Monday, December 22, 2014

FINMA - “We regulate more intensively, especially where products and innovations are concerned.”

What does a financial regulator do? Here is an example, describing what the Swiss financial regulator FINMA (“Eidgenössische Finanzmarktaufsicht”) does.

FINMA Essentials

FINMA is an institution under public law that has its own legal personality. The own legal personality underlines the regulator’s independence from political interferences. The independence is also financial in that FINMA’s funding stems from fees and duties paid by supervised entities instead of public Government funds.

Two main bodies govern FINMA:

  • The Board of Directors decides on matters of substantial importance, issues ordinances and circulars, and is responsible for FINMA’s budget.

  • The Executive Board is namely responsible for audit, risk, and nominations.

Employing roughly 500 people (14 % of which are non-Swiss nationals), the Swiss regulator is a rather small organization.

What should FINMA achieve?

FINMA has vocation to

  • protect the (collective, not individual!) interests of creditors, investors, and insurance policyholders;

  • ensure the proper functioning of financial markets and the overall stability of the financial system.

FINMA’s goals translate into which concrete activities?

FINMA carries out four principal sets of activities:

  • Licensing: The authority grants and publishes licenses to individuals and legal entities active in regulated financial markets. We are essentially talking about banks, insurance companies, stock exchanges, securities dealers, collective investment schemes, distributors, and insurance intermediaries.

  • Regulation: FINMA can issue ordinances and circulars where it is authorized to do so. However, regulation only takes place at the lowest level, in order to make supervisory practices transparent.

  • Supervision: This is a core task. The administration takes a risk-oriented approach and deliberately monitors less risky areas less intensively than riskier areas.

  • Enforcement: On the one hand, FINMA investigates possible breaches of financial market legislation and takes corrective action vis-à-vis regulated entities. On the other hand, the agency has no authority to impose administrative fines.

Supplementary activities relate to participating in national and international rule-setting bodies:

  • In Switzerland, FINMA advises the Parliament, the Federal Council, and other authorities on technical issues of financial legislation.

  • Internationally, it participates in setting regulatory principles globally within the Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), the International Association of Insurance Supervisors (IAIS), and the International Organization of Securities Commissions (IOSCO).

However, FINMA is not an institution that directly boosts the Swiss economy. In its own words, “credible supervision and direct promotion of the economy by the supervisory authority are mutually exclusive.”


Monday, December 15, 2014

BIS Annual Report 2013 – How to tackle a balance sheet recession

In its annual report for 2013, the Bank for International Settlements writes that we are in a balance sheet recession. It also proposes ways how we should tackle it. Here are the essentials.

What is a balance sheet recession?

The last financial cycle ended in 2009 and gave birth to a balance sheet recession. The BIS explains what a balance sheet recession is, using three key features:

  • A balance sheet recession is very costly and tends to be deeper, gives way to weaker recoveries, and results in permanent output losses, i.e. output may return to its previous long-term growth rate but hardly to its previous growth path.
  • It is less responsive to traditional demand management measures because banks need to repair their balance sheets. As long as asset quality is poor and capital meager, banks will tend to restrict overall credit supply and, more importantly, misallocate it.
  • Overly indebted agents will pay down debt and save more instead of spending. As one agent’s spending is another’s income, a balance sheet repair logically depresses income and value of asset holdings.

How can we tackle a balance sheet recession?

The first priority is to repair balance sheets by reducing debt. In the BIS' view, many countries have not completed this task yet. As a matter of fact, private and public sector debt levels remain high in many countries.

Second, countries should implement structural reforms, allowing resources to transfer from unprofitable to profitable sectors and, thus, raising the economy's productivity and growth potential.

Unless productivity growth picks up, the prospects for output growth are dim.”

More specifically, structural reforms can consist of

  • deregulating protected sectors, such as services;
  • improving labor market flexibility;
  • trimming public sector bloat; and
  • putting the fiscal house in order.

Which role plays monetary policy when it comes to balance sheet recoveries?

In short, extraordinary monetary policy is not the right tool for achieving a balance sheet recovery. Even though it is the first means to combat a financial crisis, it does, at the same time, encourage bad debt taking, through keeping interest rates low. Therefore, central banks need to pay attention to the risks of exiting too late and too gradually.

