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The Credit Liquidity TrapMacro Credit Research
SSX and SBC, 26 November 2014Alberto Gallo, CFA
Head of European Macro Credit Research+44 (0) 20 7085 5736
Lee Tyrrell-HendryMacro Credit Analyst
+44 (0) 20 7085 [email protected]
Tao PanMacro Credit Analyst
+44 (0) 20 7678 [email protected]
Mateja PopovicMacro Credit Analyst
+44 (0) 20 7085 [email protected]
Rajarshi MalaviyaGaurav Chhapia
Chanchal Beriwal
2
The Credit Liquidity Trap
“There is always a temptation for the central bank to speak in a whisper, because anything that gets said reverberates so loudly in markets. But the softer it talks, the more the market leans in to hear better and, thus, the more the whisper gets amplified. So efforts to overly manage the market volatility associated with our communications may ultimately be self-defeating.” Jeremy C. Stein, Federal Reserve Governor, May 6, 2014
The persistence of current benign market conditions largely hinges on three key factors. First, continued strong investor confidence centres on a fragile euro area recovery with significant downside risks. In view of this, low levels of corporate default and volatility could be tested by a normalisation of global liquidity conditions. Second, strong risk appetite among global investors could be threatened by rising geopolitical tensions, growing vulnerabilities in emerging markets or an unexpected increase in global benchmark rates, which remain at historical lows. Any such unravelling of recent search-for-yield behaviour could prompt a sharp repricing of risk, which could be amplified by low market liquidity in key segments. ECB Financial Stability Review, April 2014
“The whole system relies on liquidity illusion: We know we can’t all buy or all sell all our assets the same day. If you don’t have a contingency plan if liquidity goes away, then you’re up the creek without a paddle” Peter Fisher, Blackrock Investment Institute, June 2014
Some broad combination of these pockets of evolving vulnerabilities—set against a backdrop of a rise in short-term interest rates or an unwinding of currently compressed risk and term premia—could prove disruptive. In particular, a tail risk where there was a precipitous attempt by investors to exit certain markets—perhaps exacerbated by outflows from ETFs and mutual funds as well as near-term market illiquidity—could trigger an abrupt and self-reinforcing re-pricing of a range of financial assets. IMF Article IV Consultation on the United States, June 2014
3
Corporate bond markets have grown and changed since the crisisFund and household holdings of corporate bonds (% of US corp. bond market)
Source: RBS Credit Strategy, Federal Reserve
0%
5%
10%
15%
20%
25%
30%
35%
1945 1951 1957 1963 1969 1975 1981 1987 1993 1999 2005 2011
Household ownership share Fund ownership share
4Source: RBS Credit Strategy, FRED
Asset managers face pressure as yield decline, fees stay the sameSome respond with lower fees, most hunt for more yield
0%
2%
4%
6%
8%
10%
12%
1956 1964 1972 1980 1988 1996 2004 2012
10y Bund yield
Asset Manager fees
5Source: RBS Credit Strategy, FRED
Asset Manager fees as a % of 10-year Bund yield
0%
5%
10%
15%
20%
25%
30%
35%
1956 1964 1972 1980 1988 1996 2004 2012
6
The beta trade: this time is different vs 2004-2007
Source: RBS Credit Strategy
Stylised efficient frontier. From “rating arbitrage” (pre-crisis) to search for high beta, nominal yield
0%
2%
4%
6%
8%
10%
12%
14%
0% 5% 10% 15% 20% 25% 30%
Volat ility
Expected return
QE effect
Today: inves tors buy unlevered, high risk assets (e.g. HY, cocos)
Pre-crisis: leveraged high-rated port folios (e.g. synthetic
CDOs, CPDOs)
“There are three ways to make a living in this business: be first, be smarter, or cheat” John Tuld, Margin Call (2011)
7
Compression in risk premia
Source: RBS Credit Strategy, FRED, Bloomberg. Date range: from 1999 to today (except EM HY where data is only available from Dec 2003 onwards).
