Thursday, January 22, 2015

Ukraine Conflict – A Summary of EU Sanctions on Russia

Since last summer, the EU is refining its sanctions on Russia. The sanctions intend to “increase the costs of Russia’s actions to undermine Ukraine’s territorial integrity, sovereignty, and independence and to promote a peaceful settlement of the crisis”.

Here is a brief of what is forbidden:

Imagine you have a son. He is 25 years old and working as a plumber. Unfortunately, he is smoking 50 cigarettes a day. You want him to quit smoking. How can you do that? The most obvious tactic is to stop giving him cigarettes. Second, you will stop awarding him money to avoid him spending it on cigarettes. But what if your son doesn’t need your money? After all, he is working as a plumber. That is why you could try to forbid him working as a plumber, thus restricting his money making capacity.

EU sanctions do basically the same with Russia: To avoid Russia using its military capacity in Ukraine, they want to weaken Russia’s military and financial capacity. The financial capacity is targeted directly through disconnecting the Russian financial sector and, indirectly, through targeting Russia’s main source of revenues, its energy industry.

EU entities cannot sell dual-use goods and technology which are or may be intended for military use or for a military end-user. (Art. 2 of EU Regulation 833-2014)

Dual use items can be used for both civil and military objectives. They are detailed on almost 300 pages in EU Regulation 428/2009 and include categories such as nuclear, electronics, computers, telecommunication, marine, and aerospace.

EU member states’ authorities can grant exceptions and allow for execution of obligations under a contract concluded before August 1, 2014.

EU entities cannot sell (or provide technical, brokering, and financial assistance related to) dual-use goods and technology to nine Russian entities (Art. 2a of EU Regulation 833-2014)

The target companies are

  • JSC Sirius,
  • OJSC Stankoinstrument,
  • OAO JSC Chemcomposite,
  • JSC Kalashnikov,
  • JSC Tula Arms Plant,
  • NPK Technologii Maschinostrojenija,
  • OAO Wysokototschnye Kompleksi,
  • OAO Almaz Antey, and
  • OAO NPO Bazalt.

EU entities need official authorization to sell (or provide technical or financial assistance related to) certain oil & gas technologies either to Russian buyers or for use in Russia (Art. 3 and Art. 4.3 of EU Regulation 833-2014)

Annex II of EU Regulation 833-2014 specifies the technologies at hand.

The EU has limited national authorities’ discretion to some extend:

  • First, authorization shall not be granted if the material pertains to deep water, Arctic, or shale oil exploration or production.
  • Second, authorization shall be granted for exports executing contracts concluded before August 1, 2014.

EU companies cannot provide services for deep water, arctic, or shale oil exploration in Russia (Art. 3a of EU Regulation 833-2014)

This ban is generic and, as opposed to the above, not limited to oil & gas technologies. However, the restriction does not apply to contracts concluded before September 12, 2014.

EU firms cannot deliver technical or financial assistance to Russian entities related to military technology and equipment on the Common Military List of the EU (Art. 4 of EU Regulation 833-2014)

You better glance at the Common Military List to get an idea of what material we are talking about.

Contracts passed prior to August 1, 2014, are exonerated.

EU firms cannot provide investment banking services to some Russian credit institutions, aircraft- and defense groups, and energy firms (Art. 5 of EU Regulation 833-2014)

  • Credit institutions: Sberbank, VTB Bank, Gazprombank, Vnesheconombank, and Rosselkhozbank (Annex III of EU Regulation 833-2014)
  • Aircraft and defense groups: OPK Oboronprom, United Aircraft Corporation, and Uralvagonzavod (Annex V of EU Regulation 833-2014)
  • Energy firms: Rosneft, Transneft, and Gazprom Neft (Annex VI of EU Regulation 833-2014)


Tuesday, January 13, 2015

TLAC for G-SIBs tackle TBTF. – “Resolution is not resurrection. But nor is it insolvency.”

The Financial Stability Board (FSB) wants to make banks safer. For this monumental task, it puts every possible means on the table: TLAC, G-SIB, TBTF, BSCB, RAP, BIS, RWA, CET1, BRRD, SPE, and QIS.

Frankly, what is happening here? Let’s for a moment forget about all the shortcuts and talk about the basics. The overarching principle is the following: If a bank is in crisis, it should be, first, up to the shareholders and, second, up to the unsecured and uninsured creditors to bear any loss. This is to ensure that the bank can accomplish an orderly resolution process, either to recapitalize or to disappear.

How can we achieve this? The buzzword here is TLAC.

What is TLAC?

TLAC means total loss-absorbing capacity. It consists of liabilities that mature in at least one year and can be transformed into equity. In other words, people who have lent money to a bank will no more be paid back. Instead, they receive shares of the bank that is about to die. However, this will only apply to unsecured and uninsured creditors. Obviously, if all creditors, including depositors, were concerned, we could not avoid a bank run.

To make banks safer, the FSB suggests imposing minimum TLAC levels:

  • Pillar 1 Minimum TLAC: TLAC must represent at least 16 – 20 % of the bank’s risk-weighted assets (RWA) and, in addition, be at least twice the Basel III leverage requirement.
  • Pillar 2 Minimum TLAC: Depending on the complexity of the bank, home resolution authorities can impose additional TLAC requirements.

Together, Pillar 1 and Pillar 2 TLAC are called “external TLAC”.

