(instrumental music)
- [Raghu Sundaram] Good afternoon everybody.
And welcome to the second
of our Faculty Insights
series, this summer.
My name is Raghu Sundaram,
I'm the Dean of NYU Stern,
and I will be acting
as the moderator for today's talk.
It's always a pleasure and a privilege
to introduce any
of Stern's extraordinary faculty,
but today's a very special plessure
because Viral Acharya,
who's a speaker today
was my student at Stern when he was doing
his PhD some 20 odd years ago.
In fact, I think he might've even written
his first paper,
one of his first papers with me.
And suddenly got one
of his first Dissert Awards with me.
Since then, of course he has gone
to become one
of the most distinguished members
in all of the academic finance fraternity.
And Viral is not just an academic
as many of you know,
he's also been an active policy maker.
He spent two and a half
years as deputy governor
of the Reserve Bank of India,
which is an extraordinarily difficult job
because it is also puts you
in the political process
quite a bit of the time.
And but I'm most caught
in a bit of controversy
then himself on handling
himself with aplomb.
So let me turn it over
to Viral for today's talk.
And as always please feel free
to submit your questions
through the Q&A channel and we will take
those questions after
Viral finish this talk
Viral over to you.
- [Viral Acharya] Thank you so much, Raghu.
I think what Raghu was trying
to summarize very briefly
is that I was a rising
star until I met him.
And after the award with him,
I'm now a fallen angel.
But let me talk about
some other fallen angels
that are out there right
now in the markets.
And in a way, what I want to talk about
is going to be a very natural takeoff
from where Professor Aswath Domudaren
left last Tuesday.
I was moderating his talk.
Those of you who were
there had seen it already,
but for those who
weren't, let me remind you
that two of the striking facts
that Professor Domudaren
drew attention to,
were that some industries and sectors
in the stock markets
have been hit much more
severely than others.
And two of the top ones
that he mentioned in being
the most severely affected
were the banking sector
and the energy sector.
He also mentioned in the context
of the energy sector,
that oil prices had actually
had a very different pattern over
the last three, four months time
say couple suggesting that some
other technical dislocations
are at work there.
I'm going to delve a lot
more into both of these,
but especially into the crash
of bank stock prices since mid-February
that we have observed.
This is a joint work with Rob Engle,
also the NYU stern and Sascha Steffen
who's at the Frankfurt
School of Management.
And let me stress that while I will focus
on COVID-19 as the specific microscope,
I'm going to use to understand the crash
of buying stock prices.
My overarching goal is to paint something
which is a slightly longer term,
which is that something
happens episodically
in causing bank stock prices to crash.
Every time we have a significant shock
to the economy, and I
want to try and explain
what that channel is,
why do the bank stock prices crash
and what can be done
about it going forward.
So, let me start out by first giving you
a motivation as to what I'm talking about.
So, what I've done here
is something relatively simple.
I've essentially plotted
the stock price performance.
Let's look at the left panel chart.
And I'm gonna do most of it through charts
and a few numbers at the end.
You can see that all
of these energy sector,
banking sector and other corporates,
they've all been indexed to 100
at the beginning of the year.
You can see that as the pandemic reaches
the shores of the Western economies
and gradually starts spreading
these prices, correct.
And you can see that the price correction
is rather notable for banks,
which are right at the
bottom of that graph.
You can see that post the federal reserve
and the treasury packages being announced
on 23rd of March,
there is a significant reversal
in the stock prices of other corporates.
In fact, as we speak at least
as far as stock market is concerned,
we are looking at a very
small correction of,
in many of these relative to mid-Feb.
But you can see that the bank stocks
have really languished.
There's some pickup in the energy sector,
but even that has languished,
and this is why I'm calling it a crash.
It doesn't look something
that was just a temporary dislocation.
The bank stock prices
have remained subdued
after having collected
for between 40 to 50%.
They've essentially
stayed flat more or less
at that level.
Now, and also what is peculiar,
if you look at the right hand side,
now, again, the banks are at the bottom,
but now they are in the black thick line
rather than the dash line.
The other dash lines are
other financial firms,
broker dealers, insurance firms,
securities investment firms.
And you can see that,
even there relatively speaking,
the part of the financial sector
that has done particularly poorly
in this last three months is again
the traditional banking
of the depository sector.
And this is what I want to try
and understand in some detail.
Now, the focus of my talk
for most part is going
to be on the connection between the banks
and the corporate sector.
Most of the time, we
focus on banks performing
the intermediation function
as one of extending loans to companies.
But the classic intermediation function
that banks provide to corporations
is actually not just of providing loans,
in fact, increasingly large companies
also borrow in the capital markets.
They can go to the markets and get bonds,
which in many ways
looks as a similar intermediation function
as getting a loan from a bank.
Of course, there are differences
because of maturity, collateral,
covenants and so on.
But, I would say that the primary function
of banks that differs
from what capital markets do
is that banks provide
liquidity insurance to companies.
Banks, allows companies
to have prearranged lines
of credit or credit facilities,
which they can drawdown
at pre-agreed spreads based
on their credit quality,
not at the time of drawdown,
but at the time that the facility
has been put in place.
Now, why is this important?
This is important because
if firms cannot rely
on liquidity being available
to the analogy I like is that,
you are driving on a highway
and if you can't fuel your car every now
and then at a gas station,
if you don't think the
gas stations are going
to be with fuel, as you are driving,
you are very unlikely to
undertake a very large
or long car journeys.