0
500
1,000
1,500
2,000
2,500
3,000
$ IG € IG EM IG $ HY € H Y EM HY 10yUST
10yBunds
10ySPGBs
10y BTPs
V2X VIX P/E
LT average
CurrentMax
Min
20
40
60
80
100
120
8
Six years of exceptional returns for bond investors
Source: RBS Credit Strategy, Bloomberg, iBoxx
Cumulative returns of high yield bonds, investment grade, periphery, Jan 2009 - now
0%
50%
100%
150%
200%
250%
300%
U K H Y EuropeHY
US HY $ EM IG U K IG Ireland US IG EuropeIG
Portugal Italy Spain
Periphery
IGHY
9
The end of the beta trade?
Source: RBS Credit Strategy
High-beta credit continues to weaken while Euro IG stays resilient, total returns, 100 = 31 Dec 2013
86
90
94
98
102
106
110
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Euro IG US IG
Euro B US CCC
Cocos Corporate H ybrids
US Distressed
10
1. The architecture of the bond market has changed. The corporate bond market has grown in size as well since the crisis (from $6tn to roughly $10tn in the US). Households and especially mutual funds now own a larger share of credit
2. More mutual funds means more market participants in competition to outperform each other. Low yields have put pressure vs fee structures. Some asset managers have reacted by lowering costs – most instead have taken more risk.
3. Unlike pre-crisis, the search for yield since 2009 has manifested itself as a search for beta. This is different than pre-crisis, when investors were mostly leveraging highly rated assets. Today, investors rely less on rating agencies and building exotic/leveraged products is more difficult. The preference is for high nominal yield products, some of which have embedded leverage (e.g. contingent capital)
4. As a result, the last five years have seen strong performance in high beta bonds, including high yield, corporate and financial hybrid bonds, and periphery – this was accompanied by constant inflows into mutual funds
5. But as monetary policy normalises, the market is vulnerable to re-pricing, and the bottleneck of trading liquidity remains tight
11
Exit risk: Policy normalisation and risk repricing“Now, back to Macro. What is your exit strategy? The players won't be in on the scam, so they'll all think it's their lucky night, but you'll never get them out of there with their winnings, they'll gamble it all back. That's Vegas and that's your problem.”
Roman Nagel, Ocean’s Thirteen
12
What is liquidity? Systemic and refinancing liquidity risks are low
EUR 3m Libor-OIS spread, bp
Source: RBS Credit Strategy, Bloomberg
Debt maturity wall for European IG corporates, % of total debt
Source: RBS Credit Strategy, Bloomberg. *Included all non-financial corporates in iTraxx Main
0%
10%
20%
30%
40%
50%
60%
2014 2015 2016 2017 2018 2019 2020onwards
0
20
40
60
80
100
120
140
160
180
200
2006 2007 2008 2009 2010 2011 2012 2013 2014
13
But transactional liquidity is low: RBS liquid-o-meterTrading liquidity in US credit markets continues to decline, but is improving in Treasury markets.
Source: RBS Credit Strategy, Bloomberg, SIFMA, MarketAxess.
0
20
40
60
80
100
120
140
160
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
US T reasuries US corporate bonds100 = D ec 2006
14
Market grows but dealers pull backMarket size ($bn) vs dealer estimated holdings of corporate bonds (% of market size)
Source: RBS Credit Strategy, Bloomberg, SIFMA, MarketAxess, Federal Reserve Bank of New York
0.0%
0.3%
0.6%
0.9%
1.2%
1.5%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
10,000Credit market s ize (RHS) Dealers ' est. holdings (LHS)
15
Lower liquidity is partly a symptom of lower dealer inventoriesUS corporate bond dealer inventories, $bn.
Source: RBS Credit Strategy, Federal Reserve Bank of New York, SIFMA, MarketAxess. Note: because corporate bond dealer inventories are not broken down prior to 2013, we have assumed IG and HY inventories are in the same proportion as the average from 2013-present.
