Although U.S. financial and household sectors have deleveraged following the 2008 crisis, overall global leverage has actually increased. One surprise has been the rise in Latin American issuance of international corporate debt. Latin America’s share of global issuance has been surprisingly high, and all this increased leverage comes with greater risk. An important question, then, is whether LatAm companies are properly mitigated or prepared for these risks?
The growth in LatAm international corporate debt (issued in foreign currency, or FX) is a result of greater financial integration, low interest rates, and low term premia. Financial integration has meant greater access to international capital markets. Being able to borrow in FX, particularly the dollar, has enabled LatAm corporations to take advantage of low rates and thereby make more long-term investments such as capital expenditures.
At the same time, this increased exposure to the dollar, which is experiencing an extended period of strength, raises the cost of dollar-denominated liabilities relative to assets. It also increases interest rate risk: Should U.S. monetary policy tighten, borrowing costs would climb. Further, it could damage companies’ creditworthiness. These risks could spill over into the domestic banks that house LatAm corporate deposits, the global banks and asset managers that have invested in LatAm corporate debt, and the real economy.
Governments have reserves for dealing with these situations, but how do companies prepare? Corporations mitigate these risks in a couple of ways: they can ensure that their FX liabilities are naturally hedged by matching their FX asset returns and revenue, or they can use financial derivatives to hedge FX exposure. Since exact firm-level hedging data are not available, issuer-sector exposure and volume of derivative transactions can serve as proxy indicators.
As it turns out, the largest issuers are companies in financially integrated commodity producing nations[1] such as Brazil, Chile, Colombia, Mexico, Peru, and Uruguay. Their private sectors issue the most debt and have the greatest foreign liabilities. They also have a higher proportion of commodities and energy exporters. Such firms are more accustomed to dealing with FX risk and are therefore more likely to have partially matched their FX assets and liabilities.
Furthermore, the volume of FX and interest rate derivatives transactions has increased in Latin America. Among Brazil, Chile, Colombia, Mexico, and Peru,[2] transactional turnover rose between 2007 and 2013, from $28 billion to $67 billion for OTC FX derivatives and from $3 billion to $6 billion for OTC interest rate derivatives.
Overseas borrowing and leverage pose risk to financial stability all over the world. However, there are indications that indebted LatAm corporates, especially those in the sectors and countries that are most vulnerable, are a little less vulnerable than they might appear.
Thursday, December 25, 2014
Wednesday, December 17, 2014
How Yu'e Bao Arbitrages Financial Repression
In China, the government’s policy of capping deposit interest rates has set off a competition for the savings of the nation’s growing consumer base, spurring product innovation that takes advantage of regulatory conditions. Tech companies, well-positioned because of their strong presence in payments, e-commerce, and social networks, have entered the fray with online money market funds (MMFs). Leading the charge is Yu’e Bao, the fund created by ecommerce giant Alibaba’s payments arm, Alipay. As funds like Yu’e Bao navigate a new field, they are certain to face mounting business, liquidity, and regulatory risk.
The government’s policy has traditionally been to set deposit yields instead of letting the market decide them to lock in the profits of state-owned banks and lower their funding costs. As a result of such financial repression and the added burden of inflation, savers often have to accept negative real returns on deposits, incentivizing them to seek other vehicles offering higher returns.
Consequently, many investors eschew bank deposits and even equity markets in favor of bank wealth management products (WMPs) and now online funds such as Yu’e Bao. WMPs are offered by banks, which pool the cash and deploy it into stocks and debt to generate higher yields than conventional deposits. Huaxia Bank introduced the first WMP in 2004, but the real prelude to this showdown occurred in June 2013, when Alibaba launched Yu’e Bao. The competition escalated this year, when Alibaba, Tencent, and eight other companies acquired licenses to jointly establish and operate five private banks (separate from the online MMFs).
China wants to gradually liberalize deposit rates and make them more competitive, but Yu’e Bao and other online MMFs have taken the initiative in providing higher returns. They have done so by letting savers put their money in funds that invest in the interbank market, where rates are driven by market forces—a form of regulatory arbitrage.
At this juncture, Yu’e bao has amassed upward of RMB ¥535 billion ($87 billion) since it launched last June. Though that represents only 0.5 percent of the RMB ¥113 trillion in total deposits, China’s increasingly diversified tech giants,[1] along with six other companies, have also launched online MMFs. This has in turn has triggered banks to counter with their own online funds, provoking a broad grassroots liberalization of interest rates.
As competitors and regulators have adjusted, challenges have emerged to tech MMFs’ business models and the liquidity of their holdings. This year, China’s central bank (the PBOC) eased credit conditions, slashing the interbank interest rates and consequently the returns that had made Yu’e Bao so attractive relative to bank deposits. To maintain its competitive yields, Yu’e Bao has allocated more assets to repurchase agreements and products with longer maturities, resulting in a maturity mismatch on its balance sheet.
