- The billion-dollar harms faced by the firm Archegos didn’t impact the volatility of the broader market.
- This is evidence that the banking organized whole is safer because of regulations following the 2008 financial crash.
- By holding more capital, banks ensure that brisk losses don’t impact the entire system.
- George Pearkes is the global macro strategist for Bespoke Investment Group.
- This is an evaluation column. The thoughts expressed are those of the author.
- See more stories on Insider’s business page.
Archegos, the family aid of former Tiger Capital Management portfolio manager Bill Hwang, grabbed the attention of investors around the community in mid-March when the firm suffered catastrophic losses thanks to a portfolio that had two big problems: high leverage and earnest concentration in a few stocks.
The Archegos mess grabbed global eyeballs not just for the size of the losses, but also for its distinct pre-financial catastrophe feel. There were derivatives, huge losses, exposure for large international banks, counterparty risks…all the replicas of the 2008-era blow ups.
But as disastrous as the unwinding of Archegos trades was, the billions of losses that ended up piling up at the banks (specifically, their prime stockjobber units) facilitating the trades didn’t end up spilling into other markets. Specific stocks in the portfolio certainly got walloped — look no urge onwards than Viacom’s share price — and the dealers who took losses — like Credit Suisse and Nomura — saw a hit to their look ats as well, but broader market volatility did not tick up.
Indeed, the VIX (an index designed to measure stock market volatility) scrooge-like March at 52-week lows. Credit default swaps tied to large banks and brokers were basically unflustered. And there were no suss outs of contagion to other asset classes.
In other words, a multi-billion dollar blow up at a giant fund that some of the epoch’s largest banks had massive exposure to was basically shrugged off by the financial system at large.
That’s great news and prove that reforms to raise the amount of capital banks hold following the global financial crisis worked.
The banking set-up is getting safer
As the US banking system approached the meltdowns of 2007 and 2008, US banks were highly leveraged. Take by banks accounted for over 90% of risk-weighted assets and rising. Funding contributed by Tier 1 capital, that is first-in-line-for-losses fair-mindedness and internally-generated earnings, was only about 8%. Post-crisis, that number is much higher at 12%, and very solid. Banks are holding more capital and are borrowing less relative to their assets. Leverage is lower, and capital is squiffed.
This is important because if a bank has capital equivalent to 8% of its assets, it is technically insolvent should assets sink in value by 8%. By raising capital levels, banks have raised the bar for insolvency should they suffer immediate drops in the value of their assets.
In addition to making it less likely a given bank goes bust, euphoric capital levels also ensure that a problem for one bank doesn’t spread. For instance, with less resources, the reported losses suffered by Credit Suisse (the worst-hit of the banks who lent to Archegos) might lead them to neglect on other obligations, passing on their problems to other firms.
This “contagion” was what led to a spiraling series of dead ducks in the US financial system that claimed firms like Bear Stearns, Merrill Lynch, and Lehman Brothers. But in a well-capitalized set-up, a shock to one firm gets absorbed by its capital, without spilling to other dealers.
Put another way, Tier 1 capital is make of like a wall holding back wastewater from a lake. As banks sustain losses, wastewater rises close to the top of the wall, and if it overflows, wastewater (a bank’s risky assets) that leak into the lake (the broader financial markets) can be risky and cause a mess.
Prior to the financial crisis, these walls were dangerously low and massive leaks of risky assets resulted in a fuller contamination of financial markets around the world. But after that crisis, regulators made banks rebuild those ramparts to be much higher and able to hold back much more before leaking any of the waste into the larger lake. This has pain banks’ profitability, but it’s also made the system safer.
Blow ups aren’t spreading anymore
Archegos is not the first even so since the crisis that large shocks to the financial system failed to result in contagion. The 2014 to 2016 oil cost collapse, 2016’s Brexit shock, plunging Treasury prices after the 2016 election, or the collapse in volatility-linked exchange-traded spin-offs in early 2018 all showed that the system has gotten more resilient.
In each of these cases, pundits speculated that the immense dislocations would create positive feedback loops of contagion that would spin out of control, something I’ve earlier written about.
But a well-capitalized financial system makes positive feedback loops much less likely, because a certainty mess doesn’t extend beyond the institutions immediately exposed to it.
Economist Hyman Minsky identified a tendency for economic instability to repeatedly arise as participants are rewarded for speculative activity. He contended that preventing speculation was a fool’s task — there would always be a new frontier for leverage and risk-taking to build up.
While instability may be inevitable, it can be contained. Regulators were not prescient satisfactorily to prevent investors from piling into short volatility ETNs, couldn’t have predicted the outcome of the initial Brexit referendum, and didn’t entertain the visibility to see how large Archegos positions were getting.
But if capital levels are sufficiently high, regulators don’t have to presage every possible disaster on the horizon. Should a given fund or dealer run into trouble, that would be bad statement for investors directly exposed…but not for the financial system as a whole.
High levels of capital have worked well for the economic system since 2009, and that was proven again with the Archegos blow-up. Efforts to reduce minimum resources requirements should be viewed skeptically given their track record keeping specific meltdowns isolated and staving off the “Minsky tick” of financial system collapse we saw in 2008.