Low interest rates do not solve the problem of high debt. They may keep service costs low for some time, but by encouraging rather than discouraging the accumulation of debt they amplify the effect of the eventual normalization.”

After so many years of an exceptional monetary expansion, the risk of normalizing too slowly and too late deserves special attention.”


Tuesday, December 9, 2014

Extreme Money – A provoking book about the finance industry

Back in 2006, Satyajit Das has written a book about the financial derivatives industry called “Traders, Guns & Money”. I really liked reading this book. It was, therefore, logic that I got also interested in reading his book “Extreme Money: The Masters of the Universe & The Cult of Risk”, published in 2011. “Extreme Money” is a pretty provocative story about the finance industry. In fact, the title fits pretty well the overarching idea of the book: Satyajit’s view is simply “extreme”. In my view, many of his thoughts reveal some truth about the industry; however, they certainly are over-exaggerated and overlook many people and organizations simply doing a good job in finance.

Here are some of Satyajit’s provoking statements that I found most interesting:

Modern economies don't make anything anymore; their major activity is investing, borrowing, and trading money. Money has become the main way to make money.”

A long time ago, money simply served as a means to pay for real goods and services. However, in the second half of the twentieth century, money became something important in its own right. It became, in itself, a way to create wealth.

Satyajit describes a three step evolution resulting in today’s “business of business”:

  • The industry consisted of making things.
  • The industry then became a business, meaning making money from producing things.
  • Ultimately, increasing financialization lead to the “speculation economy” which consists of making money from things not necessarily linked to producing things. The typical example is trading goods that you don’t produce or consume.

Why did financial engineering replace real engineering? The author’s answer is that real engineering means innovation, which is, by definition, a very risky business, contrary to pure financial engineering.

“Rather than making things, trained engineers joined banks to provide turbo-charged financial structures for companies.”

Examples of this financialization include the developments of General Motors, General Electric, and Enron.

“Dealmaking beats working, dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work… Dealmaking is romatic, sexy. That’s why you have deals that make no sense.”
Peter Drucker

“Finance had become the panacea for arresting America’s industrial decline.”

The study of money is a field in which complexity is used to disguise truth or to evade truth, not to reveal it.”

A good example for how complexity can evade truth is the tranching of securitized assets:

“Tranching is like buying a place to live in a flood-prone area. To protect yourself from the one-in-10,000-year flood, you buy an apartment in a tower above previous known flood levels, with a large margin of safety. However, when the flood hits, your higher situated apartment doesn’t help you because the foundations of the tower itself and the surrounding infrastructure are also hit.”

Another aspect of complexity that the author pinpoints to is the lack of responsibility of individual actors to understand complex finance products. Satyajit writes, “Everyone relied on someone else to do their job”.

Finally, complexity generates high profit margins: “Opaque and inefficiently priced financial products produced high profit margins.”

Why is complexity bad? Because it creates financial instruments disconnected from the real world and capable of damaging it: “If correlation between two loans in a normal portfolio was an educated guess, then the correlation input into a structured finance CDO, CDO2, or CDO3 was fantasy.”

“There is a strong correlation between the complexity of an instrument, its remoteness from the real economy and its likelihood to spread contagion.”

In my view, complexity in finance is, indeed, often artificial and home-made. On the other hand: Isn’t everything easy once you have understood it?

A propos complexity, the author doesn’t seem to like Alan Greenspan. Satyajit makes particularly fun of the following quote:

“I know you believe you understand what you think I said, but I am not sure you realize that what you heard is not what I meant.”
Alan Greenspan

In modern economics and finance, until something is said mathematically, it isn’t said at all.”

Today’s math based risk management techniques don’t work, because markets are not efficient and price changes not normally distributed.

“Exceptions and anomalies increasingly undermined the theory of efficient markets.”

“Risk management assumes that price changes are normally distributed. But normal distributions do not exist in practice. Unpredictable extremes of price movement, known as fat tails, were more common than theory implied.

Hedge funds are courtesans, high-class prostitutes whose clients come from the wealthy. Banks are the pimps and bordello keepers.”

Here is how Satyajit sees the culture in the finance industry:

“All successful financiers have selective amnesia, remembering what fits their current world view.”

“Wall Street and the City are bad judges of value. Having enjoyed the milk, in a moment of confusion they tend to over pay for the cow.”