This mismatch risk and the ability of Yu’e Bao investors to make withdrawals on the day of the request (in banking terms, a T+0 settlement basis) pose a serious problem: If a large number were to quickly withdraw their money, Yu’e Bao would face a classic bank run situation. It would be forced to sell assets at fire-sale prices to generate liquidity and cash. Losses would likely mount.
Chart 1: Yu'e Bao Returns vs. China Benchmark Deposit Rate, percent
Chart 2: Yu'e Bao Assets by Duration, percent
Like other regulatory arbitrageurs that are not disruptors in the strictest sense, Yu’e Bao and other online funds may face mounting regulation in addition to those risks as officials concerned about financial stability rein in their growth to a more temperate pace. As they act, regulators will have to juggle concerns that include continued rate reform, opposition from the banking industry, and the risk of stifling innovation in the tech sector.
So far, the PBOC seems to have taken the lead in regulating these MMFs, just as it has with WMPs and the broader shadow banking sector. Other agencies are also involved. For example, the PBOC oversees Alipay, which owns Yu’e Bao; securities regulator CSRC supervises Tianhong Asset Management, which manages Yu’e Bao’s assets; and the banking regulator, CBRC, is concerned with the banks in which those assets are invested.
Potential PBOC moves include requiring online MMFs to hold minimum reserves on their deposits. The PBOC is also considering placing limits on online consumer spending, which would affect how much cash flows into online funds. The central bank has already temporarily halted the use of virtual credit cards and QR codes for online shopping. While this does not directly affect online funds, it signals a desire to manage the pace of growth in such platforms.
To discern regulators’ general disposition toward online MMFs, one could also look to their stance on WMPs, which play a similar role in China’s markets. Regulators view WMPs as useful vehicles for advancing rate liberalization, providing savers with competitive returns, and preparing banks for change—but also as an experiment to be watched closely.
China has further to go in reforming its capital markets, and the path it takes could shape the future of online finance. Regulators are allowing the field to expand and pushing commercial banks to change as well, but they are likely to clamp down if risks to financial stability arise.
How policy led to arbitrage and innovation
The government’s policy has traditionally been to set deposit yields instead of letting the market decide them to lock in the profits of state-owned banks and lower their funding costs. As a result of such financial repression and the added burden of inflation, savers often have to accept negative real returns on deposits, incentivizing them to seek other vehicles offering higher returns.
Consequently, many investors eschew bank deposits and even equity markets in favor of bank wealth management products (WMPs) and now online funds such as Yu’e Bao. WMPs are offered by banks, which pool the cash and deploy it into stocks and debt to generate higher yields than conventional deposits. Huaxia Bank introduced the first WMP in 2004, but the real prelude to this showdown occurred in June 2013, when Alibaba launched Yu’e Bao. The competition escalated this year, when Alibaba, Tencent, and eight other companies acquired licenses to jointly establish and operate five private banks (separate from the online MMFs).
China wants to gradually liberalize deposit rates and make them more competitive, but Yu’e Bao and other online MMFs have taken the initiative in providing higher returns. They have done so by letting savers put their money in funds that invest in the interbank market, where rates are driven by market forces—a form of regulatory arbitrage.
At this juncture, Yu’e bao has amassed upward of RMB ¥535 billion ($87 billion) since it launched last June. Though that represents only 0.5 percent of the RMB ¥113 trillion in total deposits, China’s increasingly diversified tech giants,[1] along with six other companies, have also launched online MMFs. This has in turn has triggered banks to counter with their own online funds, provoking a broad grassroots liberalization of interest rates.
Business and liquidity risks loom
As competitors and regulators have adjusted, challenges have emerged to tech MMFs’ business models and the liquidity of their holdings. This year, China’s central bank (the PBOC) eased credit conditions, slashing the interbank interest rates and consequently the returns that had made Yu’e Bao so attractive relative to bank deposits. To maintain its competitive yields, Yu’e Bao has allocated more assets to repurchase agreements and products with longer maturities, resulting in a maturity mismatch on its balance sheet.
This mismatch risk and the ability of Yu’e Bao investors to make withdrawals on the day of the request (in banking terms, a T+0 settlement basis) pose a serious problem: If a large number were to quickly withdraw their money, Yu’e Bao would face a classic bank run situation. It would be forced to sell assets at fire-sale prices to generate liquidity and cash. Losses would likely mount.
Sources: Alipay, Tianhong.
Notes: "Repo agreements" means assets held under resale agreements, and "bank deposits" refers to bank deposits and settlement reserves. Alibaba for e-commerce, Tencent and Sina for social media, and Baidu for search.
