Beware, There's Another SLF 'Cliff' Coming At the End of Q1
AP Photo/Charles Krupa, File
Beware, There's Another SLF 'Cliff' Coming At the End of Q1
AP Photo/Charles Krupa, File
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You might not know it, but there’s another SLF “cliff” upcoming at the end of this year’s first quarter. This Supplementary Leverage Ratio seeks to impose liquidity and capital charges on especially the largest banks because institutions like Bear Stearns and Lehman Brothers had figured out how to manipulate the SLF’s predecessor capital ratios. Disguising otherwise risky assets as “safe”, using perfectly legal means, including instruments like credit default swaps, global banks everywhere managed to make the most efficient use of balance sheet space.

Because they wanted to.

In the pre-crisis era, they had come to see this as uncontroversial in one sense because of how the Basel Rules had been sold to the public. It was this latter framework of bank regulation which had brought the capital ratio into the mainstream; a standardized mathematical calculation that was meant to quickly expose the full nature of any large bank’s activities.

The safer the assets, the lower the applied “risk weighting” the net result being a higher capital ratio rewarding the bank for appearing itself uncontroversial or risky. The issue had been in how the rules allowed for creating “safe” assets out of those otherwise often of extreme risk – employing, mostly, securitization strategies.

Thus, in broad terms, banks around the world came to create and acquire lots of otherwise risky assets engineered into assigned lower, safe risk weights that compelled higher capital ratios than might have otherwise been truly deserved. This was a hidden form of leverage, and one that credit default swaps in particular were expertly crafted (regulatory capital relief) to achieve.

These Basel Rules had been intended to warn against this kind of behavior. With a flourishing eurodollar market, there arose an ad hoc systemic framework behind it; interbank settlement networks like SWIFT and CHIPS being a central mainline set of arrangements to govern how it was all meant to come together on the most granular transaction level.

Moving “dollars” all over the world, however, creates all sorts of potential risks (as discussed last week). How might disputes be reasonably, efficiently settled? It was one thing for members of the New York Clearinghouse Association (the trade group responsible for CHIPS) to sign on to the messaging and payments rules. What happens if some government on the other side of the ocean claims jurisdiction?

Theoretically in the early days (CHIPS was set up in 1970), on an otherwise uninteresting morning in June 1974 it happened. On the 26th, a midsized German bank hardly anyone had ever heard of, Bankhaus Herstatt, had been closed by regulators in that country. What made the episode historically remarkable was this one tiny firm’s firm connection to this burgeoning global monetary regime.

Herstatt had been very active in London trading, eurodollars. Not simply taking in eurodollar deposits and arbitraging the spread between offshore and New York dollar markets, this mid-market German firm had become a relatively significant player in derivatives transactions, mostly currency forwards, in dollars.

And these had come to the attention of authorities in England as well as Germany as far back as 1971. In the fall of 1973, Richard Hallett from the Bank of England, according to archival sources, had made direct contact with Iwan Herstatt, the bank’s founder, about what seemed to have become “excessive” positions in the eurodollar market.

Herstatt instead reassured Hallett, claiming various legitimate reasons for such large essentially shortdollar positioning.

“…[we] had very important Ruhr customers who had entered into large forward contracts with the Bank, which the Bank, in turn, had covered in the market. Consequently, their forward book, though large did not leave them with exposed positions.”

Whether this was ever true is still a matter of some debate (given the losses eventually booked, it likely wasn't). Regardless, by promising to pay dollars to these Ruhr customers tomorrow the bank didn’t possess today had left Herstatt open to risks of foreign exchange; not just a rising dollar in the sense of newly floating currency exchange values, but also the less recognizable rising dollar “stuff” which includes a much more expensive borrowing environment (especially controlling forward liabilities).

This gave rise to a ballooning foreign currency liability, as regulators in Germany noted early in June 1974 just weeks ahead of the firm’s final chapter.

“Checking through the monthly data of Bankhaus Herstatt, it is striking that the receivables due daily to foreign banks have raised in April of this year by 283 [million DM] to reach 589 and in May this year by a further 257 to reach 846; so that they reach a good third of the bank's balance sheet of 2421.”

In order to participate in the eurodollar market, Herstatt had opened a correspondent relationship with Chase Manhattan Bank in New York City, not London. This was not a trivial difference, as it turned out, though it always had been in terms of how the market seemed to operate seamlessly.