“In risk management, you learn that you are irrelevant, despite everybody saying you are vital. In the back office, you are chained to the oars of the banking trireme, processing an avalanche of paper.”

“Banks take smart people and plug them into their dull, trivial culture where they waste their lives on the hamster wheel of corporate life. There is a mismatch between expectations and the reality of banking.”

“Banks have no strategy, only hustle. One bank decided its strategy was to have no strategy. Imitation is the only real strategy.”

“In the culture of the deal, banks endlessly copy each other’s strategies or products, chasing the same customers, competing on price and the ability to take risk.”

“Happy employees mean that you have paid them too much. Disgusted employees mean that you have paid them so little that they will leave. The optimal point is between satisfied and dissatisfied – enough to keep you but not enough to make you complacent or diminish the manager’s own bonus.”

“The financial elite is narrow and limited, too smart, too fast, wanting too much, lacking any sense of history, and reinforcing each other’s opinion.”

“In finance, flexibility and split personalities are important.”

“Empty words like governance and oversight masked a lack of adult supervision of business and markets. A culture of benign neglect presided over increasing debt, greater leverage, higher risk, lower capital, and accounting fudges.”

As I wrote above, the book is extreme…

There is no simple, painless solution: The world has to reduce debt, shrink the financial part of the economy, and change the destructive incentive structures in finance. Individuals in developed countries have to save more and spend less.”

Satyajit describes in his book how the importance of debt kept rising in the global economy over the last decades.

He defines debt as a Darwinian scheme in which only those players survive who can withstand the highest debt levels. If interest cannot be paid back, more borrowing is needed until the player, ultimately, collapses under the weight of debt. From the point of view of the entire economy, this leads to a constant cycle of credit booms and bust.

“Debt became the essential part of the modern lifestyle. Even wealthy people borrow to increase their return.”

But why is debt so attractive? The author’s answer is that the debt’s attractiveness lies in its capacity to provide instant gratification as it borrows from tomorrow to pay for today. However, this only works as long as the debt level is sustainable. Sustainable means that debt is invested productively, i.e. in a way that generates the necessary revenue to repay debt and interest. Spending debt simply to finance consumption or larger houses, to the contrary, does not generate any revenue and then ultimately must result in a financial bust.

“The best loans are made during the worst times, the worst loans are made during the best times.”

The financial system was a case of financial groupthink, the madness of crowds.”

Das criticizes more or less every institution of the finance industry:

  • “Financial journalism is superficial.” The BRIC symbol (Brazil, Russia, India, and China) that expressed the raising power of emerging countries in the global economy in the years after 2000 may serve as an example.
  • “Financial TV never bothered with plot, dialogue, or production values, focusing only on the action. Occasional outside shots on the steps of a stock exchange or outside some monumental bank headquarters interrupt the visual monotony and interviews are never longer than 5 to 10 minutes.”
  • “At Davos the diverse mix is confusing – celebrities wanting to be intellectuals, intellectuals wanting to be celebrities, and bankers wanting to be both celebrities and intellectuals.”
  • Regulators seem to be powerless: “When things were going well, regulators favored self-regulation, which bears the same relationship to regulation that self-importance does to importance.” If ever banks could not obtain self-regulation, they always ended up avoiding regulation by imposing exclusions and exemptions.

Botox economics

Let’s finish with the concept of botox economics that Satyajit uses to highlight the inefficiency of central bank / central government financial support for the economy:

“Botox is a toxin, commonly used to improve a person’s appearance by removing signs of ageing. However, the effect is only temporary, with significant side effects. As the global financial crisis rolled on, financial botox, a flood of money from central banks and governments, covered up unresolved and deep-seated problems. Tax cuts, investment incentives, and subsidies all boosted activity. Low or zero interest rate policies engineered a recovery in stocks and financial markets.”

This debate is still vivid today. Let’s wait and see…


Satyajit Das – Extreme Money

Monday, December 1, 2014

FOREX Manipulation - „Call me legend!! Front run legend.“

Earlier this month, on November 12, 2014, U.S., U.K., and Swiss regulators have fined several investment banks for manipulating FOREX markets.

The Fines

Let’s first have a closer look at the fines:

Fines are pretty evenly distributed among the banks. UBS stands out because it not only settled with U.S. and U.K. regulators but also with its home regulator FINMA.