Assessing the regulatory reaction and landscape
Like other regulatory arbitrageurs that are not disruptors in the strictest sense, Yu’e Bao and other online funds may face mounting regulation in addition to those risks as officials concerned about financial stability rein in their growth to a more temperate pace. As they act, regulators will have to juggle concerns that include continued rate reform, opposition from the banking industry, and the risk of stifling innovation in the tech sector.
So far, the PBOC seems to have taken the lead in regulating these MMFs, just as it has with WMPs and the broader shadow banking sector. Other agencies are also involved. For example, the PBOC oversees Alipay, which owns Yu’e Bao; securities regulator CSRC supervises Tianhong Asset Management, which manages Yu’e Bao’s assets; and the banking regulator, CBRC, is concerned with the banks in which those assets are invested.
Potential PBOC moves include requiring online MMFs to hold minimum reserves on their deposits. The PBOC is also considering placing limits on online consumer spending, which would affect how much cash flows into online funds. The central bank has already temporarily halted the use of virtual credit cards and QR codes for online shopping. While this does not directly affect online funds, it signals a desire to manage the pace of growth in such platforms.
To discern regulators’ general disposition toward online MMFs, one could also look to their stance on WMPs, which play a similar role in China’s markets. Regulators view WMPs as useful vehicles for advancing rate liberalization, providing savers with competitive returns, and preparing banks for change—but also as an experiment to be watched closely.
China has further to go in reforming its capital markets, and the path it takes could shape the future of online finance. Regulators are allowing the field to expand and pushing commercial banks to change as well, but they are likely to clamp down if risks to financial stability arise.
The Trade Finance Gap
The use of trade finance is an important funding method in Asia, one of the most vibrant, influential regions of the world. However, due to regulatory and other barriers, there is a large gap between supply and demand. Currently, the industry is being transformed by an increasing desire to marry trade finance with the wider capital markets, as well as by the internationalization of the renminbi (RMB).
Trade finance uses traded goods as collateral, unlike traditional lending, which lends against balance sheet or assets. As a result, a key component is the ability for banks to set up safeguards to take possession and sell the goods and commodities themselves. Bank-intermediated trade financing is also short-term in nature, with about $6.5 trillion to $8 trillion in short-term annual trade finance flows versus just $175 billion in medium- to long-term trade finance exposures.
Trade finance is a hallmark of emerging Asia, with almost half of global bank-intermediated trade finance devoted to firms in that region. Its popularity there is due to the heightened risk that comes with such factors as: longer trade routes between Asia and its trade partners, product types, less established trade partnerships, weaker contract enforcement, lower degree of financial development and higher political risk. Europe, in contrast, has shorter trade distances and better established institutions that insure trade credits and discount trade receivables.
image
Chart 1: Trade finance, trade credit insurance, and trade by geography
Trade financing is thus able to come in with more complex, sometimes syndicated structures that shift the risk burden to banks, which can then monitor the transactions and exert greater control over the flow and receipt of funds. This is especially useful in situations where there is a lack of mutual understanding between parties.
Differences in regulations and legal frameworks have also created arbitrage opportunities and played a role in the regional popularization of trade finance. For example, in China, the degree of interest rate liberalization varies between RMB loans and trade finance. Also, the discount rates of RMB and foreign-currency letters of credit (L/Cs) were at times lower in offshore than onshore markets. These various reasons conspired to make trade finance instruments like L/Cs relatively cheap and popular instruments to finance working capital.
Despite the importance of trade finance in supporting production, job creation and economic growth, there is currently a funding shortfall of $1.6 trillion globally, and $425 billion in developing Asia alone. Based on the volume of rejected loan requests, there exists a substantial amount of unmet demand for import and export finance.
Ongoing regulatory change is one major barrier for trade finance. Basel III requirements have increased operating costs and capital allocation to trade loans, making profitability more difficult, and possibly increasing pricing and decreasing liquidity. Under Basel III, credit risk conversion factors increased from 20 percent (under Basel I and II) to 100 percent, and other elements like the liquidity coverage ratio, the net stable funding ratio, and the asset value correlation multiplier have contributed to hiking capital requirements.
Other barriers that have created a trade finance gap include: banks’ poor payment records, low credit ratings, weak capacity, unsatisfactory performance, lack of dollar liquidity, weak overall banking systems and low country ratings.
There has been a surge in securitization deals backed by trade finance loans, as banks look to divvy up risk and offset trade finance capital requirements. Trade finance assets are mainly generated by banks and were traditionally traded only in the interbank market, but a recent spate of issuances has increased non-bank investors’ (i.e. capital markets) access to trade-finance assets.