0
50
100
150
200
250
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
IG + HY CP + RMBS + CMBSIG HYCP RMBSCMBS
16
Low volumes and higher transaction costs
Average daily trading volumes, %mkt size
Source: RBS Credit Strategy, SIFMA
Index members’ bid-ask, % CDS spread
Source: RBS Credit Strategy, Bloomberg
0.0%
0.1%
0.2%
0.3%
0.4%
0.5%
0.6%
0.7%
0.8%
05 06 07 08 09 10 11 12 13 140%
5%
10%
15%
20%
25%
30%
35%
2006 2007 2008 2009 2010 2011 2012 2013 2014
CDX HY Xover CDX IG
17
Markets are polarised between few liquid and many illiquid bonds
Distribution of bond by trading frequency in US TRACE
Source: RBS Credit Strategy, Michael A. Goldstein (Babson College)
0
200
400
600
800
1,000
1,200
0 50 100 150 200 250 300Number of bonds
Num
ber o
f tra
des
in 3
0 da
ys
Percent of trading days per quartile
Source: RBS Credit Strategy, IMF GFSR Oct 2014
0
10
20
30
40
50
60
70
80
90
100
0 25 50 75 100
Percent of index const ituentsPe
rcen
t of t
radi
ng d
ays
Corporate EM Bond Index HY
More liquidLess liquid
18
High quality collateral is shrinking
QE effects: repo volume goes down as Fed holdings go up Daily ave. collateral value in tri-party repo vs Fed holdings, $bn
Source: RBS Credit Strategy, SIFMA, Federal Reserve Bank of New York
Collateral velocity is going down Overall collateral volume (blue) vs sources of collateral (green)
Source: RBS Credit Strategy, Singh, M. (IMF, 2012 & 2013)
200
700
1200
1700
2200
2700
2011 2012 2013 2014
OtherTreasury securit iesAgency securitiesFed holdings of Treasury securit iesFed holdings of agency securit ies Central Collateral Desk
$10tn (2007) $5.8tn (2010) $6.1tn (2011) $6tn (2012)
$1.7tn (2007) $1.1tn (2010) $1.1tn (2011) $1.0tn (2012)
Hedge funds
$1.7tn (2007) $1.3tn (2010) $1.3tn (2011) $1.8tn (2012)
Securities lending via custodians
Money market funds
de minimis
Commercial banks
Velocity (overall collateral/sources)
2007: 3.0 2010: 2.4 2011: 2.5 2012: 2.2
“suppliers”“users”
19
Do you get paid for illiquidity? Not much
Deviations of estimated bond liquidity risk premia from historical averages
Source: RBS Credit Strategy, Bank of England
Decomposition of €HY spreads, bp
Source: RBS Credit Strategy, Bloomberg, Moody’s
0
200
400
600
800
1000
1200
1400
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Volat ility riskD efault riskLiquidity risk
-200
-100
0
100
200
300
400
500
600
2000 2002 2004 2006 2008 2010 2012 2014
USD H YUSD IG (RHS)EUR IG (RHS)GBP IG (RHS)
20
Exiting stimulus can be painful
Source: RBS Credit Strategy, Bloomberg
Total returns during the taper tantrum (22 May – 29 August 2013)
-16%
-12%
-8%
-4%
0%
€ Fi
n T1
€ 1-
3yr
€ H
YS
&P 5
00S
pain
€ 3-
5yr
€ IG
Fin
sH
ealth
Cap
ital G
oods
Con
s N
on-c
ycM
ater
ials
€ IG
Italy
Con
s C
ycIn
dust
rials
Tech
Util
ities
Ene
rgy
BK
LN E
TF€
5-7y
r€
Fin
LT2
Telc
osX
over
JNK
E E
TF
$ H
YC
DX
HY
€ 7-
10yr
UC
00$
IGH
YG E
TFJN
K E
TFC
DX
EMPo
rtuga
lLQ
D E
TF$
EM IG
$ E
M H
Y$
EM
SO
VE
MB
ET
FE
MH
Y E
TFE
MLC
ETF
Gre
ece
IndicesSectorsPeripheryETFs
21
Tantrum 2.0 vs Tantrum 1.0
Source: RBS Credit Strategy, Bloomberg.
Total returns during the taper tantrum (22 May – 29 August 2013) vs 2014 sell off (30 June – 16 October 2014)
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
€ Fi
n T1
€ 1-
3yr
€ H
YS&
P 5
00Sp
ain
sov
€ 3-
5yr
€ IG
Fin
sH
ealth
Cap
ital G
oods
Con
s N
on-c
yc€
IGIta
ly s
ovC
ons
Cyc
Indu
stria
lsTe
chU
tiliti
esEn
ergy
BKLN
ETF
€ 5-
7yr
€ Fi
n LT
2Te
lcos
JNK
E ET
F$
HY
€ 7-
10yr
£ IG
$ IG
HY
G E
TFJN
K E
TFPo
rtuga
l sov
LQD
ETF
$ EM
IG$
EM H
Y$
EM S
ovEM
B E
TFEM
HY
ETF
EMLC
ETF
Gre
ece
sov
Taper tantrum 2014 tantrum
22
Liquidity survey: Are you prepared?