The same way a corporation
will not make longterm
ill-liquid investments,
if they don't expect their liquidity needs
unanticipated liquidity
needs along the way
to be met by the banking sector.
Now, banks provide large quantum
of these credit lines
to the corporate sector.
And when you get an
event such as COVID-19,
when other sources of funding dry down,
banks become the first and actually
the last resort of financing,
of course, I hate to use the word loss
because that's usually the central bank
or the federal reserve in case
of the United States coming to the rescue.
Now, what do you,
what am I showing you
here on the two plots?
On the left plot, I'm
showing you how large,
the drawdowns of these prearranged
liquidity insurance facilities have been.
In a short span of three weeks,
corporations in the United States,
primarily lower grade corporations,
but also the triple-B rated corporations
that face the risk of
becoming fallen angels.
They drew down heavily
on these bank credit lines,
in fact, close to about $250 billion
in less than a month.
To put things in perspective,
$250 billion was the size of the drawdown
on bank credit lines in the entire year
of 2008 of the Global Financial Crisis.
Okay, so this is quite
unprecedented intensity
of the drawdowns.
On the right hand side,
I'm showing that for those firms
that did drawdown their credit lines,
and of course, the ones that drew down
are the most effected by the pandemic,
so the hospitality
sector, the energy sector,
the transportation sector, the airlines,
these are the ones
that have drawn down most heavily,
but also the weaker corporations
whose access to funding in markets
has been affected significantly.
On the right hand side,
what I'm showing is that for the firms
that drew down, they drew down close
to 75 to 80% of the
outstanding credit lines
in the one month that we had seen.
Now, both of these are very large
and intense liquidity demand
from the corporate sector,
over the very short period of time
and very large compared to annual outcomes
in the past recession such as
the '01, '02, '03, '07, '08, '09 period.
So of course, there's a natural question.
Why do firms drawdown credit lines?
As I said, it's because
there are other forms
of financing dry up
and because for some,
they risk being a fallen angel,
if they can demonstrate to rating agencies
and markets that they
have enough liquidity
to tide over that temporary
cash flow problems.
Either direct cash flow
hit to their business
or rollover costs
having gone up in commercial paper,
bank loans and bond markets.
So, here's a quote from Bloomberg writers.
The markets were shaking
up in middle of March
that borrowers are drawing down heavily
on bank lines of credit and anticipating
that market sources of funding may dry up
or get costlier,
especially the short-term
commercial paper.
But I want to stress these behavior
was not limited
to the best rated nonfinancial companies
that access the commercial paper.
It was actually quite widespread
even in the lower rating categories.
Now, one other point
I want to stress here of course,
this was called as dash for cash
by some journalists.
And it was actually pretty serious
as far as the bank balance
sheets was concerned.
Now, what I want to show you
is that this crash of bank equity
that has happened over the last few weeks
has something to do with this phenomenon.
The fact that banks provision
of credit lines ahead of
time before the pandemic
is being used by the corporate sector
in order to draw down liquidity
as their sort of resort financing,
when other sources of
funding are drying up.
Now, from a re-sharing standpoint,
of course, this might
be entirely desirable
that can be done on
the productive capacity
of the corporate sector
together along with the pandemic
it's important for them to stay afloat,
it's important for them to meet
their operating leverage,
financial leverage and banks
having prearranged
this liquidity insurance function,
are essentially providing it
and they have provided it.
The reflection of that is this crash
in the bank stock returns
that we've just seen.
So in order to demonstrate this,
am going to construct,
a very simple measure
of balance sheet liquidity risk for banks.
I'm going to look at three items,
two of which are the risks
and one which is that
defense against liquidity.
The first risk are the unused commitments.
As I mentioned,
these are not just to
corporates in general.
They could also be to other forms
of credit lines,
they could also be a
credit card facilities
they could be home equity lines
of credit, et cetera.
Second source of liquidity risk
is wholesale funding,
while banks have moved
away very substantially
from wholesale funding
over the past 12 years,
thanks to the reforms
after the global financial crisis.
Nevertheless, it's
important for some banks,
at least still to keep
track of their reliance
on market finance,
especially at the short term end.
And of course, bank defense against
the materialization of rollover problems
and drawdown problems.
So, rollover problems
that wholesale funding drawdown problems
with unused commitments,
are their cash and cash equivalents.
So I'm going to subtract
that from the two sources
of liquidity demand
on the banks.
And scale it by total
assets so that the measure
is comparable across banks.
Now, once I do that,
first, let me show you
what the time series
of this balance sheet
liquidity risk measure looks like.
Okay, what this graph
shows on the left hand side
is that the liquidity risk measured
was about 33% of assets on average
just before the pandemic hit us.
It is seven,
it is about eight to 10%
smaller than it speak
before the global financial crisis hit.
Nevertheless, there is a pattern here,
which is that the vulnerability
of the banking sector
through prearrange lines of credit,
to reliance on wholesale funds
relative to their cash
and cash equivalent assets
had been rising steadily
for about two years prior to the shock.
Now of course, no one
could see the pandemic,
but I want to stress,
is that this one memorability
was actually rising
and getting closer to the
2007 cutie three levels.
There is a very important difference
between the two peaks
of the graph on the left hand side,
which is that, if you divide
the liquidity risk contribution,
coming from credit lines,
which is in the gray squares
versus the wholesale funding sorry,
the dark gray bars at the bottom
are the credit lines
and the light gray bars at the top
as wholesale funding.