As FOREX trading desks are mainly situated in London and New York, these were also the main regulators involved. It stands out that U.K.’s Financial Conduct Authority (FCA) was even more severe than its U.S. counterpart, the Commodities Futures Trading Commission (CFTC). FINMA, the Swiss financial markets regulator, however, didn’t actually impose a fine in a narrow sense. It rather asks UBS to pay back illegally obtained return and avoided costs.

In total, fines amount to 3.3 bn USD. As a comparison, this represents the fines of 28,000 aggravated thefts in France or 8 % of the combined 2013 net income of the fined banks.

On the merits

In contrast to other financial litigation, this one is, in my view, rather easy to understand.

On the merits, there is one notable difference between CFTC’s approach on the one hand and FCA’s / FINMA’s approach on the other hand: Whereas in the U.S., there exists specific legislation forbidding any willful manipulation of commodities’ (including FOREX) prices, the U.K. and Swiss regulators did not invoke such legislation. Rather, the latter sanctioned the banks on the grounds of violations of general prudential requirements such as insufficient control systems and negligence of client information confidentiality.

The facts

Obviously, the tedious work of regulators was here to establish the facts. In the end, they gathered ample evidence from private electronic chat rooms to show that traders manipulated, between 2008 and 2013, FOREX fixings by sharing client information on upcoming trades and coordinating trading strategies.

A USB trader even wrote “Call me legend!! Front run legend.“ and „Das Ding ist wir dürfen nicht mehr front runnen, compliance sitzt uns am Arsch.“ (which I don’t want translate here…).

As a reminder, front running means trading ahead of your client: If you know that you will execute a huge order on behalf of your client soon, you know that this higher demand will increase prices. It would then obviously be interesting for you to buy before and sell, at a higher price, once you have executed your client’s transaction.

But traders did not only practice front running. They also shared information about (upcoming) FX transactions and trading strategies to drive certain benchmark exchange rates up or down. They namely tweaked the 4 p.m. World Markets/Reuters Closing Spot Rates, most widely used in U.S. and global foreign exchange markets, and the 1:15 p.m. ECB fix. The Reuters fix is based on actual trades and calculates the median of bids and offers extracted from a certain electronic trading system during a one-minute window. Given this small sample, you can easily understand that traders were motivated to alter the benchmark.

The chat conversations that the regulators provide are indeed striking and show that traders placed their personal interest beyond those of their employers and clients.

What do regulators say?

The FCA does not tolerate conduct which imperils market integrity or the wider UK financial system. Today’s record fines mark the gravity of the failings we found and firms need to take responsibility for putting it right. They must make sure their traders do not game the system to boost profits or leave the ethics of their conduct to compliance to worry about. Senior management commitments to change need to become a reality in every area of their business. But this is not just about enforcement action. It is about a combination of actions aimed at driving up market standards across the industry. All firms need to work with us to deliver real and lasting change to the culture of the trading floor. This is essential to restoring the public’s trust in financial services and London maintaining its position as a strong and competitive financial centre.”
Martin Wheatley, FCA, November 12, 2014

This is not about having armies of compliance staff ticking boxes. It is about firms understanding, and managing, the risks their conduct might pose to markets. Where problems are identified we expect firms to deal with those quickly, decisively and effectively and to make sure they apply the lessons across their business. If they fail to do so they will continue to face significant regulatory and reputational costs.”
Tracey Mc Dermott, FCA, November 12, 2014

The setting of a benchmark rate is not simply another opportunity for banks to earn a profit. Countless individuals and companies around the world rely on these rates to settle financial contracts, and this reliance is premised on faith in the fundamental integrity of these benchmarks. The market only works if people have confidence that the process of setting these benchmarks is fair, not corrupted by manipulation by some of the biggest banks in the world.”
Aitan Goelman, CFTC, November 12, 2014

What do banks say?