23
Liquidity survey: Are you prepared?
What could make liquidity get worse in the near term?
Source: RBS Credit Strategy
How do you address lack of liquidity
Source: RBS Credit Strategy
84% of investors think lack of liquidity is a potential systemic risk for credit markets
0%
10%
20%
30%
40%
50%
60%
70%
Fed getsmore hawk ish
Risinggeopolit ical
risk
Idiosyncraticrisk
Eurozonedef lat ion
Other0%
10%
20%
30%
40%
50%
60%
70%
Mov
e to
mor
eliq
uid
asse
tcl
asse
s
Incr
ease
cas
h
Hol
d to
mat
urity
/laun
chfu
nds
with
targ
et d
ates
Trad
e m
ore
CD
S in
dice
s
Oth
er
Intro
duce
rede
mpt
ion
fees
24
Liquidity optimisation
Portfolio managers can improve their liquidity profile without losing yield Indicative yields are for 5-year BBB-rated bonds
AssetOld
weightNew
weightLiquidity rank (10 = highest) Yield
Cash 5% 4% 10 0.0%Sovereign (Italy and Spain 3-yr) 0% 5% 9 0.7%Covered (Italy and Spain) 0% 0% 8 1.3%€ IG corporate 95% 90% 7 1.8%€ HY corporate (BB) 0% 0% 5 3.0%CMBS 0% 0% 3 3.0%CLO 0% 1% 2 4.2%Private placements 0% 0% 1 3.5%Old portfolio 100% 100% 7.15 1.7%
Optimised portfolio 7.17 1.7%Source: RBS Credit Strategy
Potential solutions include:
Increasing holdings of liquid assets
Changing liabilities structure (target funds)
Charging fees (bid-ask or %) to withdraw funds
Rationing withdrawals or increasing delay
71% of investors in our survey were trying to manage their liquidity risk
Portfolio liquidity optimisation: reducing the weight of IG corporate bonds while increasing the weight of sovereigns and adding a higher yielding bucket to achieve similar yield with higher portfolio liquidity
25Source: RBS Credit Strategy, Markit, Bloomberg. RBS JBI is an indicator of relative value of credit based on valuations, fundamentals, investor/issuer behaviour.
Vulnerable areas: High yield markets
0%
50%
100%
150%
200%
250%
300%
350%
400%
01 02 03 04 05 06 07 08 09 10 11 12 13 14
USEurope
Overvalued
Undervalued
RBS Junk Bubble Indicator (JBI) shows that European HY is no longer cheap
26
Flows of funds: Highest volatility in retail/HY segments
Source: RBS Credit Strategy, AMG US cumulative fund flows
-50
0
50
100
150
200
250
300
350
400
Jun 2010 Dec 2010 Jun 2011 Dec 2011 Jun 2012 D ec 2012 Jun 2013 Dec 2013 Jun 2014-10
0
10
20
30
40
50
60
70
80
Equity
Corp IG
Corp HY (RHS)
Loans (RHS)
Euro debt crisis
Yellen on HY
T aper Tantrum
27
The dangers of deflation: Small firms with high leverage will suffer
There is a weak tail of periphery firms with high leverage Share of listed companies by Net Debt/EBITDA, % total firms
Source: RBS Credit Strategy, Bloomberg
Default rates are low, but bad loans are rising European HY default rates vs average bank NPL%
Source: RBS Credit Strategy, Moody’s, Bloomberg, bank filings
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
U K Ire Fra Ger Ita Esp Gre Por
<0 0-1 1-2 2-3 3-4 4-5 >5
0%
2%
4%
6%
8%
10%
12%
14%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
HY default rates Average bank NPL%
28
Vulnerable areas: Contingent capital instruments
…but do expect a steep drop when a conversion occurs How do you think the market will react to a conversion?
Source: RBS Credit Strategy
Investors are searching for yield Why are you buying cocos?