You can see that in 2007,
almost the entire component
of liquidity risk was
due to wholesale funding.
In contrast wholesale funding
has dramatically deteriorated.
Nevertheless, it space has been filled up
through the surging
credit lines since 2015,
and especially over the
last few quarters.
Now, how am I going to use this?
I'm going to use this measure
before the pandemic hit,
so I'm going to use the measure
as of first, January of 2020,
to divide banks
into high liquidity risk
and low liquidity risk banks, okay?
Those who are exposed
to a sudden stop of a rollover finance
or a sudden macro shock
versus those who are relatively immune.
And what you see is that,
even though both suffered
the incremental performance
of the high liquidity risk banks
is about 10% worst as
shown in the right graph.
The difference between the two shows that,
the liquidity risk is being punished
by an incremental 10%, okay?
This makes two points.
One is that something happened,
which is perceived to
be a risk to all banks,
not just those who are liquidity risk.
And we have to try and understand that,
but that banks were exposed
to liquidity risk,
as I showed you, in case of the pandemic,
more through credit lines
have been punished by an extra 10%
in the markets.
In fact if you want to
see this graphically
you can see on the left hand side,
I have just regressed
the bank stock returns
in a very simple Y versus X plot
against liquidity risk.
And you can see there
is negative slope banks
that had higher liquidity
risk in the spectrum.
You can see between the two extremes
of the liquidity risk values,
there's a differential pattern
of about 20% in the stock market crash.
Now, what's very interesting,
and this is a point that our colleague,
Ed Altman makes repeatedly,
is that in the benign
phase of the credit cycle,
there is virtually no risk premium
in the markets.
So, on the right hand plot,
what I've done is something very simple.
So, in your
corporate finance classes
with Aswath Domodaran
or otherwise, you would have run
the cap M regressions.
And when you run the cap M regressions,
if you regress the stock on its beta,
you basically get what one might think
of as the market risk premium.
These risk premia estimated
as of January or February,
were practically close to zero.
That's the red vertical line.
Neither liquidity risk,
nor even the market risk,
were very significantly priced for banks
as of January and February.
And you see this episodic ignition,
the risks ignited
the risk premium has now become large.
If you recall last week,
Professor Domodaran said that,
based on his survey,
the risk premium actually went up
by a good 3% from 4.75% or 7.75%.
Of course the market prices
were not even reflecting a 4.75%.
Now, arguably these are very
short period estimates,
nevertheless, using a similar
short period estimate in March,
you can see that the pricing
of both beta and liquidity risk,
has become very
significant in the markets.
So, that explains the
liquidity risk component,
as I said, though,
it may not just be all liquidity risk,
maybe the pandemic
and the loss of productive capacity,
the reorientation of style of consumption
that might result as a result of this,
is a permanent shock
to certain kinds of businesses.
And so, there may just be credit risk
that has gone up on bank balance sheets.
Of course, that doesn't fully square up
with why the corporate sector
has rebounded so well in the stock market,
but the banks haven't rebounded.
And I want to explain that, yes, indeed,
there is a credit risk component here.
This is the second important point,
but the component of credit risk
that banks are suffering the most from,
is actually linked
to their fossil fuel exposures.
It's linked to their
exposure, to the oil sector,
especially in the United
States, as you know,
the Shell Gas explorations
and the existing capacity
is not that profitable,
even at the presently rebounded levels
of oil prices.
Now, why is this a potential candidate?
It's for the simple reason
that if you look at the left hand chart
on these two graphs,
the oil volatility has basically reached
almost unprecedented levels
in the last few months.
The oil price volatility
measured a CVOX index,
reached a peak of 300%
on the day of the big crash
when the opaque could not agree
to the supply cuts
and it still remains close to 80%.
Now, this is very important
because VIX, which is
also another market gauge
or a fear index
has actually come back very sharply
from its peak of 80% down
to between 20 to 30%.
This however, has not been the case
for oil price volatility,
all indicators of oil
price war in the markets
are right now between 80 to 100%,
they have not corrected much.
It suggests that the problems being seen
in this sector are extraordinarily high.
A global recession or
a consumption slow down
will hurt this sector very significantly.
Ed Altman has been quoted
and cited in many papers,
showing that some of these sectors
have been gearing up for distress
steadily over the last few years.
And in fact, on the right hand side,
if you look at the two-day,
adjusted return of banks,
adjusted for the liquidity risk exposure,
adjusted for their beta two-day return,
right around the oil price crash.
You can see that on the X axis banks
that had higher exposure
to the oil and gas sector to their loans
as a percentage of that year,
when capital again got
hammered quite heavily.
Okay, what about other industries?
Is credit risk high also
in other industries?
It seems it's there but less so.
You can actually see
that most of the rebound
in the non-financial corporates
that I was showing to you earlier
has happened in sort of
known oil gas sector.
Oil gas is the thin dashed line,
right at the bottom.
It's sort of like banks, it's crashed,
it's not really picking up again.
These are loan returns.
You see something very similar
in the stock market returns as well.
I'm showing you loan
returns partly to show
that even after
the federal reserves rescue measures
and trying to put a floor,
these loans are not going
in the secondary markets
at actually prices,
which are a far cry from
their lowest prices.
You can see that the loans to oil and gas,
they went down to 75 to
80 cents on a dollar,
that's a twenty to 25% correction,
there is not that much recovery
in the prices of these.