The RBS Board fully accepts the criticisms within today’s announcements and condemns the actions of those employees responsible for this misconduct. Today is a stark reminder of the importance of culture and integrity in banking and we will rightly be judged on the strength of our response.”
Philip Hampton, Royal Bank of Scotland, November 12, 2014

Since becoming Chief Executive, I have worked to ensure that everyone within the bank understands the importance of regaining the trust of our customers. In order to achieve that trust we must set ourselves the highest standards of integrity and professionalism, both individually and collectively - this episode has clearly shown us to have fallen well short of that. Now, it’s up to us to show that we can learn the lessons of these mistakes and can be worthy of earning trust in the future.”
Ross Mc Ewan, Royal Bank of Scotland, November 12, 2014

If felt pain for our stuff and customers again [referring to FOREX fines against RBS].”
Ross Mc Ewan, Royal Bank of Scotland, November 12, 2014

Citi acted quickly upon becoming aware of issues in our foreign exchange business and we have already made changes to our systems, controls and monitoring processes to better guard against improper behavior. While today’s settlements resolve significant investigations into Citi’s foreign exchange business, as we have previously disclosed, several additional regulatory agencies and enforcement bodies are conducting investigations and making inquiries into this business. We continue to fully cooperate with these investigations and inquiries.”
Citibank Press Release, November 12, 2014

"Today's resolutions are an important step in our transformation process and towards closing this industry-wide matter for UBS. We continue to cooperate with related ongoing investigations."
Sergio P. Ermotti, UBS, November 12, 2014

Last, but not least: What do (or rather did) FX traders say?

Bank R Trader: 4:00:35 pm: ”well done gents”
Bank W Trader 1: 4:01:56 pm: “hooray nice team work”
Bank U Trader: 4:02:22 pm: “nice one mate”

What’s next?

More control of chat rooms, more compliance, more whistle blowing, a change of culture, and automation of FX trading are to come. As said a UBS FX trader, back in 2012: „It’s a new world out there“.


The CFTC orders can be found here.

FINMA’s investigation documents can be found here.

FCA’s final notices on the fines are available for download here.

Thursday, November 13, 2014

BIS Annual Report 2013 - Why we should care about financial cycles

On June 29, 2014, the Bank for International Settlements (BIS) has published its annual report for 2013. A central topic of this report was the distinction between business and financial cycles.

What are business and financial cycles?

Business cycles are characterized by output fluctuations, i.e. the amount of what an economy produces. They can last between one and eight years.

Financial cycles, as you might expect, are characterized by financial fluctuations. Key factors are not only of financial nature and include

  • output growth;
  • employment;
  • industrial production;
  • consumption;
  • credit aggregates;
  • credit spreads;
  • equity prices;
  • property prices;
  • risk premia;
  • credit default rates.

On average, financial cycles can last between 15 and 20 years. They are often driven by financial booms in which surging asset prices and rapid credit growth reinforce each other, often in connection with prolonged accommodative monetary and financial conditions as well as financial innovation.

To illustrate the distinction, here is how the BIS analyzes the business and financial cycles of the U.S. economy since 1970.

Why is the difference important?

The problem is that financial cycles often develop largely undetected and end up in banking crisis.

As a matter of fact, during financial cycles,

  • households, firms, and governments accumulate debt based on optimistic expectations about their future income, asset prices and the ease with which they are able to access credit;
  • banks overestimate the solidity of their assets, the solvency of their borrowers, and their own ability to refinance themselves by rolling over short-term debt;
  • capital and labor are allocated across different sectors but don't match the composition of sustainable demand.

In addition, financial cycles are often synchronized across economies, as many of their drivers have an important global component (for example as regards liquidity conditions).

Finally, peaks in financial cycles are typically followed by deeper and longer recessions and slower recoveries, compared to business cycle peaks.

This is why monetary and fiscal policy needs to go beyond managing business cycles. It has to address the longer-term build-up and run-off of macroeconomic risks that characterize the financial cycle. Put differently, politicians cannot exclusively address immediate problems (namely employment and inflation) at the cost of creating a bigger one down the road.

A central problem here is to avoid debt accumulation over successive business cycles. In other words, debt cannot be the main engine of growth.


Sunday, November 2, 2014

Are you Swedish? – S&P’s new methodology on Bank Hybrid Capital

On September 18, 2014, Standard & Poor’s has published a new methodology for evaluating banks’ hybrid capital instruments (“hybrids” in short).

What are hybrids?

Before we go into detail, we have to understand what hybrid capital is. It is something between debt (“I will always pay you back.”) and equity (“I will pay you a dividend if I make a profit and decide to distribute it to my shareholders.”).

Examples of hybrids include preferred stock, deferrable and certain non-deferrable subordinated debt, trust preferred securities, and mandatory convertible securities.

What is the purpose of S&P’s new methodology?