Standard Chartered led the way in 2007 with Sealane I, a special-purpose vehicle (SPV) set up to sell protection against the portfolio to the bank and to issue securities to the public. Banks can ordinarily distribute and offset trade finance risks by directly selling their loans or through credit insurance. In the past two years, though, six large public issuances have followed, indicating that outright and synthetic securitizations for investors might become a more frequent path for banks. One caveat is that different regulatory and tax regimes may make this pursuit complicated in Asia.
Chart 2: Trade finance securitization deals.
Source: Company press releases.
Another change is the increased use of RMB in payments and trade financing. With more companies considering the practice, more banks are developing their own RMB trade finance capabilities to meet those needs. Though the figure is purported to be inflated by shadow lending practices, the RMB recently replaced the euro for the No. 2 spot in terms of world usage in trade finance. This represents a growth opportunity for financial institutions, as China continues to liberalize its capital account.
On the other hand, the effect upon the trade finance business will be limited until more commodities start to be priced in RMB. Though commodities trade will gradually convert to RMB settlement in some areas, much of it is still denominated in U.S. dollars. Asian and European banks in particular are well-positioned to adapt to the change, due to offshore centers and hubs in Hong Kong, London and Singapore.
Chart 3: Trade finance currency usage
Trade finance uses traded goods as collateral, unlike traditional lending, which lends against balance sheet or assets. As a result, a key component is the ability for banks to set up safeguards to take possession and sell the goods and commodities themselves. Bank-intermediated trade financing is also short-term in nature, with about $6.5 trillion to $8 trillion in short-term annual trade finance flows versus just $175 billion in medium- to long-term trade finance exposures.
Driving force: Regional risks and attributes
Trade finance is a hallmark of emerging Asia, with almost half of global bank-intermediated trade finance devoted to firms in that region. Its popularity there is due to the heightened risk that comes with such factors as: longer trade routes between Asia and its trade partners, product types, less established trade partnerships, weaker contract enforcement, lower degree of financial development and higher political risk. Europe, in contrast, has shorter trade distances and better established institutions that insure trade credits and discount trade receivables.
image
Chart 1: Trade finance, trade credit insurance, and trade by geography
Sources: BIS.
Trade financing is thus able to come in with more complex, sometimes syndicated structures that shift the risk burden to banks, which can then monitor the transactions and exert greater control over the flow and receipt of funds. This is especially useful in situations where there is a lack of mutual understanding between parties.
Differences in regulations and legal frameworks have also created arbitrage opportunities and played a role in the regional popularization of trade finance. For example, in China, the degree of interest rate liberalization varies between RMB loans and trade finance. Also, the discount rates of RMB and foreign-currency letters of credit (L/Cs) were at times lower in offshore than onshore markets. These various reasons conspired to make trade finance instruments like L/Cs relatively cheap and popular instruments to finance working capital.
Barriers to trade finance
Despite the importance of trade finance in supporting production, job creation and economic growth, there is currently a funding shortfall of $1.6 trillion globally, and $425 billion in developing Asia alone. Based on the volume of rejected loan requests, there exists a substantial amount of unmet demand for import and export finance.
Ongoing regulatory change is one major barrier for trade finance. Basel III requirements have increased operating costs and capital allocation to trade loans, making profitability more difficult, and possibly increasing pricing and decreasing liquidity. Under Basel III, credit risk conversion factors increased from 20 percent (under Basel I and II) to 100 percent, and other elements like the liquidity coverage ratio, the net stable funding ratio, and the asset value correlation multiplier have contributed to hiking capital requirements.
Other barriers that have created a trade finance gap include: banks’ poor payment records, low credit ratings, weak capacity, unsatisfactory performance, lack of dollar liquidity, weak overall banking systems and low country ratings.
Recent developments
There has been a surge in securitization deals backed by trade finance loans, as banks look to divvy up risk and offset trade finance capital requirements. Trade finance assets are mainly generated by banks and were traditionally traded only in the interbank market, but a recent spate of issuances has increased non-bank investors’ (i.e. capital markets) access to trade-finance assets.
Standard Chartered led the way in 2007 with Sealane I, a special-purpose vehicle (SPV) set up to sell protection against the portfolio to the bank and to issue securities to the public. Banks can ordinarily distribute and offset trade finance risks by directly selling their loans or through credit insurance. In the past two years, though, six large public issuances have followed, indicating that outright and synthetic securitizations for investors might become a more frequent path for banks. One caveat is that different regulatory and tax regimes may make this pursuit complicated in Asia.
Chart 2: Trade finance securitization deals.
Source: Company press releases.