And of course now,
if I throw in this oil exposure
to tier one capital as another risk factor
that is getting episodically
priced in the market.
Once again, you see January, February,
literally no risk premium on any risks
in explaining the cross section
of bank stock returns.
And there is a very large loading
on oil exposure and to tier one capital.
And it's in fact,
larger and then the
liquidity risk explaining
that a big chunk of the correction
has actually happened
because of these oil exposure.
You can add in other sectoral exposures.
And what is striking
is that it's really the bank exposure
to the oil sector that helps understand
what's happening to the
stock price performance.
So, I would say two big things
to watch out for as far
as bank performance,
going forward is concern.
What is the likely drawdown
on their credit lines
and two, how is the performance
of the oil sector?
These two remain the primary risks
based on the data that we have seen
over the last three months
in the bank returns.
Now, one question that often gets asked,
is the pandemic different?
And of course it is different.
It's a very different kind of a shock
compared to the global financial crisis,
there, the crisis was deeply rooted
in the housing sector,
perhaps fuel to both public policy,
as well as poor underwriting standards
in mortgage lending by
banks and unknown banks.
Nevertheless, I would tend to think
that as far as bank outcome is concerned,
these kinds of shocks, make me think
that while history may
not exactly repeat itself,
as far as banks are concerned it rhymes.
Okay, so I did exactly the same exercise
using the liquidity risk measure
that I constructed using,
by constructing it as of January, 2007.
I already showed you that there,
it was wholesale funding reliance,
which was the biggest contributor,
not the extension of
corporate credit lines.
Now, if you go to about January, 2008,
which is about six months
into the global financial crisis,
you can once again, see that the market
was differentially pricing
the high and the low liquidity risk banks
by about 10%.
Now, if you project
that forward all the way
until collapse of Lehman brothers,
this difference widened to about 40 to 50%
as you see on the right hand side.
The right hand side is the difference
between the stock performance
of the high and the low
liquidity risk banks.
And you can see that.
And we actually verify that this pricing
of the balance sheet
liquidity risk is episodic.
Virtually no pricing until Q2, of 2007.
And once the crisis hit,
the stock market is
discriminating between banks
based on their balance sheet exposure
to wholesale funding and
credit line products.
So, I think that is
very much a pattern here
that repeats every time
there is a large shock,
large enough to create problems
in wholesale markets,
large enough to cause growth prospects
to come down,
large enough to cause
global equity markets
to correct in a significant way.
Okay, so why is this important?
This is important
because now we can ask the question,
and this is my third point.
What do we do with all this?
And I'm going to focus
on the liquidity risk
aspect because presumably
the federal reserve is working hard
on the stress tests
to get at least the direct
credit risk exposure
such as to the energy sector, right.
They will ask banks
to hold the right levels of capital
when this comes about.
But because this liquidity risk
is off balance sheet it's not materialized
as a rollover problem or as a drawdown,
it's an off balance sheet risk.
And because it is so episodic,
it's important to include
it in the stress tests.
Because that's the only way you can limit
the kind of carnage of bank stock prices
that we have seen, from happening forward.
I would in fact say,
that the differential pricing
of credit risk right
now is only about 10%,
which was Jan, 2008 levels.
If the slow down continues,
if corporate credit drawdowns continue
for another two, three quarters,
we could easily see a further widening
between the exposed banks
and the less exposed banks.
Okay, so what do I want to do?
I want to quickly show you
how all this can be put to good use,
to come up with a number
as to how much capital
we should ask banks to raise
and why I think we should do this ASAP.
Of course it will have
to be the regulators
who do this.
Okay, so I looked at a pattern
of how much does the
corporate sector draw down
as a function of the S&P 500 decline?
The left hand side,
is a microscope within the pandemic.
The right hand side graph,
is a longer time series microscope
over all the stress quarters
of the last two decades, okay?
So, that includes the GFC 2001, 2002,
some of those periods and
then the recent stress.
And what you see on the left hand side
is a very steep slope.
That steep slope implies
that if there's a 40%
correction in the market,
a global market decline
or an S&P 500 market decline,
out of the total credit lines
that are outstanding,
you will see between 30
to 40% of a drawdown.
And the right turn chart abuse
something very similar.
So, what can we do with this?
I'm to say that we can use this to conduct
a stress test.
It will be a pandemic stress test,
given the numbers we use right now,
but otherwise it's going to look like
a stress test to a large shock.
Now, as you know,
at the Volatility and Risk Institute,
founded by Rob Engle
and presently run and managed
by Rob Engle and Professor Dick Berner.
We calculate a measure
overnight called SRISK,
which tells you the capital shortfall
of an individual bank in case of a crisis.
I won't bore you with all the formula,
but roughly what it tries
to do is to simulate
a stress test in an academics computer.
It asks the question,
suppose there was a 40% correction
to the global stock market,
if I wanted a bank
to have in that correction scenario,
at least 8% of market
equity value relative
to its total liabilities,
will it have that much equity value
or will it have a shortfall?
And if it does have a shortfall, how much?
Okay?
So, we calculate these numbers.
It requires you to calculate
what's the downside
exposure of the equity.
Clearly, you know the
equity value of today,
so, you have to project an LRMES,
which is just a acronym for,
then the stock market corrects by 40%.
What is the correction say,
in Bank of America
stock or JP Morgan stock
that would be captured in the LRMES?