Who needs to meet TLAC requirements?

First, a bank only needs to hold minimum TLAC, if it is a global systemically important bank (G-SIB).

Second, TLAC must, in principal, be issued by a resolution entity inside the banking group. A resolution entity can be a parent company, (intermediate) holding company, or, depending on the preferred resolution strategy of the firm, a subsidiary operating company. If not issued by a resolution entity, liabilities can still be recognized as TLAC if they are qualified as Tier 1 or Tier 2 capital instruments under applicable consolidated capital requirements.

Third, inside a G-SIB, there might be some entities, which are, on their own, big enough to trigger a bank run. This is why the FSB intends to distinguish so-called material subsidiaries inside the group that have to meet proper TLAC requirements. A subsidiary is material if it

  • either represents more than 5 % of the consolidated risk-weighted assets of the G-SIB group;
  • or represents more than 5 % of the consolidated revenues of the G-SIB group;
  • or represents a leverage exposure that is larger than 5 % of the G-SIB group’s total leverage exposure;
  • or exercises critical functions for the G-SIB group.

TLAC held by a material subsidiary is called “internal TLAC”. I find that a bit misleading as external and internal TLAC actually don’t add up to form total TLAC. Rather, they are two different ways to look at the same amount of liabilities.

The amount of internal TLAC applicable to any material subsidiary is set in proportion to the size and risk of the material subsidiary’s exposure. It should amount to 75 – 90 % of the (external) TLAC that would apply if the subsidiary were treated on a stand-alone basis.

When does all this apply?

TLAC requirements will not apply before January 1, 2019.

What is the problem?

Please go through the following FSB quotes and guess what the problem is:

If we want to avoid our Governments bailing out banks in a financial crisis, we need to avoid the risk of a bank run. As a matter of fact, it is the lack of confidence in banks and the financial system that triggers a bank run. In my view, the crucial question then is: Will customers understand that G-SIBs hold TLAC to avoid TBTF? My answer is no: I simply don’t think that you can build confidence with bureaucratic complexity.


The FSB press release and the consultative TLAC document, both dated November 10, 2014, are available here.

Tuesday, January 6, 2015

Raghuram Rajan’s Fault Lines – A 2011 crisis book still interesting today

In geology, fault lines are breaks in the Earth’s surface where tectonic plates come in contact or collide. In 2011, Raghuram Rajan has written a book about the fault lines in the global economy and explains how these fault lines affect the financial sector.

The book is well written; I especially liked the good mix of storytelling and academics. Here are some examples of fault lines in the global economy:

Export-led growth strategy

Countries pursuing an export-led growth strategy rely heavily on foreign consumers to stimulate the local economy. Typical examples are Germany and Japan after the Second World War and China since 2000.

Export-led growth typically has two phases:

  • First, the exporting country benefits from low local labor costs to sell abroad.
  • Second, upon increasing labor costs, the exporting country moves up the value chain of production and to the frontiers of innovation.

On the upside, an export-led growth strategy creates strong exporting firms, which are no longer constrained by the size of their domestic market. In addition, international competition forces exporters to remain competitive. The downside is an excessive dependence on the foreign consumer, often coupled with weak local household consumption.

“There is no natural, smooth, and painless movement away from export dependence to becoming a balanced economy.”

Character of bankers

How do bankers think? Raghuram tells the following story to explain:

In the 18th century, the French Government sold annuities. Annuities were bonds guaranteeing a payment of cash flows by the French Government until the bond holder’s death. Bankers reacted by arranging for young healthy women (with high life expectancy) to buy the annuities. Then, they pooled the annuity claims together and sold the resulting cash flows to investors. This early form of securitization actually worked well until the French Government defaulted, at the outbreak of the French Revolution in 1789.

What can we learn about bankers from this story?

  • Few have a better nose for good moneymaking opportunities than bankers. This stems from the competitive nature of banking where easy opportunities to make money are rare and where a banker’s performance is almost exclusively measured in terms of the money a banker generates.
  • Bankers invariably find the biggest edge in taking advantage of unsophisticated players and players who do not have the same incentive to make money.
  • Banker behavior tends to be self-reinforcing, at least for a while: Early success drives security prices up higher (often far away from fundamentals), making the business temporarily even more profitable until prices ultimately fall dramatically.
  • There is safety in numbers, as a responsible government cannot let all its bankers fail, given the likely collateral damage to the citizenry. This means that prices do not reflect proper compensation for the risks that bankers take.
  • “Pecunia non olet” (= “Money has no odor.”) means that the anonymity of money makes it a poor mechanism for guiding employees’ activities towards socially desirable ends.

“Because their [bankers’] business typically offers few pillars to which they can anchor their morality, their primary compass becomes how much money make.”

Why investment managers must assume tail risk

Investment managers are paid to generate excess returns (= alpha). This means that they have to outperform the expected return on the market. How can they do this? Here comes tail risk into play: Because it occurs very rarely, investment managers can hide it for a pretty long time and, thus, use it to generate alpha.

“It is the very willingness of the modern financial market to offer powerful rewards for the rare producer of alpha that also generates strong incentives to deceive investors.”

This is why risk-adjusted return measurement is so crucial, not only for regulatory compliance purposes but also as an instrument of management control.

Some additional quotes


Raghuram Rajan – Fault Lines – 2011