Source: RBS Credit Strategy
Investors are asking for more standardisation. Real money demand could retreat on recent restrictions
Yield is the top reason why people buy cocos, despite heavy losses expected upon trigger event
0%
10%
20%
30%
40%
50%
60%
70%
80%
Yield Conversion isunlikely
Lack ofalternat ives
Cheap vs risks
0
10
20
30
40
50
60
70
0 -2 -4 -6 -8 -10 -12 -14 -16 -18 -20
Avg expected drop: -15%
% answers
But high tail risk
Coco market price drop following a conversion
29
Cocos: Large divergence in conversion/cancellation risks
Source: RBS Credit Strategy; based on model estimates for a 7% conversion trigger and an 8.5% cancellation threshold
Conversion and coupon cancellation probabilities
IntesaBBVA
Barclays
SocGenDB
Nationwide
Credit SuisseCredit Ag Group
UniC redit
UBS
Danske
Lloyds
Santander
NordeaKBCHSBC
0%
5%
10%
15%
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Probability of >1 cancellation in 5 years
Probability of conversion in 5 years
High earnings volat ility, weak capital
Low earnings volatility, strong capital High earnings volatility, strong capital
Low earnings volatility, weak capital
30
Vulnerable areas: Credit ETFs
ETFs own a larger share of the credit market now Corporate bond ownership in the US, % total
Source: RBS Credit Strategy, Federal Reserve
Liquidity mismatches are rising Days for the full liquidation of credit mutual funds & ETFs
Source: RBS Credit Strategy, IMF
0
10
20
30
40
50
60
70
2007 2008 2009 2010 2011 2012 2013 2014
U.S. corporate bond total
U.S. high yield7-day lim it for redemption payments
0%
1%
2%
3%
4%
5%
2006 2007 2008 2009 2010 2011 2012 20130%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%Money market funds Closed-end funds
ETFs Mutual funds (RHS)
31
1. Trading liquidity is low in corporate bonds. It has declined by around 70% since the crisis. Liquidity remains good on low-risk government bonds.
2. We measure trading liquidity using a combination of transaction costs, volumes and dealers’ inventories
3. Liquidity is polarised across areas of the bond market: few bonds trade every day, 80-90% do not
4. Are investors compensated for taking liquidity risk? Various indicators suggests they aren’t. Liquidity is a risk, no longer an opportunity
5. Which areas and instruments are most vulnerable? The low-end of the high yield market is fundamentally weak and exposed to deflation. It is also a highly retail- held market. Contingent capital instruments also bear strong negative convexity and lack standardisation, and are not priced according to risks
6. Is liquidity risk overstated? 84% of investors in our survey think lack of liquidity is a potential systemic risk for credit markets
7. The asset management industry can resist shocks, but some products may be vulnerable (e.g. credit ETFs)
32
Eurozone: Why liquidity will get worse
33
Banking systems: Euro area vs US
Source: RBS Credit Strategy, Bank of Italy, ECB, IMF, World Bank, FRED
5,605 - Number of banks - 5,783
3.1x - Bank assets/GDP - 0.8x
37 - Number of branches - 35 per 100,000 adults
22% - Bonds/total debt - 52%
16% - Mkt share of top 5 banks - 33%
€1,041bn - NPLs - $200bn
10.9% - NPLs/GDP - 1.2%
USEuro area
34
Stress test: Many passing banks are still weak
44% of banks failed or passed narrowly % by number and by total EU banking assets
Source: RBS Credit Strategy, ECB
Austria, UK and Germany have more narrow passes Assets as % of total banking system assets in the country
