Last Updated: 18 January 2023
Over recent weeks banks in the UK have been furiously lobbying the government ahead of next Monday’s publication of a special report into the sector. It’s widely expected that the Independent Commission on Banking will recommend that UK-domiciled banks’ retail operations are “ring-fenced” from wholesale, investment banking activities, with only the retail part bearing any form of government support in future.
The banks, in aggregate, are against such a proposal, as it will cost them real cash. A June estimate by HSBC of the cost of ring-fencing for the largest four UK banks (primarily funding, liquidity and capital costs for their investment banking operations, if run as future stand-alone entities) was £10 billion. That’s before accounting for likely corporate deposit outflows, administrative costs or the impact of a probable slowing of the UK economy as a result of ring-fencing, all of which will have further knock-on effects for the banks, HSBC argued at the time.
But others may view these “costs” for the banks as the return of taxpayer money that had already been given to them for free. Andrew Haldane of the Bank of England estimated last year that banks had received an implicit government subsidy of £50 billion a year in 2007-2009. On this measure HSBC’s suggested ring-fencing costs look a bargain.
Given the heated debate that’s been going on over the ICB’s report even before it’s published, we can expect a lot more wrangling before the final rules on banking sector reform are decided. There have been repeated claims in the press over the last two weeks that the UK government wants to water down or delay the commission’s (leaked) recommendations.
There’s one big flaw, however, in the argument of those who suggest that banks can be trusted to look after their own affairs without structural change; that they won’t come calling again on the taxpayer for bailouts, in other words.
And that’s the abundant evidence that banks don’t trust each other. Three charts demonstrate this.
The Euribor-OIS spread, a measure of the willingness of banks in Europe to lend to each other on an unsecured basis, has risen to its highest level since 2009, as is shown in the following chart form CIMB Research.
For a larger view, please click on the image above.
The Markit iTraxx Europe Senior Financials index, a broad measure of the cost of default insurance for leading European financial names, has today hit an all time high of over 280 basis points. Banks are quoting ever higher rates to protect against their own counterparts’ failure to meet contractual obligations.
And even in the most liquid market in the world there are signs of trouble. Fred Sommers of Basis Point Group pointed out to me a couple of days ago that settlement fails in US Treasury bonds have shot up this month. This may indicate that banks are looking to hoard Treasuries which, after gold, are the most sought-after type of collateral for obtaining secured finance.
A chart of fails data from the DTCC website speaks for itself, and indicates a steady rise from a year ago.
Sommers also says that data published by the New York Federal Reserve Bank indicates a surprising and growing imbalance between the total fails to receive and the total fails to deliver reported by the 20 primary dealers in US government securities.
You might have thought that, among a single group of dealers, the total of securities not received for settlement should equal the total not delivered. Not so, apparently. This suggests, according to Sommers, either that there’s an accounting problem or (more likely) that custodians or financing banks are causing the discrepancy by using contractual settlement date accounting.
Under this practice, custodians credit (or debit) client accounts on the planned settlement date even if settlement hasn’t yet occurred. Although such account entries can be reversed later, the imbalances may be of concern in themselves to those monitoring the integrity of payments systems.
Regulators are attempting banking sector reforms at a tough time, for sure. It would also have been better if the credit bubble hadn’t been allowed to occur in the first place. But attempts by some governments to underwrite all banking sector liabilities have so far proven impossible—the debts are just too big. Some form of triage of the banking system into parts that can be saved, parts that go on life support and parts that die (i.e. default) is inevitable.
As banking sector risk measures climb higher, collateral and counterparty risk exposures in exchange-traded funds become more of a concern too. And market liquidity is getting tighter, something we’ve already written about on this site at length in recent weeks.
On a related note, next Thursday we’re holding a webinar to throw light on some of the concerns expressed by global regulators about the ETF market. I’ll be joined by Brian Kelliher of Dublin-based law firm Dillon Eustace, and by two investors who’ve been vocal on the subject of ETF risk exposures, Alan Miller of SCM Private and Gary Mairs of TCF. Please join us and share your views. You can sign up here.