The Rulebook: Counterintuitive capital snuffer
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The Rulebook: Counterintuitive capital snuffer

Nearly one intense decade into the re-regulation of the financial sector, tensions in Europe threaten to tear the new rulebook apart. The Rulebook is GlobalCapital's round-up column, and take on, the week's developments.

Bank of England governor Mark Carney may have served up a nice little headache for himself on Tuesday when he announced banks won’t be forced to apply countercyclical capital buffers until at least June 2017.

A freshet of tweets and news commentary have suggested that Carney’s counterintuitive buffer snuffing amounts to an admission that the capital requirement was overkill in the first place.

But that is to misunderstand the very ‘countercyclicality’ of the buffer. The CCyB is, by design, meant to be increased to slow down or even prevent “periods of excess aggregate credit growth that have often been associated with the build-up of system-wide risk”, as the Basel Committee has it.

But authorities are also allowed to reduce the buffer in times of stress — say, an unprecedented secession of a powerful economy from a major Western union. In fact, it’s Principle #4 of Basel’s guidance to national authorities operating the CCyB: “Promptly releasing the buffer in times of stress can help to reduce the risk of the supply of credit being constrained by regulatory capital requirements.”

In its Financial Stability Report (FSR), the Bank of England repeatedly refers to “stretched valuations”, particularly in the UK commercial real estate sector, to which UK banks' exposures average 55% of their common equity tier one capital, according to the BoE. Indeed, the CCyB was implemented by the bank as a macroprudential measure to deflate a perceived overexuberance in UK CRE investment.

So one might argue that the reasoning behind wiping away the CCyB is flawed. But CRE prices in the UK were flat in the first quarter of the year, likely due to the uncertainty foreign investors faced with the impending referendum on UK membership of the EU. Up until then, CRE prices had steadily risen — some 40% higher than the 2009 low.

Now, open-ended CRE funds are taking a bath, (probably precipitated in part by the BoE’s note in its FSR that open-ended funds tend to get hammered during periods of stress), and CRE valuations could well begin falling. That would further justify a reduction of the CCyB — unless a further reduction of rates causes another surge in CRE borrowing and investment. Then the BoE could be on the hook for having helped a bubble form in the first place.

What about the claim that by cutting the buffer, the bank has freed up £150bn in lending capacity? Now this is where the egg begins to hover dangerously close to Carney’s face.

As GlobalCapital opined on Tuesday after the announcement, demand for loans is likely to stay low given weak growth, a possible recession and regulatory and political uncertainty. Increasing the availability of credit, of course, doesn’t increase demand of itself, so Carney’s argument is already flawed. Many borrowers are bound to shy away from taking on more debt in the face of the kind of economic picture Carney’s FSR painted.

CMBS vs real estate funds: open ended question

Pretty much every major open-ended real estate fund in the UK experienced what Carney said they might: redemptions so great they should be preceded with “The Shawshank”.

Canada Life, M&G, Aviva, Standard Life, Columbia Threadneedle, Henderson Global Investors and Aberdeen Fund Management all halted redemptions this week.

It’s not the first time this kind of panic has struck the sector. Any fund invested in illiquid assets which investors can redeem at short notice is, on the face of it, a pretty absurd idea. Which is why we have (correction: had) commercial mortgage backed-securities, which take illiquid assets and turn them into: bonds you can trade!

CMBS had a rough run of post-crisis regulations, not least because the documentation used in Europe for the deals was often baroque and, in retrospect, not legally watertight. It wouldn’t be a huge exaggeration to say that most of the CMBS news stories out of Europe since the crisis have been loan workout/lawsuit stories, rather than new deals.

No investment is totally safe from losses, and CMBS have had their share. CMBS have less granular loan pools than other securitization types, so when losses do happen, they tend to be large. But there’s something nice about having a static pool of loans that, if they do go bad, are transferred to experts in distressed loan workouts to maximise the value returned to bondholders.

What that means is that when CMBS prices tank, losses don't happen all at once, but over a long period of workouts that allows cooler heads to determine an outcome. Meanwhile, open-ended funds only have so long before they have to start dumping assets regardless of their long-term fundamentals.

The CMBS market was denied inclusion in the ‘simple, transparent and standardised’ qualification available to other asset classes. But in light of what is happening to open-ended funds, maybe it’s time to rethink how these bonds are treated under capital regulations.

BSR: It’s… ALIVE!?

No one’s heard mention of the bank structural reform (BSR) initiative — the EU’s version of ring-fencing. One government relations official at a bank in London summed it up when he said that regulations in Brussels never really die, but they can stay asleep for pretty much ever. That’s been the hope of many in the banking industry who are already worried about the future of the sector.

But when European Commission vice president and soon-to-be Jonathan Hill replacement Valdis Dombrovskis sat in front of the Parliament’s Committee on Economic and Monetary Affairs, BSR reared its ugly mug again.

Dombrovskis waded carefully into the BSR issue — his approach to the entire hearing was, as expected, statesmanlike. But in the end, it’s clear Dombrovski wants to resuscitate the regulation.

“This proposal is currently, if I may say, stuck, and not really moving forward,” he said. “Some of the concerns raised on this proposal — how, for example, banks can continue to provide important services like market making, some concerns on proportionality… those are valid concerns.”

A collective sigh must have been issued across the finance centres of Europe.

But he continued: “My intention is, in any case, to meet with rapporteurs, with shadows, to discuss the situation as regards bank structural reform, and whether we need to move forward. Because the intention of the proposal — to address the 'too big to fail' problem — is still a valid intention.”

There are probably a lot of hopes pinned on that ‘whether’.


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