America’s banks are more exposed to a downturn than they appear

The earliest depiction of the ouroboros—a serpent coiled in a circle, eating its own tail—was found in the tomb of Tutankhamun, a pharaoh who ruled Egypt around 1320BC. It was used in his funerary texts to depict the infinite nature of time, and later cropped up all over the place. In Ancient Rome it signified the seasonal cycle of the calendar year; in Norse mythology the snake was large enough to encircle the world. The idea is also an allegory for the modern financial system. It depicts how credit risk has been cycled out of banks, only to be gobbled up by them once more.

After the global financial crisis of 2007-09, lawmakers in America and Europe penned new rules to govern finance. These had two aims. First, to force banks to hold more capital against their assets, so as to cushion losses. Second, to curb the risky activities in which banks had indulged. Some, such as proprietary trading, were prohibited; others were simply discouraged, sometimes by assigning higher “risk weights” to spicier assets. Both aims are measured by “common equity tier 1 capital” or cet1, which divides bank equity by asset value, adjusted for risk weights.

At first glance, the effort has been a success. Big banks that held 5% CET1 in 2008 now hold 10-15%. Despite this, it is not clear that risk-weighting is doing what was intended. The rise of private credit and the growing popularity of derivatives through which banks sell credit risk to hedge funds imply that risk has been transferred out of the system. But the same firms taking the risk often turn around and borrow from the banks to fund themselves—cycling some of the risk straight back to the banks.

Start with the rise of non-bank lenders, such as those in private credit. The industry barely existed in 2007. Now it makes $1.5trn-worth of loans to firms. That is a small slice of the $14trn in debt that non-financial companies owe in America. However, it might well be the most dangerous. Large blue-chip firms, which rarely default, tend to rely on the $7trn corporate-bond market. By contrast, those companies that make use of private credit tend to be smaller, more indebted and riskier. Investors in private-credit funds are typically other non-bank financial institutions, such as insurance firms and pension funds.

The trouble is that leverage gets mixed in. Private-credit firms borrow some of the money they lend. Insurance and pension funds borrow against their investments to boost returns. Traced to its source, much of this lending will emerge from banks. After staying flat for years after the financial crisis, the amount owed to banks by American financial institutions has risen from $2.5trn in 2016 to $3.5trn now.

Next consider the spread of the “synthetic risk transfer” or srt. These derivatives are popular in Europe and becoming more so in America, as banks prepare to implement the final phase of post-crisis regulations. Lenders create a bundle from loans they have made. Say the package in question is worth $100. The lender then slices it into three tranches. If the loans sour, the first tranche will take the first $5 in losses. The next tranche will take the next $5 in losses. The third and final tranche will wear everything else. Banks typically hold onto that third tranche, but sell the first and second tranches to hedge funds or other investors. Thus if only half the loans are paid back, the bank would lose $40. Some $25bn of srts were issued by banks last year, offloading risk from perhaps $300bn in loans.

Again, the issue is how hedge funds and others pay for these derivatives. Annual returns from them are typically in the single digits, meaning such outfits often borrow to juice pay-outs. Nomura and Morgan Stanley are among the lenders that accept SRTs as collateral against loans, taking some of the danger.

In both examples there has been risk transfer. Hedge funds buying SRTs will take losses before banks do. A private-credit fund that lends to a company which goes bust will lose out first, before any failure reaches a bank. Still, both examples show the difficulty of trying to push risk from the banking system. Ultimately, banks are in the business of maturity transformation: taking short-term deposits to make long-term loans. They have an unassailable advantage when doing this because they have access to a lender of last resort, the Federal Reserve, which will lend cash freely against long-term assets to solvent institutions. Attempts to cut them out are a bit like playing whack-a-mole—or perhaps whack-a-serpent.■

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