Now, we make two important assumptions,
which is what I'm going to adjust.
One is that we assume,
whatever you see
at the debt liabilities
today on the balance sheet,
they will be the debt
liabilities in future.
Why is this important in the context
of my presentation that
I just showed you so far?
It's because,
there are these undrawn credit lines
which are unstated,
not on balance sheet liabilities of banks.
Second, LRMES is calculated
using small shocks
of about one to 2% to extrapolate
what would happen in a 40% crash scenario.
But what I just showed you,
is that liquidity risk
gets episodically priced
by the stock market.
It's not there and suddenly
the risk premium ignites.
And so, I'm going to
show you how to correct
for this in the stress test that we do.
Now, this measure itself,
once the vulnerability
and the stock price correction
has already happened,
shows that the capital shortfall estimates
increased by about 600 billion
from January to March.
And it's very important to understand
why the estimate goes up.
Clearly, the oil sector exposure
and the deterioration
in its quality explains
a big chunk of it.
But I want to show you
that about 200 billion.
So, about one third of
this can be attributed
to liquidity risk.
So, what am I going to do?
I'm going to assume make two corrections.
The first correction, is to recognize
the debt at a future point of time
on a financial sector,
that forms balance
sheet it's today's debt,
plus some drawdown rate,
in a market correction scenario,
times the outstanding credit lines, okay?
And that's going to give
an incremental SRISK
because now you're going to need capital
once these drawdowns happen
and loans come on balance sheet,
you need capital against that as well.
And further, the episodic risk premium
in these large market correction states
is going to imply that the downside beta
or the LRMES of the bank stocks
is actually far greater
than what we might estimate or extrapolate
from local one to 2% market corrections.
So, there's going to
be an incremental SRISK
because of the erosion inequity
that's going to take place
because of let's call it,
some kind of a market risk premium,
which could also be a
leverage effect and impact.
So when I do these
calculations, what do I find?
Three big things.
One, the predicted drawdowns
as a function of market
correction for 40%,
would be on the order of 30 to 50%,
depending on which recession you look at.
That's number one.
Number two, if I do
bank-by-bank calculations,
therefore, of the
incremental capital shortfall
that they will face because of these
off balance sheet liabilities,
focus on say the fourth column,
which has the most extreme assumption
of a 50% drawdown
that from the top 10 banks,
we would have an additional
$60 billion capital requirement.
And point three, if you repeat this,
for the extra correction
due to the repricing,
again, I won't go to the mechanics
of the calculation,
but basically the various slopes
that I've estimated
the measure of the liquidity risk,
all of these imply that
for the top 10 banks,
then if you, again,
focus on the right most column,
that would be an additional $122 billion
of capital requirement.
Put it all together,
and this is going to be
my sort of last number.
In all, it says that ideally,
we should be asking banks right now,
all banks, if you take
about two,
slightly over $200 billion of capital.
Because this is due to credit lines
and liquidity risk, that
was not being priced,
that were not being drawn down upon,
they are being drawn down upon,
it is being priced in the market,
it's time to redo our
capital calculations.
So, first and foremost,
of course, regulators need
to preserve bank capital.
I think they should just require
a blanket suspension of any payouts,
not just share by banks,
but also dividends.
but that's not going to be enough,
they need to immediately ask banks
and systemically important
financial institutions
to raise capital.
Back of the envelope numbers suggest
it should be at least $200 billion.
It's not sufficient to nudge them,
they will not do it on their own.
It's going to be too late to do this,
if dependent make outcome is not pleasant.
Because then banks will
be even more reluctant
to do it on their own,
and the cost of equity capital will rise.
And any bank that individually goes out
to the market will essentially be,
it will be a kiss of death for them
because they would not want
to be the first one to raise equity.
Also, if regulators do
the stress test now,
and then say, banks need capital,
it's going to be a very adverse signal.
This is a point that
Professor Yakov Amihud
has been making quite a bit,
which is that no, ask them right now based
on common information
that we have that bank stock prices
have lost value, they are not correcting,
energy sector has lost value,
it's not correcting, loan prices
are not correcting
and credit lines are getting drawn down.
You have all the public signals,
do some simple back
of the envelope calculations.
If the capital we ask from banks
turns out to be too much,
it can always be returned
two or three quarters down the line.
It would be a very small cost
to pay right now in my view
for a very significant hedge
against financial fragility risk.
And I showed you this fine chart
of how banks liquidity
risk problems manifested
in stock prices from January 8th onwards.
We clearly don't want
to be in that scenario.
I think the regulators were too late
in asking for bank capital.
Then I think it's time to do it upfront
rather than later.
Let me stop there,
I think we may have to start thinking
about broader issues down the line.
Should we just worry about a pandemic?
Is a pandemic linked
to zoonotic diseases
increasing in their frequency
because of global warming?
If yes, what are the other kinds
of shocks we might see?
I think much food for thought
from the market data
that we see out there.
Let me stop here, Raghu
and take questions.
- Yeah.
So I'm gonna ask you a
broad question first,
it gonna come from me.
A lot of what you've been talking about
has to do with liquidity
in the banking sector,
but you're not only an academic,
you've also been a central banker.
Weighting both types,
we went into this
really low interest rate environment
12 years ago,
which has led to an incredible inflation
of asset prices
and we have seen no attempt at going back
to a normally tested regime.
And now we're back in a crisis mode,
back in providing
liquidity to the markets.