Source: RBS Credit Strategy, ECB
0%
10%
20%
30%40%
50%
60%
70%80%
90%
100%
Gre
ece
Cyp
rus
Aus
tria
UK
Italy
Bel
gium
Slo
veni
aP
ortu
gal
Ger
man
yIre
land
Fran
ceLa
tvia
Spa
inP
olan
dN
ethe
rland
sD
enm
ark
Finl
and
Hun
gary
Luxe
mbo
urg
Mal
taN
orw
aySw
eden
Fail Pass narrowly Pass
Narrow pass24%
(20% by total assets)
Pass56%
(77% by total assets)
Fail20%
(3% by total assets)
25
2969
35
Too big to fail has not gone awayBank asset size / GDP
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
200%
Dan
ske
UBS C
S
ING
Ban
k
San
tand
er
Rab
oban
k
HS
BC
Cre
dit A
g
BNP
Bar
clay
s
SEB
DB
KB
C
Soc
Gen
Uni
cred
it
BES
RZB
JPM
BAC C
iti
GS
MS
Source: RBS Credit Strategy, Bloomberg, company filings
36
0
10
20
30
40
50
60
70
80
Museums High schools Secondaryschools
Primaryschools
Pharmacies Kindergartens Hotels Bankbranches
Costs are still high
Source: RBS Credit Strategy, OECD, Istat
Number of branches per 1,000 people, Italy
37
Interconnectedness: Cross-holdings in Europe’s banking system
Source: RBS Credit Strategy, Bloomberg, company filings. Red = bank, Grey = sovereign, Blue = other
3.15%
Mediobanca8.7% UniCredit
Generali
12.2%
IntesaMonte
Groupama4.9%
Mediolanum
3.4%Credit AgricoleSocGen
0.52%
Natixis AM
AXA 0.52%
BNP
0.1%0.34%
Toro
1.4%1.3%
100%
0.10%
0.6%
2.45%
4.5%
Libya
2.6%
SantanderCredit Suisse
3.65%
France 2.51%
Deutsche Bank1.21%
0.01%
Commerzbank
0.19%
Allianz
Germany
Italy
17%
2.27%
2.28%
Bankinter
0.15%
2.8%UBS
Singapore
6.4%
Norway
3.26%
BBVA
0.22%
6.43%
Abu Dhabi
POP
State Street
0.14%
Caixa Geral4.92%
Portugal Telecom
0.16%
Telefonica
RepsolCaixabank
2.81%
11.6%
5.6%
5.75%CRH
4%
Veolia
5%
IberdrolaQatar9.42%
Gas Natural
Caixa Holdings34.6%
1.7%
BlackRock6.44%
0.07%
1.18%
9.88%
Fondo Strategico
77.7%
2.57%
38
Current leverage ratio requirements are too low
Bank losses in previous crises Losses as % of loans and assets
Source: RBS Credit Strategy, Bloomberg, Company filings
European banks are generally between 3-4% capital Leverage ratio, Q4 2013
Source: RBS Credit Strategy, Company filings. Using our estimates for Intesa and UniCredit
We estimate that banks need to reach a leverage ratio of 5.8% to insulate sovereigns from the cost of a crisis
Bail-in is only useful for idiosyncratic losses. 3% leverage ratio is insufficient
0%
5%
10%
15%
20%
AIB
Ang
lo
NB
G
Bank
ia
Amag
Mon
te
HB
OS ML
BoI
WaM
u
B&
B
Wac
h
Nro
ck
SN
S
UB
S
Dex
ia
Losses as % initial loans Losses as % initial assets
0%
1%
2%
3%
4%
5%
6%
BBV
A
Inte
sa
San
tand
er
Rab
oban
k
Uni
cred
it
KBC
Nor
dea
ING
Ban
k
Cre
dit A
g G
roup
BN
P
Soc
Gen
AB
N
Lloy
ds
UB
S
CM
ZB
Dan
ske
DB
Bar
clay
s
CS
Leverage ratio
39
Bank capital is near a 200-year low. More capital = less liquidity…
Source: RBS Credit Strategy, FDIC, Historical Statistics of America
0%
10%
20%
30%
40%
50%
60%
70%
1834 1844 1854 1864 1874 1884 1894 1904 1914 1924 1934 1944 1954 1964 1974 1984 1994 2004
Book value of equity / total assets for US banks
40
Capitalism without capital: The RWA optimisation arbitrage
Source: RBS Credit Strategy, Bloomberg
Large banks have optimised risk weights, but absolute capital levels remain low
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000
Credit Ag
HSBC
BNP
DB
Barclays
Soc Gen
Santander
BPCELloyds
UBSNordeaCS
UniCredit
ING
BBVA
Intesa
Rabo
Natixis
DanskeABN
SHSEB
PohjolaNwideDeka
LBBWDZ
Balance sheet size, EUR bn
RWA % total
41
Is more stimulus a solution?