Another change is the increased use of RMB in payments and trade financing. With more companies considering the practice, more banks are developing their own RMB trade finance capabilities to meet those needs. Though the figure is purported to be inflated by shadow lending practices, the RMB recently replaced the euro for the No. 2 spot in terms of world usage in trade finance. This represents a growth opportunity for financial institutions, as China continues to liberalize its capital account.
On the other hand, the effect upon the trade finance business will be limited until more commodities start to be priced in RMB. Though commodities trade will gradually convert to RMB settlement in some areas, much of it is still denominated in U.S. dollars. Asian and European banks in particular are well-positioned to adapt to the change, due to offshore centers and hubs in Hong Kong, London and Singapore.
Chart 3: Trade finance currency usage
Source: SWIFT.
Untangling China's Shadow Banking and Real Estate Issues
Real estate is an engine of the Chinese economy, but many experts believe the possibility of overinvestment in the sector poses serious systemic risk. Shadow banking and local government debt are the other massive, interwoven financial issues, but property could be the one that triggers distress in the others.
In 2012, the government embarked on numerous financial reforms. They included liberalizing interest rates, clamping down on property price increases, limiting government agency spending, and imposing new rules on lending. These narrowed bank lending margins, so money flowed instead into retail trusts and wealth management products (i.e., shadow banking) through which banks could continue to invest in real estate and chase yield.
Nevertheless, a large portion of official lending in China is still aimed at the real estate sector. By some measures, housing absorbed up to one-third of total lending in 2013. Furthermore, maturity peaks are coming, with more than 60 percent of all loans due in Q2 2014, and almost 45 percent of those in Q1 2015, being in the real estate sector. The impact is felt even beyond official loan channels because property is often used as collateral to support billions of dollars in corporate borrowing.
Chart 1 & 2: China's real estate is a crucial part of its economy
Now, housing inventory is overflowing, and it's not limited to first-tier cities like Beijing, Shanghai, Guangzhou, and Shenzhen. In fact, second-, third,- and fourth-tier cities account for 95 percent of housing under construction. In the same way that infrastructure development (e.g., subway projects) in many small cities has overshot their actual needs, the supply of real estate has far outstripped demand in recent years.
Because of this structural overbuilding, the market has displayed cracks. For example, Zhejiang Xingrun Real Estate, a major property developer, defaulted this year on $567 million in debt owed to more than 15 banks. Li Ka-shing, a real estate investor and the richest man in Asia, sold nearly $3 billion in Chinese property in the past year.
As these fissures appear more frequently, the government has two policy choices: Embrace reform by letting companies default and trusts fail, or continue to bail them out. The more likely route, in our view, is continuing bailouts because so much of investors’ wealth depends on growth targets remaining high, which in turn relies on the continual expansion of real estate. There’s just too much at stake for the leadership to do otherwise.
In 2012, the government embarked on numerous financial reforms. They included liberalizing interest rates, clamping down on property price increases, limiting government agency spending, and imposing new rules on lending. These narrowed bank lending margins, so money flowed instead into retail trusts and wealth management products (i.e., shadow banking) through which banks could continue to invest in real estate and chase yield.
Nevertheless, a large portion of official lending in China is still aimed at the real estate sector. By some measures, housing absorbed up to one-third of total lending in 2013. Furthermore, maturity peaks are coming, with more than 60 percent of all loans due in Q2 2014, and almost 45 percent of those in Q1 2015, being in the real estate sector. The impact is felt even beyond official loan channels because property is often used as collateral to support billions of dollars in corporate borrowing.
Chart 1 & 2: China's real estate is a crucial part of its economy
Sources: Bloomberg, Nomura, Milken Institute.
Notes: Loans from large and middle-market banks, including ICBC, Bank of China, BoAg, BoCom, China Construction Bank, China Merchants, Minsheng, Everbright, and Citic. "Gov’t" refers to regional and local government, while "M&M" stands for metals and mining.
Now, housing inventory is overflowing, and it's not limited to first-tier cities like Beijing, Shanghai, Guangzhou, and Shenzhen. In fact, second-, third,- and fourth-tier cities account for 95 percent of housing under construction. In the same way that infrastructure development (e.g., subway projects) in many small cities has overshot their actual needs, the supply of real estate has far outstripped demand in recent years.
Because of this structural overbuilding, the market has displayed cracks. For example, Zhejiang Xingrun Real Estate, a major property developer, defaulted this year on $567 million in debt owed to more than 15 banks. Li Ka-shing, a real estate investor and the richest man in Asia, sold nearly $3 billion in Chinese property in the past year.
As these fissures appear more frequently, the government has two policy choices: Embrace reform by letting companies default and trusts fail, or continue to bail them out. The more likely route, in our view, is continuing bailouts because so much of investors’ wealth depends on growth targets remaining high, which in turn relies on the continual expansion of real estate. There’s just too much at stake for the leadership to do otherwise.
