It should strike us as peculiar that dealing and spending in terms of “big bucks” is really back in style. I am not even referring to the ongoing divide between the “haves” and “have-nots” of society, as I previously discussed, but rather to the evolution of the global financial derivatives market. Even after a hard-to-bear financial crisis, with origins closely linked to financial engineering, the total nominal dollar exposure of financial derivatives can hardly be fathomed, and remains (quite literally) off the charts. Try comprehending $710 trillion: this is a 15-digit number, and little short of 45-times U.S. GDP, or merely 11-times the $63 trillion held in global equity markets! It is hard to imagine ever unwinding (even partially) those positions, for reasons foreseen or not.
What has become known as “too big to fail”, U.S. financial institutions continue to grow even bigger, especially with respect to their derivatives business. Total activities of U.S. banks are currently marked at $230 trillion in nominal exposure, an increase from $200 trillion at the end of 2008. Whereas the Comptroller of the Currency (OCC), the administrator of national banks, was somewhat apologetic in its Q4 2008 report, describing the sharp increase in exposure as a necessary consolidation effort, those words of caution have become a distant echo.
Policymakers, nevertheless, may not be entirely “asleep at the wheel.” Call it fortitude or good housekeeping, but the Fed (before the OCC) last week finally agreed on new liquidity coverage ratios, mandating banks to hold additional high-quality liquid assets (such as equities and bonds) to proactively meet and prevent credit crunches as a result of shocks to the financial system. According to the new set of rules, financial institutions should be able to maintain liquidity for a minimum of 30 days, which is comforting given the potentially hard-to-address derivative exposure during times of systemic stress.
All good regulatory intention aside, there are implications for investors to consider:
- First, the Fed's choice of applicable high-quality, or “easy-to-sell assets” (for now), does not include municipal bonds (munis). If this status-quo is upheld, we could see a severe impact on the $3.7 trillion muni market, as many municipalities continue to suffer from lack of sufficient distribution channels and interest in the particular asset class overall. If issuers have difficulty placing muni debt with the retail market and they cannot leave it with the banks (as before), then the entire asset class would be impacted, potentially pushing up interest rates.
- Second, the new set of rules may limit financial institutions in their ability to provide sufficient credit to the private sector, and consequently curb bank profits and economic expansion. The limited availability of credit, especially to small companies, has been a factor in the uneven economic recovery. Recently, bank credit surpassed 2009 peak levels, but this recent uptrend may be at risk. Further, banks will likely become less attractive as “profit engines” compared to previous economic cycles. With the new requirements going into effect by 2017, large banks will be mandated to hold $2.5 trillion in highly liquid instruments, instead of in more profitable risk assets.
- Last, we have the pressing question: how effective and realistic will the implementation and enforcement of the new regulatory framework be? The U.S. economy has been and probably will remain “hooked" on credit. Big numbers, in this respect, have been the norm, and continue to dominate, as evidenced by “ballooning” non-housing debt balances, including more than $1.1 trillion of student loan obligations. If credit is desired and can be “baked” into the system, it will be created somewhere. With banks not able to take a dominant position in this business, someone else will, potentially leaving the financial system with more fragmented risk pools in the future.
The U.S. banking system will most likely never return to the “heyday" of the pre-crisis, potentially leaving the economy at risk of insufficient credit supply. The flip side is that lessons from mismanaged risk and self-defeating excesses, as clearly experienced in the aftermath of America’s and Europe’s great financial recession, have still not resulted in the creation of reliable global risk management standards. Whereas the western world is curbing its banking system (slowly but surely), emerging market economies are “ramping up,” potentially creating the basis for significant non-performing loans and credit-supply reduction in the future.
Matthias Paul Kuhlmey is a Partner and Head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to High Net Worth and Ultra-High Net Worth Individuals, Family Offices, and Institutions.