The rating agency pursues a double purpose: It classifies a bank’s hybrids to assign a proper issue rating to the hybrids and to build a proper issuer rating of the bank. In the context of the methodology, the term “bank” refers to deposit-taking institutions, finance companies, bank non-operating holding companies, and securities firms.

How does S&P classify bank’s hybrids?

Before we come to the classification, we need to understand S&P’s concept of adjusted common equity (“ACE”). To make it simple, ACE determines how much equity a bank needs to compensate for losses in stress situations. The term “adjusted” is a polite indication that S&P counts hybrids as if they were equity, although they are not.

The concept of ACE then leads us right away to the notion of “equity content”. Equity content describes the extent to which a bank’s hybrids can function as equity. Features such as non-payment, deferral of coupons, write-down of principal, and conversion into common equity enhance the equity content of a financial instrument.

Hybrids can have high, intermediate, and minimal equity content. In the first case, up to 50 % of ACE can be made up of hybrids. In the second case, up to 33 % of ACE can consist of hybrids. In addition, you can only cumulate hybrids of high and intermediate equity content if, together, they don’t exceed 50 % of total ACE. Hybrids with minimal equity content don’t count for the calculation of ACE.

What does all this tell us?

Frankly, I don’t like terms such as “hybrid” or “adjusted”. In my view, from a risk perspective, you issue either equity or debt, full stop.

It’s like the question of citizenship: Let’s assume you are Canadian, someone in your family is Swedish, and you are wondering whether you can become a Swedish national. It makes a huge difference whether you already have a Swedish passport in your pocket or whether someone simply tells you that you fulfill all conditions to become Swedish and “only” need to follow the naturalization process with the Swedish administration.


Standard & Poor’s – Bank Hybrid Capital and Nondeferrable Subordinated Debt Methodology and Assumptions – September 18, 2014

Sunday, October 26, 2014

TLTRO – How the ECB refinances long-term loans to the real economy

On June 5, 2014, the ECB has announced a new refinancing program for European banks. It is called TLTRO which stands for “targeted longer-term refinancing operations”.

What is the purpose of TLTRO?

With TLTRO, the ECB intends to improve bank lending to Europe’s non-financial private sector. In other words, the central bank wants banks better fund companies of the real economy.

To achieve its purpose, the TLTRO provides for mandatory repayments if the bank’s net lending (i.e. lending adjusted for redemptions, loan sales, and securitizations) to the real economy falls below predetermined benchmarks. Quarterly reporting obligations and annual audits of data accompany this repayment mechanism.

Who can benefit from TLTRO?

Banks in the Euro area can use TLTRO to refinance their lending to the real economy. However, loans to households cannot enter into consideration if they serve house purchases.

What are the conditions of TLTRO?

The maximum amount each bank can initially borrow depends on its outstanding loans to the non-financial private sector on April 30, 2014. Its borrowing capacity cannot exceed 7 % of such amount.

Additional allotments depend on each bank’s net lending to Europe’s non-financial private sector between 30 April 2014 and the respective allotment reference date.

Banks pay interest, in arrears, at the Eurosystem’s main refinancing rate at the time of take-up plus 10 basis points.

24 months after each TLTRO allotment, banks will start repaying the respective loan, at a six months frequency.

Finally, TLTRO are subject to the same collateral rules as any other refinancing operation in the Eurosystem.


Sunday, August 24, 2014

Securitization in Europe – Overcome current impediments to boost the economy?

Roughly six years ago, the whole world learned about securitization and how it had destroyed the world economy. It will not be a surprise for you that securitization markets have, since the financial crisis, shrunk substantially. This is especially true in Europe.

Today, the European Central Bank and the Bank of England want to change this situation. They have taken a joint initiative to explain why securitization is important and how we can revitalize it in Europe.

The securitization market in the EU continues to be impaired.”

The European asset backed securities (ABS) market remains small, shrinks, and is mostly concentrated in a few jurisdictions. Two figures underline this statement:

  • Today, ABS of around 1,500 BEUR are outstanding in the EU. The absolute figure doesn't matter here. Just keep in mind that this is 67 % of the ABS peak in Europe (2,250 BEUR) and roughly 25 % of today's U.S. ABS market.
  • New issues of ABS in Europe are constantly declining since 2008: In 2013, less than 200 BEUR were issued which is roughly 25 % of Europe's 2008 peak.

