Equity versus fixed income: the predictive power of bank surveys

September 9, 2023

Jupyter Notebook

Bank lending surveys help predict the relative performance of equity and duration positions. Signals of strengthening credit demand and easing lending conditions favor a stronger economy and expanding leverage, benefiting equity positions. Signs of deteriorating credit demand and tightening credit supply bode for a weaker economy and more accommodative monetary policy, benefiting long-duration positions. Empirical evidence for developed markets strongly supports these propositions. Since 2000, bank survey scores have been a significant predictor of equity versus duration returns. They helped create uncorrelated returns in both asset classes, as well as for a relative asset class book.

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Modern financial system risk for macro trading

June 27, 2020

Financial system risk is the main constraint and disruptor of macro trading strategies. There are four key areas of modern systemic risk. [1] In the regulated banking sector vulnerability arises from high leverage and dependence on funding conditions. The regulatory reform of the 2010s has boosted capital ratios and liquidity safeguards. However, it has also induced new hazards, such as accumulation of sovereign risk, incentives for regulatory arbitrage, and risk concentration on central clearing counterparties. [2] Shadow banking summarizes financial intermediation outside the reach of standard regulation. It channels cash pools to the funding of asset holdings. Vulnerability arises from dependence on the market value of collateral and the absence of bank backstops. [3] Institutional asset management has grown rapidly in past decades and is now comparable in size to regulated banking. Asset managers play a vital role in global funding conditions but are prone to aggravating self-reinforcing market momentum. [4] Finally, emerging market financial systems have grown in size and complexity. China constitutes a global systemic risk factor due to the aggressive use of financial repression to sustain high levels of leverage and investment.

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Modern financial system leverage

March 24, 2018

Leverage in modern financial systems arises from bank balance sheets and off-balance sheet transactions that involve banks and other financial institution. Non-bank funding of banks and credit is large, rising, and not fully captured in official statistics. Collateralized transactions and wealth management products are important underappreciated parts of system leverage. The classic narrow focus on bank credit-to-GDP ratios does not only underestimate leverage in size, but also overestimates the stability of sources of funding.

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Volcker Rule and liquidity risk

January 7, 2017

The Volcker Rule has banned proprietary trading of banks with access to official backstops. Also, market making has become more onerous as restrictions and ambiguities of the rule make it harder for dealers to manage inventory and to absorb large volumes of client orders in times of distress. This increases liquidity risk, particularly in market segments with longer turnover periods, such as corporate bonds. A new empirical paper confirms that the Volcker Rule has indeed reduced corporate bond liquidity and aggravated the price impact of distress events, such as significant rating downgrades.

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Rules of thumb for banking and currency crisis risk

June 27, 2015

A new ECB paper explores macroeconomic indicators for banking and currency crises over the past 40 years. Banking crises arose mostly in constellations of [i] low credit-deposit spreads and high short-term rates (over 11%) or [iii] high credit-deposit spreads (over 270 bps) and flat or inverted yield curves. Housing price growth has also been a warning signal. Currency crises ensued from exchange rate overvaluation (more 2.7% above trend) and high short-term interest rates (over 10%).

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The impact of non-conventional monetary policy on banks

August 24, 2014

Non-conventional monetary policy seems to benefit banks’ balance sheets. After all, it offers cheap refinancing and credit market support. However, an empirical analysis by Lambert and Ueda casts doubt on that belief. Market measures of bank credit risk have mostly deteriorated in episodes of policy stimulus. Easy monetary policy has been encouraging risk-weighted asset accumulation and discouraging balance sheet repair.

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The “net stable funding ratio”: a basic briefing

June 22, 2014

The “net stable funding ratio” is a quantitative liquidity standard for regulated banks, scheduled to go into effect in 2018. It will require stable funding sources to be equal or exceed illiquid assets. It may to some degree restrict term transformation of regulated banks and encourage migration into shadow banking. The impact of the new regulation will differ across countries and institutions.

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The unintended consequences of leverage ratio requirements for banks

June 8, 2014

The Basel III capital regulation reforms introduced a non-risk based leverage ratio for banks. A new ECB paper shows that a leverage ratio requirement may have unintended negative consequences. It encourages banks that specialize on low-risk lending to raise their share of high-risk loans. And it could make overall bank portfolios more similar, increasing the contamination risk from negative surprises to expected default risks.

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The vulnerability of modern dealer bank financing

March 28, 2014

Modern dealer bank financing relies largely on collateralized transactions. In order to achieve collateral efficiency institutions engage in rehypothecation, for example through matched-book transactions, internalizing trading activities, and re-pledging of margin collateral. A New York Fed article suggests that this funding structure faces risks from rollover, credit rating downgrades, and reputational considerations.

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How banks have adjusted to higher capital requirements

March 23, 2014

Capital regulation reform requires banks to hold a much higher ratio of core capital to risk-weighted assets, taking some toll on lending and economic activity. An empirical analysis by the BIS suggests that the process is well under way. Mathematically, most of the adjustment has been achieved through retained earnings. However, in developed countries also lending spreads have increased, credit growth growth has slowed, trading assets have declined, and the share of higher risk-weighted assets has fallen.

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