Investment Banks Get a Coronavirus Trading Pass

(Bloomberg Opinion) -- Regulators and central bankers, pressed to keep economies alive through the Covid-19 lockdowns, have whizzed through their crisis playbooks to pump liquidity into the financial system. The mission is noble, and essential: to make sure banks can support companies and individuals until business activity resumes. But the methods need to be scrutinized carefully. There’s plenty that can go wrong when you start going easy on the finance industry. 

For example, while supervisors have rightly lowered the demands on how much capital a bank should hold, they’ve also granted greater flexibility in how lenders make provisions for loans that turn bad. Equally troubling is a new move to ease the capital requirements on trading businesses that have come under extreme market strain. There’s a risk here of investors losing confidence in the handful of companies that are most critical to financial stability: the world’s biggest investment banks.

During the first quarter of 2020, Wall Street banks earned the most from trading in eight years, as mayhem in the markets forced clients to buy and sell securities at unprecedented speed. Yet global regulators — in the euro zone, the U.K., Switzerland and Canada — have decided to loosen the rules where firms didn’t do so well. Banks that faced trading losses that repeatedly exceeded their modeled forecasts will get temporary respite on how much additional capital they have to set aside to make up for the shortfalls.

Each regulator has relaxed these trading rules to varying degrees, a deviation from post-2008 global banking standards that could itself damage investor trust. But their goal is similar: The world’s biggest trading firms are getting leeway if they’ve scored poorly on a crucial indicator of market risk. It’s similar to a bank not penalizing a credit card borrower for overdue payments.

Banks set aside capital for the different types of risk they take on. Typically, credit — or lending — risk makes up most of their exposure. It accounts for 85% of European banks’ risk-weighted assets on average. Market risk — essentially the exposure from trading — accounts for between 3% and 4% of those assets on average in Europe. That ratio rises to as much as 6% at Barclays Plc and 7.7% at Deutsche Bank AG, two European banks with big trading operations.

Banks determine how much capital they need to set aside for that market exposure by measuring “value-at-risk” (VaR). That’s the maximum they could lose in a set time frame, based on recent historical prices. To make up for this being a backward-looking measure, and one that may not capture more extreme market moves, banks must also compute a measure of “stressed VaR,” reflecting how their positions might have fared in the worst market conditions; as the 2008 crisis showed, VaR on its own can give a false sense of the finance industry’s resilience.

The more frequently a bank’s VaR model undershoots the actual risk that emerges in real-world trading, the more capital the bank is required to hold. Or at least that was the case until the new rule relaxations. Regulators have now decided, temporarily, to tweak or do away with that additional capital requirement. In effect, they’re deciding to ignore an alarm bell.

The Swiss financial watchdog conceded that firms witnessed an increased number of trading losses that exceeded their forecasts when markets went wild over the past few weeks, but it says market volatility was the problem, not the banks’ models.

Yet as recently as February, France’s BNP Paribas SA was boasting of VaR’s reliability over many years, including during the 2008 crisis. It told investors that it had only experienced 22 incidents of VaR not getting it right between January 2007 and December 2019, less than two per year.

The new regulatory leniency raises questions about how much capital support the banks need. Companies will argue that their own VaR assessments have gone up anyway over the past quarter, meaning they’ll have to hold more capital to cover the exposure. Take JPMorgan Chase & Co., which reported earnings last week. Its average VaR for the quarter rose to $58 million from $37 million in the previous three months.

For some European banks, the capital impact of similar increases in VaR could be significant. For every 10% increase in its trading-risk assets, Barclays would see its common equity Tier-1 ratio drop by 14 basis points, while Deutsche Bank would see it fall 11 basis points, according to analysts at Berenberg. At JPMorgan, market risk rose by about 30% in the period.

Asking these lenders to set aside more capital at a time of unprecedented economic contraction may hurt businesses and individuals. But turning a blind eye to potential trading risk is a troubling alternative.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News.

©2020 Bloomberg L.P.