Why should Europe care about securitization?

Europe should care because securitization

  • is ,despite all we have heard about it, a good financial instrument: As a matter of fact, most European structured finance products performed well throughout the financial crisis. Default rates between Q3 2007 and Q3 2013 were only about 0.05 %.
  • , if appropriately structured and regulated, can complement other long-term wholesale funding sources for the real economy, including for small and medium-sized enterprises (SMEs). The buzzword here is “diversification of funding base”.
  • can tansfrom relatively illiquid assets into more liquid securities and, thus, make them more attractive to investors.
  • can customize cash flows and risk exposures, creating different asset pools and investment tranches.
  • can support both monetary and financial stability.
  • disciplines the issuer willing to operate a securitization as he must collect and disseminate substantial amounts of information for the deal.
  • is a good compromise between capital-markets based lending and bank lending. This is especially true for SMEs and residential and commercial real estate borrowers.
  • allows banks to transfer risk.

How can Europe develop securitization?


Why is securitization not more successful today? The reason is eightfold:

  • Investing in securitized assets comes with a stigma, because it has an adverse reputation among investors and because regulators and standard-setters are conservative.
  • In addition, investors are more risk-averse than before the 2008 financial crisis and question sponsor support in securitization structures.
  • ABS and securitization lack transparency and harmonization across European jurisdictions.
  • Due to regulation (namely Solvency II insurance standards), investors may be deterred from holding ABS on their balance sheet. The same is true, on the other end of the investment chain, for banks, which are unsure about capital relief which securitization may or may not grant.
  • Some pools of assets are difficult to securitize, because historical data on significant asset pools fall short.
  • Historically, trading volume in ABS has been low, leading to low liquidity of ABS investments.
  • The need for securitization is less important in Europe than in the U.S., given Europe's deep covered bond markets.
  • Structuring securitization deals requires costly IT systems; smaller banks and non-bank companies may shun such fixed costs.


The European and U.K. central banks suggest six principal ways to develop securitization in Europe:

  • Risk retention rules have already been introduced to ensure that originators of securitizations maintain skin in the game.
  • Transparency is key to address information asymmetry between originator and investor in securitizations. Namely, credit registers for all asset classes would allow investors to better compare the performance of underlying financial instruments.
  • Rating agencies should act more transparently and be held accountable for their ratings.
  • Regulators across Europe should treat securitized assets consistently. What's more, holding ABS on a bank's balance sheet should not have negative consequences for the bank's liquidity ratios.
  • Securitization structures must become simple, with well-identified and transparent underlying asset pools with predictable performance. Investors must be capable “to model and understand with confidence the risks incurred”; for example through reading standardized prospectuses and investor reports.
  • Every securitization should be backed by a real economy asset. This, by definition, bans re-securitizations.

Some quotes

The ideas of the reports are interesting, even though they remain a bit vague. Let's wait and see if and how they will be put in practice.


Friday, August 15, 2014

Economic Sanctions III – When can the UN impose economic sanctions?

As we have seen in the last two posts, economic sanctions can be taken by sovereigns against one-another. In addition, the UN can also impose sanctions on a single country.

This type of sanction is not only the most effective (“All UN countries against one country.”) but also the most difficult to obtain. The reason is that a UN sanction requires a Security Council resolution, decided either unanimously or by some UN member states.

UN sanctions intend protecting international peace and security. They can take the form of interruptions of economic relations, arms embargoes, travel restrictions, aviation bans, communication restrictions, and financial restrictions.

When elaborating sanctions, the UN Security Council must

  • duly consider the feasibility and the implications of targeted sanctions;
  • be clear about the behavior it intends to change;
  • clearly define the scope of the sanctions and how they can be eased or lifted;
  • put up a credible mechanism to monitor the sanctions regime.


Tuesday, August 12, 2014

Western / Russian Sanctions – A story about national security, political stability, and retaliation

Last time, I promised to compensate for my rather academic post on sanctions. So how do current Ukraine-related sanctions fit the scheme I described a few days ago?

Who has imposed which sanctions so far?

Since March 5, 2014, the Council of the European Union adopted several conclusions, freezing funds of Russian citizens identified as responsible for misappropriation of Ukrainian state funds. The Council also imposed travel restrictions. On July 29, 2014, the EU expanded the sanctions. It now limits access to EU capital markets for some Russian financial institutions and corporations, imposes embargoes on trade in arms, and limits transfer of technologies.