Wednesday, December 10, 2014
South Korea's Notoriously Stringent Financial Sector
At the moment, policies meant to deal with South Korea’s slowing economy and high level of household debt are putting pressure on its already-weakened banking sector. Banks operating in Korea have struggled with profitability, causing many to restructure and downsize. For instance, foreign banks such as Standard Chartered, HSBC and Citibank have trimmed headcount, sold business operations or closed retail units.
The slow economy and weak business sentiment have resulted in slower loan growth, and have also prompted the Bank of Korea (BOK) to respond with monetary easing, which naturally squeezes bank margins. There have already been several rate cuts in the last couple of years, but in August the BOK cut the policy rate again in order to restore confidence and boost the economy. As a result of falling net interest spreads and bank lending rates, bank returns on assets and equity have suffered, and margins will continue to be pressed until the central bank raises rates.
Chart 1
President Park Geun-hye’s plans to tackle high household debt are also pressuring banks. Park’s efforts to relieve heavily indebted households have resulted in the implementation of a debt write-off program called the personal debt rehabilitation scheme (PDRS, aka the Happiness Fund). Because banks must sell their loans at a loss to the state fund when borrowers apply successfully for the scheme, this has resulted in a rise in loan impairments and a general deterioration of asset quality.
The majority of household debt is made up of mortgages, so prudential regulators are also trying to strengthen the resilience of mortgage loans to credit risk. While this should stabilize the banking system, it will also further hamper bank profits. Specifically, regulators are encouraging a shift from floating rates and bullet payments toward fixed rates and amortizing mortgages. As a result, bank-funding costs have risen and net-interest margins have been constrained, as banks have sought to attract borrowers by offering lower rates on fixed-rate loans. Banks must also match the increasing amount of fixed-rate loan assets with similarly long-term debt financing, which tends to be more expensive than short-term funding. Prepayment risk, or the risk of borrowers refinancing at lower rates, may also bite into profits.
These issues are often cyclical, but they are also indicative of a broader struggle in South Korea’s financial services sector. The government is stringent in regulating the safety of the financial sector, but at the same time domestic banks find it difficult to compete internationally and foreign banks struggle to make a profit in Korea due to the culture of intervention and protectionism.
Chart 2 & 3
The slow economy and weak business sentiment have resulted in slower loan growth, and have also prompted the Bank of Korea (BOK) to respond with monetary easing, which naturally squeezes bank margins. There have already been several rate cuts in the last couple of years, but in August the BOK cut the policy rate again in order to restore confidence and boost the economy. As a result of falling net interest spreads and bank lending rates, bank returns on assets and equity have suffered, and margins will continue to be pressed until the central bank raises rates.
Chart 1
President Park Geun-hye’s plans to tackle high household debt are also pressuring banks. Park’s efforts to relieve heavily indebted households have resulted in the implementation of a debt write-off program called the personal debt rehabilitation scheme (PDRS, aka the Happiness Fund). Because banks must sell their loans at a loss to the state fund when borrowers apply successfully for the scheme, this has resulted in a rise in loan impairments and a general deterioration of asset quality.
The majority of household debt is made up of mortgages, so prudential regulators are also trying to strengthen the resilience of mortgage loans to credit risk. While this should stabilize the banking system, it will also further hamper bank profits. Specifically, regulators are encouraging a shift from floating rates and bullet payments toward fixed rates and amortizing mortgages. As a result, bank-funding costs have risen and net-interest margins have been constrained, as banks have sought to attract borrowers by offering lower rates on fixed-rate loans. Banks must also match the increasing amount of fixed-rate loan assets with similarly long-term debt financing, which tends to be more expensive than short-term funding. Prepayment risk, or the risk of borrowers refinancing at lower rates, may also bite into profits.
These issues are often cyclical, but they are also indicative of a broader struggle in South Korea’s financial services sector. The government is stringent in regulating the safety of the financial sector, but at the same time domestic banks find it difficult to compete internationally and foreign banks struggle to make a profit in Korea due to the culture of intervention and protectionism.
Chart 2 & 3
Sources: Bank of Korea, Bloomberg.
Monday, March 17, 2014
Securities Exchanges, Part I: Global Proliferation
The securities exchange industry has grown prolifically behind globalization for nearly four decades, but industry-specific challenges are now clouding its future.
Each link in the globalization chain tells of a need for risk and capital intermediation, and loosely illustrates why securities exchanges have boomed. With trade liberalization, trade agreements are inked or restrictions are lifted, and trade routes open up; meaning more exchange of commodities like raw and primary materials, finished goods, currencies, and cross-border payments.