When the fed balance
sheet exceeded $2 trillion
a decade ago, everyone raised an eyebrow.
Now it's like 6 trillion climbing
and we've become almost
in year to What is going on?
What is your feeling about where we are,
in terms of central
banking in this context,
in this liquid decryption context
and where do you see
us coming out of this?
And most importantly,
what you see the implications
as being for long term growth.
- Yeah, no, that's a great question Raghu.
And of course we can spend
the entire afternoon today discussing it,
but I'll try my best
to sort of give it in short nuggets.
Three points.
One of course, I focused on the risk
of the financial sector
and the liquidity risk
being faced by companies
and being met through lines of credit.
What we have to recognize
is that while the
households were deleveraging
over the last decade as a whole,
the public sector balance sheets
were adding massive debts
even otherwise,
in most of the developed economies.
Now, we are beginning to reach levels
of public debt, where one
has to at least entertain the scenario
that the policy responses
in developed economies
may start facing difficult trade offs
that have been historically faced
only in emerging markets.
What I mean by this is,
will there be financial repression?
Then we have to force banks
and others in the financial sector
to keep funding government debts
so that debt sustainability
doesn't become a problem before growth
is on a firmer footing.
If you don't do that,
and the private sector growth
is catching up in parallel
you could see all kinds of cost
of capital effects bubbling
into product prices.
You might even face central banks
getting fiscally dominated
and having to monetize
the rollovers of government financing
and focusing on inflation.
As you know, Tom Sargent
in his famous work explained
that the Central Bank gets distracted
and has to focus on avoiding
a sovereign debt crisis
rather than focusing on inflation.
Now, of course, when you do that,
you still have to face the inflation costs
that are arising on the side.
So, first I want to say
that we have to seriously entertain
two, really bad scenarios in my opinion,
which are at opposite extremes.
One is a financial repression,
which would be low
productivity, low growth,
and likely deflationary
versus a very high risk scenario
in which you have
a sovereign debt sustainability problem,
but high inflation
and with likely attendant consequences
on the safe heaven status
of some of these countries.
So, two really horrible
scenarios in my opinion,
that we are to start attaching
significant problem (muffled speaking).
Second, coming back a little bit
to the discussion that I had,
I think a key question for me,
and I think my sort of thought
for the regulators is that it is time
to accept that the way monetary policy
is being practiced,
it is primarily working in transmission,
if at all, it is working
through leveraging.
So, first we used monetary policy
to lever up the households.
Then we used it to help
lever up the sovereigns
to get out of the global financial crisis.
Then when growth was been rebound,
in spite of the leveraging
of the sovereigns,
we enabled the corporate
leveraging in process.
Now, whether you like it or not,
if that is the mechanism
through which monetary policy works,
for sure, the vulnerability to shocks
in the system goes up.
And I think this point
is not being adequately recognized.
It's not good enough
that your banking system is stable,
because if the underlying
dislocation for leveraging,
which is extremely low rates
and promise for low rates
and promise to do whatever it takes
and promise to accommodate
any liquidity risk is out there,
leveraging will happen directly
on the corporate balance sheets,
it will happen through
shadow banking markets.
And I think this transmission
of monetary policy through leveraging,
through whoever can take leverage
in the system is I think something
that needs to be taken head on,
because it says that you need
a system wide perspective on leverage
rather than just
a banking sector perspective on leverage.
And I think we have seen it manifest.
I think the scale and the pace
of federal reserve actions
is both unprecedented.
And while I think I give
them a lot of credit
for going through an amber light
with a lot of decisiveness.
You don't want to drive to an amber light
and just rest in the middle of the box.
I think they've kind of driven
through it very quickly.
I give them credit for it,
but I think I'm sure when they reflect,
they're going to ask the question,
how did we end up providing liquidity,
including to hedge funds indirectly
through distress funds and so on?
And third question,
and I'm going to tie this again
to the financial sector,
even banking sector stability
is that entertain a scenario
in which growth picks
up, inflation picks up
and the federal reserve has to raise rates
in an environment when public debts
have gone up very significantly.
The classic trade off
that emerging market
central banks are faced
is if I raise rates,
bond prices will correct.
And there will be collateral damage
on the balance sheet
of the financial sector
when I do that.
Now, this is a concern,
and in my view,
while I did not present this as the reason
why I'm asking that the banking sector
be capitalized,
there's gonna be all sorts
of collateral benefits
of having a more stable banking sector.
If we ask banks to be capitalized,
I think the Federal Reserve
and other central banks
will exonerate themselves
from having to keep rates low,
even when inflation
is actually picking up in the economy.
Because otherwise,
there's gonna be this bloodbath,
which is that everyone
who is loaded up on government bonds
at the first sign of a reversal
in the interest rates,
and when they see that low for long
is no longer the norm,
there's going to be a massive correction
that gonna happen in the market values
of all these financial players.
So, I would say first and foremost,
financial stability of the banking sector.
Second, take a systemic view.
And third, I think it's
time to draw a line
and recognize that at some point,
many of these policies
directly or indirectly
are helping fuel the
public sector, bond public.
When that crashes,
it's not going to be very pleasant
because there are two forks
in the road as I said,
repression or hyperinflation,
and neither is going to look very good.
Maybe hyperinflation is too strong a term.
I just mean to say that it may be higher
than the target levels of inflation
we are comfortable with
investment economies.
- Okay, so there are two questions
that are related.
