The crisis of 2008 rocked the global economy to its very core. Factors from both Main Street and Wall Street contributed to the outbreak of the crisis, with neither party acting independently of each other. The roots of the damage are broad and deep. Cheap credit and excess liquidity led to the systematic underpricing of risk, resulting in:
- Over-leverage embedded within the financial system caused, in part, by 10 years of low, long-term interest rates.
- Enormous growth in foreign capital and the associated impact on the balance of payments.
- A decline in lending standards through misaligned remuneration policies leading to a bubble in credit and, in turn, the housing market.
As demonstrated in mid-2008, this environment was unsustainable. The US sub-prime market collapsed and with it Bear Sterns and Lehman Brothers, along with the near collapse of a number of other systematically important institutions. The cost of credit soared, emergency policy measures were imposed, and depression was narrowly avoided.
The Current Environment
Two years on, the environment has evolved. Emergency policy measures undertaken during the crisis have left government finances weakened with austerity measures now being implemented. Last week Ireland, as widely anticipated, struck a deal to inject an additional €10bn into three financial institutions, signalling that further rounds of stress on government finances are likely to come. We expect to see significant increases in the volumes of sovereign debt issuance and higher volatility in foreign exchange (FX) and interest rate markets.
Significant government debt issuance along with quantitative easing programmes will have an inflationary effect on the economy. Recent falls in house prices and weak consumption levels have to-date mitigated this effect, however this does not remove the threat in the longer term. The relative attractiveness of currency as a store of value is likely to be affected as precious metals increase their relative attractiveness to currency as a store of value. It is worth noting that we do not believe that the highs reached during the 1970s will be seen again, for two reasons:
- Capital controls during the 1970s limited investment opportunities along with the number of investment vehicles.
- The silver market was being manipulated by the Hunt Brothers, affecting the pricing of all precious metals.
Treasury portfolios will have to be re-evaluated to hedge against interest rate and FX volatility. We expect to see increased diversification away from assets sensitive to FX movements, in particular, towards precious metals as they increase their value relative to currency.
Increasing Capital Requirements
Over-leverage within the financial system was at the core of the crisis and since 2008 we have seen rounds of de-leveraging from both Main Street and Wall Street. Additional capital requirements are now being introduced with Basel III requiring a minimum core Tier 1 ratio on risk-weighted assets of 7%. However, the deadline for all of Basel III’s counter-cyclical measures to come into force has been set at 1 January 2019, well behind the expected date of 2012. When assessing the impact of the requirement on the banking community we need bear in mind a number of points:
- Eight years is a long time in financial markets. It is long enough to encompass the peak of the Nasdaq bubble in 2000, a bubble in equities, a bubble in credit, and the collapse in dozens of global financial institutions. As such, we would argue that this introductory period is too long.
- Risk-weighted assets (RWA) will increase as more assets and activities are deemed riskier, requiring changes in the composition of Tier 1 capital.
Banks will try to mitigate rising RWAs, for example by moving OTC derivatives to centralised clearing. However, the overall result will be lower returns on equity. The overwhelming temptation, therefore, will be to reduce the banks’ RWAs by potentially ceasing activities deemed too risky.
Increased central clearing will pose additional problems for financial institutions. Analysis carried out by the International Monetary Fund (IMF) suggests that OTC derivatives held at the largest banks in the US, Europe and the rest of the world could be under-collateralised by US$2 trillion.1 This would include having to find an additional US$200bn in initial margin and guarantee funds when standardised contracts are moved into central clearing houses and hold an additional US$70-140bn in regulatory capital to cover non-standard contracts they retain on their balance sheets.2
These changes will clearly have a deep and lasting impact on the operations of treasury. Repo markets have been identified by the IMF as a source of potential risk during significant market turbulence due to the full legal transfer of collateral and the freeze in trading since the collapse of Lehman Brothers. This adds extra weight to the argument for centralised clearing enhancing liquidity and reducing systematic risk.
The increased capital requirements announced by the Basel Committee have already been seen to have an effect on the banking community. Deutsche Bank has announced a rights issue set to raise €10.2bn to bolster its capital position. Going forward we expect to see an increase in the use of alternative forms of fundraising such as the use of sovereign wealth funds. The use of liquidity risk insurance fees to cover the cost of emergency public support has also been proposed. This would force financial institutions to internalise the cost of being unable to meet their liquidity needs in times of market stress and in turn assess their risky activities. All these factors will combine to increase the cost of funding.
2011 and Beyond
Despite these announcements, there remains a significant amount of uncertainty as to what lies ahead. Recent weaknesses in economic data have sparked worries over a double-dip recession. However, the relative resilience of equity markets does not suggest an imminent fall back into recession. From a treasury perspective we believe that analysis will need to be carried out in three areas:
- Review of capital management practices front to back will be necessary in order to effectively manage capital in the new environment.
- Greater robustness will be required around liquidity. This could involve liquidity risk insurance and/or changes to capital management processes.
- Increased requirements on the management of collateral, with additional collateral having to be paid to central counterparties and on non-standard OTC derivative contracts.
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