottom line is that Barr’s capital increase will lower bank earnings, but will not address the factors that caused Silicon Valley Bank to fail in March of 2023. Not at all.
Source: FDIC
So what should Barr do? Forget the general capital increase for banks. Instead, immediately impose a 50% minimum capital weight on all MBS to acknowledge the market risk contained in these securities. Barr should lead this discussion within the US regulatory community, but does he have the courage to speak up? Because of the borrower’s open-ended right to prepay, holders of MBS are always short duration, both in terms of market price and relative spreads. Barr should dispense with the childish nonsense about "capital" and make bank managers address that real risk.
Look at the number of stocks that have been downgraded in recent weeks because of the impact of unrealized securities losses on the balance sheets of banks and REITs. The public record is filled with relevant examples for Barr and his colleagues to ponder. If you bought whole loans or MBS during COVID and were not smart enough to shed this risk in good order, then today you are at least 10-15 points under water on price and 5-6% underwater on funding for these assets.
Moving right along in the grand parade of value destruction, the bankrupt parent of Silicon Valley Bank filed a lawsuit against the FDIC last week seeking to recover $2 billion in funds deposited with the defunct bank. Good luck. Long-time readers of The Institutional Risk Analyst will recall a similar litigation involving the 2008 failure of Washington Mutual FSB. The WaMu failure spawned numerous derivative lawsuits with JPMorgan (JPM), Deutsche Bank (DB) and other parties.
When the former parent of WaMU eventually won in court, the FDIC turned around and sued the officers and directors for the additional loss to the bank insurance fund. The failure of three regional banks in Q1 2023 is just part of the larger wreckage caused by the policy failure of the FOMC over the past five years. There are literally hundreds of billions in losses working through the US financial system as a result of the outsized market risk caused by the FOMC’s decision to “go big” with reserves starting in 2019.
Now Barr and his colleagues will impose inappropriate new capital rules on banks at a time when regulators should be seeking to boost bank profitability in order to absorb current mark-to-market and future credit losses. If we take note of the fact that the Fed is likely to keep rates at or above current levels, then all financial institutions face a period of dramatic readjustment to this new reality and lower earnings in the meantime.
Large US banks already have 11% common equity tier 1 capital / total risk-weighted assets (RWA). Just how much more capital does Mr. Barr think that banks need to prepare for the next wave of market volatility ℅ the FOMC? The sad fact is that even with another 2% capital to RWA, most US banks are arguably insolvent thanks to the Fed “going big.” Just wait for some of the juicy disclosure in Q2 2023 earnings around unrealized losses.
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