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