With financial liberalization, corporations that grow into MNCs with greater global profiles can attempt to access and raise money from new, foreign equity or bond markets; and investors can simultaneously better channel their savings towards those very cross-border investments. As a result, both corporations and investors also become exposed to more global risk, and need to offset those risks with hedges (see Chart 1 for an example of derivatives exchange growth).
Chart 1
Notes: The chart starts in 1970 because globalization accelerated in the following decades. The net number of operational exchanges is shown, with growth indicating more being established than defunct or merged.
Sources: WFE, FIA, Numa, AFM, IOS, CFTC.The most important business activity of an exchange is providing a place for investors to trade (derivatives, equities, fixed income, commodities), and a place for corporations to list and raise money (cash equities). Ancillary services often include the provision of market data and analytics to corporations, or of technology to exchanges or clearinghouses in other parts of the world.
For exchanges, organic growth might come in the form of expanding their product lines (e.g., developing faster trading platforms, and innovating new trading products), or expanding whole business segments (e.g., an equities exchange developing its derivatives business). On the other hand, inorganic growth involving M&A is also a popular route.
The securities exchange industry is always a flurry of activity: international exchanges seeking to expand aggressively by acquiring or merging with smaller, regional operations; smaller exchanges going defunct due to lack of liquidity (i.e., a lack of buyers and sellers or trading activity); and new alternative exchanges being launched all the time to provide liquidity and offer new trading products. The industry is also intensely competitive. Not only must exchanges out-price and out-innovate one another, but also they have to fend off other competitors, such as OTC markets run by broker-dealers, and ATNs (which include ECNs, MTFs, dark pools, and matching networks).
Presently, a number of headwinds are engulfing the industry, but there are tailwinds waiting in the wings as well. In the past few years, low growth, customers deleveraging, and extraordinarily low interest rates all contributed to poor business and low trading volumes. But developed economies are beginning to reverse zero-interest rate monetary policies, which is a boon for exchanges, as rising rates should bring back fundamentals and trading volume. The global regulatory overhaul of derivatives (i.e., Basel III worldwide, Dodd Frank in the U.S., MIFID II in Europe, etc.), also, is shifting the market in favor of clearinghouses and exchanges.
Thursday, February 6, 2014
Illiquidity in Fixed Income Markets, Part I: Death of the Dealer Model
U.S. fixed-income markets are in transition because of new regulations and Federal Reserve policy. The decline of the broker-dealer market-making model is causing a shortage of liquidity, which would pose risk to investors should the great bull run in bond markets come to an end. Deep, liquid markets are important for financial stability and expand access to capital for individuals and corporations.
Select banks called primary dealers, among them J.P. Morgan, Goldman Sachs, and Citigroup, traditionally played an important role in “making” bond markets by providing liquidity, holding inventory of their own, and acting as the counterparty for trades by quoting bid and offer prices. Because bonds have unique durations, covenants, and rates, and are overall less standardized than equities, they are less frequently traded and have fewer investors, making intermediaries such as dealers necessary.
Two factors have caused institutional investor bond holdings to rise substantially and dealer inventories to fall. Basel III’s higher capital requirements and supplementary leverage ratios, and Dodd-Frank’s Volcker Rule, have decreased the profitability of dealers who trade and carry bonds on their balance sheets, prompting them to retreat from the traditional dealer model and focus on their core businesses. At the same time, years of quantitative easing by the Fed have caused investors to leave government fixed-income securities for high-yield and investment-grade corporate bonds (and equities) in pursuit of bigger returns.
Chart 1
Source: Bloomberg, ICI, NY Fed, SIFMA.
The confluence of these factors has constricted the supply of fixed income to investors on the secondary market, while demand has risen. Dealer holdings of bonds have fallen to an all-time low, down 89 percent from their 2007 peak, while mutual fund holdings of bonds more than doubled in the same period. This means the amount of mutual fund credit assets susceptible to declines in liquidity equals nearly $870 billion versus $300 billion during the credit crisis in 2008.
With the inclusion in those assets of exchange-traded funds that track corporate debt, buy side bond holdings further exceed dealer inventories. In part, the huge resurgence in the issuance of traditionally illiquid securities in 2013 (i.e., leveraged loans, CDOs, CLOs, corporate hybrids, and convertible bonds) stems from attempts to satisfy the supply-demand mismatch in fixed-income markets.
On the surface, market liquidity seems to be healthy, but closer inspection reveals that is not the case. Despite high trading volumes, other aspects of liquidity have suffered: bid-offer spreads that spike when liquidity is needed; less diverse market participation and a concentration in fewer bond categories; weaker dealer participation in Treasury auctions; and thin trading in older and smaller bonds in secondary markets. Because of the issuance boom, investors mainly are buying new bond issues and have not needed to rotate into other portfolios.