So I'm going to ask both of them together.
One is a question from Dick Berner.
So, Dick says he loves the analysis,
but why raise capital in the crisis?
Should we not have asked
for higher capital requirements,
ex ante based on your analysis
of contingent claims
and liquidity attractions?
- Absolutely.
- Let me ask the second question.
- Yes.
- The second comes from Rob Engel,
who says, this is essentially
an insurance product.
Insurance companies take something
like expected losses as a liability.
Should this be reported for banks too?
- Absolutely.
Thank you, Dick and Rob
for these questions.
I think a part of reason
for doing these exercises
is that going ahead,
we can actually construct these numbers
and in fact, add them to the exam,
the capital shortfall
that the banks would have.
Nevertheless, I would
say it's never too late
to raise capital in my view.
I think to paraphrase,
Mervyn King used to say that,
the best early warning signal
you have of a crisis
is that you are in the middle of one.
Because it's very hard to predict
when a shock will hit.
In fact, that's the
spirit of a SRISK work,
which is that we don't want to say
what's going to cause a
40% market correction.
It will happen at some point.
And the question is,
are we positioned well?
So, I would say let bygones be bygones.
We didn't ask for extra capital,
but I think it is better
to ask for capital now
than say, in a scenario that looks
like the Q3 of 2008,
which at least right now,
we can't rule out based
on the real economic
outcomes that we are seeing,
even though the stock market seems to be,
seems to have recovered quite well.
I fully agree with Rob,
that greater transparency
on these lines of credit would help.
In fact, there is transparency.
These data are out there
in the Thomson Reuters
deal, scan database.
They are relatively
larger syndicated lines.
The smaller credit lines,
which accumulate to a large number
are also available with
the regulatory system.
And of course in the fall reports,
annually banks do report
their complete exposure,
they could ask them for greater frequency,
they could ask them for the specific fees
that they are charging on these products
and all of this could
be used to good effect
in our stress test calculations.
- Okay, excellent.
Now two questions on
methodology and outcome,
this is from Allen who,
that related questions again,
one is how does your measurement
of bank capital compared
to the friend's measurement
and related to that,
is why are you using
market capitalization,
which is obviously much more volatile
than it would get?
- These are both great questions, Allen
and they really get at the heart
of the SRISK calculation.
First, let me give the practical answer,
pragmatic answer,
which is that,
we don't have the
balance sheet granularity
of bank exposures that a regulator does.
So, to conduct a regulatory stress test,
unfortunately you have
to be the regulator.
It's not possible to do
that level of mapping
from macro scenarios into asset class,
by asset class losses.
In contrast, market data is available.
Markets are pricing and repricing risks
on a daily basis.
By and large markets
do collect intelligence
on where the exposures are.
And part of what I'm trying to show you
is that markets make sense.
I think this was Aswath Domodaran's point
even last week,
which is that markets seem to price risks
in a relative sense quite well.
I think market risks have
this episodic feature.
The risk premia do tend to be very small,
they tend to be procyclical,
but in the cross section,
they do seem to price stocks correctly
based on liquidity risk
or oil exposure risk.
So that's one point.
Now, second, a more real, a more,
a deeper answer rather than the pragmatism
of using market value,
is that in a crisis, what matters is,
in my opinion, not regulatory capital.
Is whether you can go to the markets
and raise financing or not.
In fact, if you look at 2008,
virtually no bank that failed
was filling regulatory
capital requirements.
They all met regulatory capital standards.
And yet we had a full
fledged banking crisis
on our hand,
in the global financial sector, okay?
Now why is that?
It's because no matter
what the regulator's marks are,
the markets are saying,
I don't think the market value of the book
is the same as what the regulatory value
of the bookmarks is.
Now, this may be risk premium related.
It may be because book values
don't recognize losses
until they materialize,
but as market values
anticipate these losses.
Whatever the reason be,
I think it's a material,
if a bank cannot go out in the market
and borrow to meet
its liquidity needs, it's toast.
It will have to go to the regulator
to borrow in the lender
of last resort facilities.
And there are limits.
There up to the amount of collateral.
So, once the confidence in the market
is lost on a banking system,
it's just too late.
You can't say at this point,
my banks are well capitalized
on regulatory capital standards.
How does it matter
that the equity is going to zero?
It really doesn't quite cut it.
In fact European regulators tried this,
in the first early stress test
of 2011 and '12,
where some of the banks
that had the risky European
sovereign exposures
were penalized the most in the markets,
but they were the best capitalized
by regulatory capital standards
because the regulatory risk rate
on sovereign bonds is zero.
So, I think we cannot
ignore market values.
In fact, I would say,
a good regulatory capital requirement
would be one that is a little bit ahead
of the market.
It's always actually requiring banks
to be well capitalized
compared to the scale of erosion
that is actually happening
in the market value of
bank balance sheets.
- So there's a question,
another question, Allen has posted,
hit almost directly of your last line.
Your line about staying
ahead of the market.
So, this question says,
your measurement of bankrupting needs
might increase capital to such an extent
that it reduces bank ROEs
to the point that investors refuse
to put up capital for the sector.
- I think this is the standard argument
that has been made.
Not that when banks raise equity,
they will be asked to repay
some of their wholesale finance
as a result of this.
So, the reason why ROE comes down,
is because the leverage
of the bank will come down.
It's not because actually
inherently the returns
to the underlying franchise
of the bank is coming down.