On the morning of June 26, that fateful day, regulators in Germany were late in gathering to make their final determination. Intending to begin earlier in the morning, local time, a flight delay along with heavy traffic instead had meant authorities wouldn’t come to that decision until 2:40 pm local time. Closing Herstatt down would become effective at the close of German trading, 4:30 pm local, which, however, was 10:30 am in the middle of a very much open New York session.

The German government hadn’t given any thought about time zones nor the peculiar quirks (for 1974) of global eurodollar banking and cross-border liabilities that arises from it. Herstatt’s correspondent, Chase, learned immediately of the closure while in the middle of still processing payment requests, on Herstatt’s behalf, through the CHIPS system.

No small issue, Chase quickly figured out that it was sitting on around $620 million in payment requests to be made on behalf of Herstatt – for which, given its closure, Herstatt wasn’t going to be reimbursing back to Chase.

Swiftly taking action, Chase froze the outgoing requests from Herstatt’s account while still accepting incoming payments for it (as a liquidity protection against possible losses). For the first time, international banks became aware of another kind of intraday credit risk due to differences in time (had Herstatt been closed by regulators before New York opened, there wouldn’t have been any imbalance to Chase as correspondent; because the decision was delayed, Chase had already begun the day processing payments on behalf of a bank in Germany that was in the process of being shut down).

Quite naturally, the New York Clearinghouse Association protested. Within a week of Herstatt’s closing, the settling members had introduced a recall provision into CHIPS that would allow them to claw back funds from foreign respondents up to 10 am New York time the following day; thus, undercutting a key fundamental function of these real time gross settlement (RTGS) interbank systems.

If clearing agents could “recall” payments already presumably cleared the day before, were they ever really cleared and settled at all? No.

It was a question that in the short run interbank counterparties sought to avoid answering. Over three consecutive days in early July 1974, CHIPS nearly ground to a halt; final settlement deadlines had to be extended to 1 am (ET) on each of them.

Consequently, the system had reached an important systemic crossroads. With CHIPS failing to provide timely processing, the eurodollar market became nearly non-negotiable; borrowing rates skyrocketed, and often funds were unavailable even at quoted prices.

Understanding just how important all this was, the NYCHA along with settling and nonsettling members got together to work out the kinks. Difficult as it may have been, there was too much business to be done. Better to have to worry about even serious structural problems than to stop everything over mere trivia.

From the outside, concerned central bankers and bank regulators, who at the time understood the crucial nature of eurodollar business as it performed the roles of global reserve currency, they informed the politicians they were going to get involved, too. On September 10, 1974, the Group of 10 central banks issued a statement which promised:

“To intensify the exchange of information between central banks on the activities of banks operating in the international market and, where appropriate, to tighten further the regulations governing foreign exchange positions.”

At their December 1974 monthly meeting, the G-10 central bankers created an informal committee chaired by George Blunden, head of supervision for the Bank of England, which began meeting in Basel, Switzerland, and whose “main objective was to help ensure bank solvency and liquidity” of this new (to authorities) international banking framework. In order to accomplish this, in the wake of Herstatt, they had “to give particular attention to the need for an early warning system.”

How to do so? Gossip.

There was simply no way for regulators in one country – preserving national regulatory regimes was declared a priority – to figure out what a foreign subsidiary of a local bank might be doing in another (in addition to Herstatt, 1974 featured a couple other cases, including the Israeli British Bank, which exposed these and other serious potential deficiencies in a global banking environment). The easy way, perhaps the only realistic way, was for regulators to try to coax information, even in the form of informal rumors, out of overseas traders in order to refine a list of who might need further local regulatory attention.

Blunden himself saw few other options:

“[T]he only possible and useful kind of international early warning system would result from the establishment of contacts…for the purpose of confidential exchanges of relevant information picked up by their own national warning systems.”

This wasn’t a popular proposal. Another of the G-10 committee members, Pierre Fanet, from France’s Commission de Contrôle des Banques, admitted, “it was hard for him to imagine that information based simply on rumors, or even on accusations, could be transmitted to the supervisory authorities of other countries.”

By the eighties, this Basel committee realized trader gossip just wasn’t going to provide the basis for an early warning system, therefore it turned toward more “objective” descriptions that could be derived from legitimate and immediate (they hoped) data sources; particularly as these could be employed for these increasingly global, increasingly huge, wholesale banks.

Capital ratios and things like that.