Furthermore, large block trade volume has waned over the past eight years. Block trades worth more than $5 million have decreased, and those in the $1 million to $5 million range have increased. The average trade size has declined due to more dealers splitting up large orders to find buyers and sellers. In retrenching, dealers are focusing on their largest clients, often leaving smaller funds struggling to complete trades affordably and further narrowing market participation and the strategies used for trading. Financial institutions are trying to remedy these issues by developing electronic bond trading platforms to facilitate liquidity.
Illiquid markets present both volatility and risk to investors. Unlike the dealers, institutional investors cannot act as liquidity stabilizers, risk warehouses, or pressure release valves. When the corporate bond bull market ends, investors, not dealers, would bear the brunt of losses as the latter are no longer positioned to take on all the bonds investors would want to offload.
Funds have built up big positions in corporate debt and taken on less liquid securities with higher yields to help meet expected returns or actuarial assumptions. If those funds should need liquidity stemming from a jump in nonperforming loans or market volatility, the door under the Exit sign would quickly become very crowded. Numerous factors could trigger this, including rising interest rates, deflation, an international financial crisis—anything that affects credit or causes defaults to multiply. It would inflict massive stress on those funds and a jarring impact on the economy, undermining the financial futures of pensioners and annuity holders.
Select banks called primary dealers, among them J.P. Morgan, Goldman Sachs, and Citigroup, traditionally played an important role in “making” bond markets by providing liquidity, holding inventory of their own, and acting as the counterparty for trades by quoting bid and offer prices. Because bonds have unique durations, covenants, and rates, and are overall less standardized than equities, they are less frequently traded and have fewer investors, making intermediaries such as dealers necessary.
Two factors have caused institutional investor bond holdings to rise substantially and dealer inventories to fall. Basel III’s higher capital requirements and supplementary leverage ratios, and Dodd-Frank’s Volcker Rule, have decreased the profitability of dealers who trade and carry bonds on their balance sheets, prompting them to retreat from the traditional dealer model and focus on their core businesses. At the same time, years of quantitative easing by the Fed have caused investors to leave government fixed-income securities for high-yield and investment-grade corporate bonds (and equities) in pursuit of bigger returns.
Chart 1
Source: Bloomberg, ICI, NY Fed, SIFMA.
The confluence of these factors has constricted the supply of fixed income to investors on the secondary market, while demand has risen. Dealer holdings of bonds have fallen to an all-time low, down 89 percent from their 2007 peak, while mutual fund holdings of bonds more than doubled in the same period. This means the amount of mutual fund credit assets susceptible to declines in liquidity equals nearly $870 billion versus $300 billion during the credit crisis in 2008.
With the inclusion in those assets of exchange-traded funds that track corporate debt, buy side bond holdings further exceed dealer inventories. In part, the huge resurgence in the issuance of traditionally illiquid securities in 2013 (i.e., leveraged loans, CDOs, CLOs, corporate hybrids, and convertible bonds) stems from attempts to satisfy the supply-demand mismatch in fixed-income markets.
On the surface, market liquidity seems to be healthy, but closer inspection reveals that is not the case. Despite high trading volumes, other aspects of liquidity have suffered: bid-offer spreads that spike when liquidity is needed; less diverse market participation and a concentration in fewer bond categories; weaker dealer participation in Treasury auctions; and thin trading in older and smaller bonds in secondary markets. Because of the issuance boom, investors mainly are buying new bond issues and have not needed to rotate into other portfolios.
Furthermore, large block trade volume has waned over the past eight years. Block trades worth more than $5 million have decreased, and those in the $1 million to $5 million range have increased. The average trade size has declined due to more dealers splitting up large orders to find buyers and sellers. In retrenching, dealers are focusing on their largest clients, often leaving smaller funds struggling to complete trades affordably and further narrowing market participation and the strategies used for trading. Financial institutions are trying to remedy these issues by developing electronic bond trading platforms to facilitate liquidity.
Illiquid markets present both volatility and risk to investors. Unlike the dealers, institutional investors cannot act as liquidity stabilizers, risk warehouses, or pressure release valves. When the corporate bond bull market ends, investors, not dealers, would bear the brunt of losses as the latter are no longer positioned to take on all the bonds investors would want to offload.
Funds have built up big positions in corporate debt and taken on less liquid securities with higher yields to help meet expected returns or actuarial assumptions. If those funds should need liquidity stemming from a jump in nonperforming loans or market volatility, the door under the Exit sign would quickly become very crowded. Numerous factors could trigger this, including rising interest rates, deflation, an international financial crisis—anything that affects credit or causes defaults to multiply. It would inflict massive stress on those funds and a jarring impact on the economy, undermining the financial futures of pensioners and annuity holders.
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