Source: RBS Credit Strategy, Bloomberg, Federal Reserve, ECB, Bank of Japan, Bank of England
Central bank assets, $tn
0
2
4
6
8
10
12
14
16
18
2007 2008 2009 2010 2011 2012 2013 Now 2015E
BoE
BoJ
EC B
Fed
PBoC
42
The QE infinity trap: Further easing expectations can delay investment
Tighter fiscal policy than when the US and Japan did QE Government deficit, % GDP
Source: RBS Credit Strategy, IMF
Drops in interest rate do not seem to boost investment Change in US corporate investment after certain events, %
Source: RBS Credit Strategy, S.P. Kothari, J. Lewellen, J. Warner, the Economist (data from 1952 onwards)
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
1 2 3 4 5 6Quarters after event
1 ppt decrease in interes t rates
10% increase in profits10% increase in return to shareholders
-14%
-12%
-10%
-8%
-6%
-4%
-2%
0%
2000 2002 2004 2006 2008 2010 2012 2014
Euro area USJapan
IMF forecas ts
Start of Fed QE
Start of ECB QE?
Start of BoJ QE
BoJ QE expansion
(Abenomics)
BoJ QE expans ion
43
The credit supercycle
Source: RBS Credit Strategy, ECB, FRED, Bloomberg
?
0
10
20
30
40
50
60
70
52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14
US GDPUS credit market debtEuropean credit m arket debt
Com petition & credit control introduced / Bretton Woods breaks down
Big Bang (UK) Glass-Steagall Act repealedFinancial crisisQuantitative eas ing
$tn
You are here
Asset bubbles
Deflation
44
Source: Google images
Conclusions: Learn to live with low liquidity
1. The size and shape of bond market has changed. There are more bonds, less trading liquidity and more leveraged products
2. Bond markets are vulnerable to policy normalisation in the US and UK, and investors are not paid for liquidity risk. Standardising bond markets will take time
3. European banks are still weak and will remain focused on strengthening capital, and liquidity will remain scarce for now
4. Investors should learn to live with low liquidity, adjusting their asset mix and liabilities structure
45
Source: Google images
BibliographyBank of England | Financial Stability Report, June 2014
BlackRock | Setting New Standards: The Liquidity Challenge II, May 2013
International Monetary Fund | 2014 Article IV Consultation with the United States of America, Concluding Statement of the IMF Mission, June 2014
M&G Bond Vigilantes | Corporate bond market liquidity – flush or flushed?, 4 December 2012
ESMA | Transparency of corporate bond, structure finance product and credit derivatives markets, 10 July 2009
SEC Fixed Income Roundtable | Michael A. Goldstein: Corporate Bonds
Biais, B.; Declerck, F. (2013), Liquidity, Competition & Price Discovery in the European Corporate Bond Market, Toulouse School of Economics
Chen, G.; Cui, R.; He, Z.; Konstantin, M. (2013), Quantifying Liquidity and Default Risks of Corporate Bonds over the Business Cycle, Chicago Booth
Dick-Nielsen, J. (2013), Dealer Inventory and the Cost of Immediacy, Copenhagen Business School
Dick-Nielsen, J.; Feldhütter, P.; Lando, D. (2012), Corporate bond liquidity before and after the onset of the subprime crisis, Journal of Financial Economics 103
Ejsing, J. W.; Sihvonen, J. (2009), Liquidity premia in German government bonds, Swiss National Bank
Fisher, R. W. (2014); Monetary Policy and the Maginot Line, Federal Reserve Bank of Dallas
Gallo, A. (2014); Fed has grown complacent on credit market risk, Financial Times
Scott-Quinn, B.; Cano, D., European Corporate Bond Trading – the role of the buy-side in pricing and liquidity provision
Schultz, P. (1998), Corporate Bond Trading Costs and Practices: A Peek Behind the Curtain, University of Notre Dame
Singh, M. (2013), Collateral and Monetary Policy, IMF Working Paper
Carroll, C.D.; Slacalek, J. and Tokuoka, K. (2014), The distribution of wealth and the MPC: Implications of new European data, ECB Working Paper Series No 1648
Gallo, A. (2014), Regulators must act on coco bond risks, Financial Times
Gallo, A. (2014), A QE Boost for business lending, WSJ
46
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