What we should be
focused on for the system
as a whole, is the return
on assets of the bank.
We don't have to be bothered
on what the returns specific
to the shareholders are.
Think about the financial crisis,
be focused too much on ROE of banks,
and didn't ask them to raise capital
in good time,
and it is the effective creditors
of the banking system,
the taxpayers like you
and me and everyone else
in this forum, who
basically ended up paying
for the bank bailout.
So, I think we have to focus
on the return on assets of the bank.
We have to factor in the
cost of the taxpayer,
put ROE of the bank, goes
up and down primarily
because of the leverage of the bank,
because risks have gone up,
it's time to bring the
leverage of the bank down.
That has to be the focus
of the public policy,
not what return the
shareholders are earning
from making investments
or not making investment.
- So, Minakkum has asked the question
that I was also thinking of,
as you were presenting your analysis
is almost completely on the U.S.
To what extent does your analysis extend
to Europe, to Asia or other countries?
And also there's a clarifying question
that Larry has asked.
What are you defining as
banks in your analysis?
Are Goldman and Morgan Stanley consult
banks in your analysis?
- Yes, so let me start
with the last question, Larry.
Goldman and Morgan are now banks
in the sense
that they are bank holding companies.
So, they would be included.
They don't do as much
traditional banking yet.
Of course they are always trying
to get into more traditional
banking activities
as we speak.
But they will not show
up as large in contrast,
JP Morgan, bank of America,
Citigroup, and Wells.
These are the four banks
which have the largest extensions
of lines of credit
and you will see that their corrections
have also been the largest,
both in terms of actual drawdowns
as well as in terms of
the market corrections
over this period.
Coming to Minakkum's point the behavior
on corporate credit lines
is somewhat different
between U.S and Europe,
Mike Walters, Sascha
Steffen, and our colleague,
Tony Saunders has documented this.
There seem to be a somewhat more
of a slow withdrawal
of credit lines in Europe compared to U.S
where the drawdowns are very massive.
I think this has something
to do with the fact
that U.S companies are quite reliant
on shadow banks.
They're quite reliant on bond markets,
and so when a shock such
as the global financial
crisis or COVID hits
and the shadow banking markets come
to a screeching halt,
they immediately have to revert
back to bank finance.
And the way they do it
is through drawdowns
of credit lines.
In Europe, by contrast,
they don't have access
to as deep bond markets.
So, they are already
heavily reliant on banks
to start with,
and then the drawdowns
on the bank credit lines
are actually not as heavy.
So, one perspective that could be taken
on this is that, the
growth of the shadow banks
in the U.S, which basically feed off
the very low risk premium
in the expansionary phase of the economy
and the federal reserves rates cycle,
actually create a sort of a fragility
in the financing of the corporations.
The banking sector through
credit lines provides
a backstop to this fragility.
But of course it does so in a way
that erodes its stability in the process,
and then the question becomes,
are they holding enough capital
to bear this shock and
continue intermediation
in a good way when the shock materializes?
And I think that was the
spirit of the stress.
I think, let me stress.
My biggest concern with lack of capital
on the bank balance sheets
is that the large companies
will have liquidity insurance
through the banking system.
They are not the ones who are going
to be stalled off credit.
It's going to be the
household cost of credit,
the cost of credit for small businesses
and the cost of credit
for unrelated firms,
which is going to rise significantly
if banks become undercapitalized.
And I think that loss of intermediation
will be felt far more in the end,
in the real outcome,
such as jobs, consumption and so on.
- Thanks so but I think
we are out of time,
but if you'd like to
take one last question,
this is back to Dick Berner.
He says your point
about systemic leverage is critical
and asks essentially,
what do you suggest the authorities
like FSOC and FBC should do now?
- I have a simple rule
that I've been recommending
though I've never actually,
I think formally written up anywhere.
Which is that,
if the safety net
is extended directly
to a class of players,
such as money market funds, hedge funds,
distressed investors, bond investors.
From the next day onward,
the federal reserve,
if it extends lender of last resort,
it should have the right to regulate
the capital structure.
If they can't regulate
the capital structure,
they should not provide liquidity
to that part of the system.
To me, the carrot and the stick,
and I'm suggesting something even simpler.
There could be a case made
that the provision
of the safety net should
be taken as given,
and therefore we should regulate
the capital structure ahead of time.
I'm asking something simpler.
I'm saying exposed,
if you extend a lender of last resort
to a new class of shadow banking players
from that day onwards,
you must have the rights to regulate
their capital structure.
Otherwise, we are just socializing risks
and privatizing the profits.
And that can't,
it just can't be
that you can get right pricing of risk.
I think this may be goes
back to Ed's question.
Why is there so much fraud
in the expansionary phase?
Maybe because the implicit safety net
is never being attached
With a stick towards the end,
we are never asking the shadow banks
to really regulate the capital structures
in a macro prevention systemic fashion.
- Thank you Raghu,
thank you for.
- Thank you very much
and thank you very much everybody.
- Yeah, thanks a lot, Raghu.
It's always great to catch up with you,
even if I'm zoom,
I miss our lunches,
but I also missing seeing
all our other colleagues and students
and I hope all of you stay safe
during the rest of the summer.
Thank you.
- We will be back in the building shortly.
- Yes, looking forward
to that (laughs) +3
- Hopefully (laughs) yes.
Always optimistic.
Bye everyone.
- Thank you.
Thank you admin team
for the tech support as always.
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