Since March 10, 2014, the U.S. Government blocks U.S. assets of persons involved in undermining democracy in the Ukraine and prohibits these persons entering the U.S.

On August 7, 2014, the Russian Government responded by banning imports of agricultural produce, raw materials, and food products from the U.S., the EU, Canada, Australia, and Norway.

Why have sanctions been taken and what do they intend to achieve?

On the U.S. side, the Government sees a national emergency:

“The actions and policies of persons, including persons who have asserted governmental authority in the Crimean region without the authorization of the Government of Ukraine, that undermine democratic processes and institutions in Ukraine, threaten its peace, security, stability, sovereignty, and territorial integrity, and contribute to the misappropriation of its assets, constitute an unusual and extraordinary threat to the national security and foreign policy of the United States.”

What a fabulous sentence! You have to read it at least ten times to know what it means! So let's look at it step by step: The U.S. perceives a threat to its national security and foreign policy. Why? Because foreign (especially Russian) people undermine democratic institutions in Ukraine. At this stage, you can agree with this statement or not; but, at least you have understood it now.

The EU targets maintaining political stability in the region:

“The European Union has important relations with Ukraine and the Russian Federation and stands ready to engage in a frank and open dialogue with them. It has a special responsibility for peace, stability and prosperity in Europe. We will pursue these objectives using all available channels and ask the EU representatives to take all necessary initiatives.”


“The EU again encourages the Ukrainian authorities to implement an inclusive process, to pursue their efforts to ensure free and fair elections and to advance constitutional reform. All human rights violations and acts of violence need to be properly investigated and measures need to be stepped up to combat impunity.”


“The European Union remains committed to uphold the sovereignty and territorial integrity of Ukraine. […] The European Council firmly believes that there is no place for the use of force and coercion to change borders in Europe in the 21st century.”

Russia, in turn, has taken its “special economic measures to ensure the security of the Russian Federation.” Its Prime Minister, Dmitry Medvedev, sees them as retaliatory acts:

“I have repeatedly stated that there is nothing productive about sanctions. We had a hard time deciding on retaliatory measures, and we were forced to make this decision.”


“For a long time, Russia has not responded to the so-called sanctions declared against it by certain countries. Until the last moment, we hoped that our foreign colleagues would realize that sanctions lead to a blind alley, and that no one benefits from them. But they didn’t realize this, and now we have been forced to respond.”

In addition, Russia's Prime Minister says that economic sanctions can stimulate the local economy:

“The retaliatory measures that we are introducing will essentially open up shop shelves for domestic producers. Of course, Russian farmers will have to accomplish a lot and work hard, but this opportunity to launch and expand import substituting production facilities should not be missed. […] I am sure that our market will be filled with fresh quality Russian products, which anyway many Russians prefer to the imported ones.”

Have sanctions been effective?

It is obviously too early to give a clear answer to that question.

Economists of the Institute of International Finance say the direct financial impact of sanctions on Russia is likely to be manageable. In fact, most Russian companies don’t depend specifically on foreign financing in the near term. In the long run, however, this might be different as Western lenders could follow economic sanctions beyond their precise scope of application to avoid any legal risk or stigma attached to financing the Russian economy.

Even in the long run, the Russian central bank might compensate for absent foreign financing. It has already started increasing bank refinancing and broadening the scope of securities and loans acceptable as collateral.

Beyond the issue of foreign financing, the Russian economy might suffer from significant capital outflows (see chart below). This could trigger a further recession of the Russian economy, especially if not compensated for by rising oil prices.

The immediate reaction of financial markets has been mixed so far:

Even though Russia's stock market (here measured by the RTS index) has declined heavily after both announcements of recent sanctions, it is not clear whether this is a sustainable trend.

The same holds true for Russian CDS spreads and government bond yields; they have increased significantly after the announcements of the sanctions.

Russian CDS Spreads

Russia - Government Bond Yields

Finally, the Ruble has experienced a sharp devaluation since the beginning of 2014. However, it seems that only the second announcement of sanctions (in July 2014) has had a significant impact on the currency.


A final thought on the importance of sanctions   
Here is a final chart on the importance Russia plays in today's world economy. I find that interesting to keep in mind when following the current debate of economic consequences of sanctions.