Both Lehman Brothers and Bear Stearns sported sterling capital ratios all the way through to their ends, though. These hadn’t been the early warning system once envisioned, though regulators had long taken their aim away from that very idea given the complacency arising from the Great “Moderation” wrongly attributed to national central bank proficiencies despite an even more intricately connected, and incomprehensibly massive, eurodollar environment.

Forget early warning, everyone came to really believe the Fed would just bail everything out if it ever went that far.

It did end up going that far and then much farther, and though it tried repeatedly the Fed couldn’t bail out any let alone all parts of the system. The central bank was left, instead, to nursemaid individual institutions reaching their final moments.

In the mainstream post-crisis opinion, capital ratios were singled out as partly but substantially to blame (for good reason). If banks had learned how to repackage their balance sheet items in order to circumvent these “early warnings”, then simply don’t give them the chance.

Thus had been born, into the post-crisis era of shock over what banks had been doing for decades, the Supplementary Leverage Ratio which no longer weights assets by presumed lower risk buckets (while also “better” accounting for off-balance sheet leverage, including more stringent derivatives inclusions).

The intent was still primarily the same – to create a standardized measure looking for trouble in global banks before those global banks could become trouble. And yet, that’s what continues to this day.

Back last May, with a mountain of Treasury debt to sell, and trillions in bank reserves (a peculiar form of bank deposit held at the Federal Reserve) about to be created by QE, bank regulators and central bankers at the Fed having already mistaken what had happened in the Treasury market during March decided that the SLR needed to be temporarily abated, permitting large banks (more than $250 billion in assets) to, “choose to exclude U.S. Treasury securities and deposits at Federal Reserve Banks from the calculation of the supplementary leverage ratio.”

Therefore, dealer banks would be SLR-free to buy up all the Treasuries they might want and participate in as much QE as they wished without the resulting increases in balance sheets running afoul of the Basel calculations.

This abatement, however, is scheduled to end on March 31, 2021. Come April Fool’s, US Treasury assets will be added back to the ratio as will any balance of bank reserves. Both have swelled greatly over the nine months in between, and the latter, in particular is about to rise even more as the federal government’s TGA balance is drawn down (resulting in, essentially, a transfer of about $1 trillion from the TGA into the bank reserves of commercial banks).

Banks have complained to the Fed, FDIC, and OCC, the agencies in charge of enforcing regulations, but there is no indication the government’s triplets are about to extend the SLR “holiday.”

To some, this could be a big problem (and an offshoot explanation was put forward for the September 2019 repo “issue”). Without spare balance sheet capacity, or at least more expensive balance sheet capacity, what might happen to dealer ability to intermediate in a range of global markets?

Rather than think of it this way, the better question is why do banks today care at all? There used to be a time when balance sheet expansion was prioritized regardless of regulation or even potential technical risks and hardships. For regulators in the seventies, they hit upon gossip for good reason; to best discern behavioral conditions that you just can’t package in a static number.  

Arithmetically derived fractions may sound objective and scientific, but since when has money ever been robotic?

Regulators are, once again, missing the point.

Whereas capital ratios had failed to act as the early warning system for eurodollar banks who had for decades onboarded and manipulated too much risk, becoming too large, their SLR replacement is inadvertently acting as an early warning system for these same, since-shriveled eurodollar banks who seek only to avoid risk and elevated balance sheet costs.

Balance sheet space used to run cheap and easy, and the whole system worked based on that, it is now hugely prized and is treated way too precious – and that alone accounts for this tendency for markets to behave intermittently like they once had in the early summer of 1974. And that includes September 2019 and March 2020. Money dealers didn’t need the SLR to just disappear.

Unsure and uncertain, these spaces can get un-liquid real fast. That the SLR is even an issue is an indication of such structural uncertainty that continues to this day, a legacy of 2008 that, as a transformative event, couldn’t have been the one-off crisis the way it has always been described.

Blunden had it right at the beginning, or had at the very least come closer to the point. A gossip system, while sounding ridiculous, would have exposed the truth underlying, the dynamic behavioral condition of banks operating in the system far more than these mathematical constructs that barely say anything about “what” let alone a single thing about “why.” 

Forget the SLR “cliff”, why are dealers so reluctant to take on that plus any other liquidity risks in order to renew the desire to do more and better like they used to so easily and readily? Instead, at times like these the closest thing to useful gossip we have is…Treasury bills. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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