While most US readers believe that the Journal’s ideological bias is limited to its editorial pages, we have repeatedly seen (and commented on) skewed reporting as well. Specifically, the Journal tends to put a positive spin on economic (as opposed to company-specific) reporting.
Today’s object lesson is the Bank of England’s latest edition of its twice-a-year Financial Stability Report. The Journal’s and the Financial Times’ stories on it are leagues apart, and the FT, which clearly has the better grasp, hones in on the worrisome aspects.
By contrast, while the Journal did have the right title (“Bank of England Study Cites Rise in Risk-Taking“), the body put greater emphasis on the positive elements of the report. In addition, it implied the study pertained only to UK institutions. The first sentence reads:
The U.K. financial system is “highly resilient,” but strong and stable macroeconomic conditions have led to greater risk-taking, increasing the system’s vulnerability to shocks.
Nice try. While technically correct, any major financial institution worth its salt is licensed to do business in the UK. In fact, the Bank of England analyzes the activities of LCFIs (large complex financial institutions), which currently consists of ABN Amro, Bank of America, Barclays, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman, HSBC, JP Morgan Chase, Lehman, Merrill, Morgan Stanley, RBS, Societe Generale, and UBS. Of this group of sixteen, only three are British. Moreover, the report analyzed markets, not merely market participants, again giving it broad relevance. The report cited six major risk factors, only two of which are UK specific (and both happen to operate in the US):
Unusually low premia for bearing risk
High and rising leverage in parts of the corporate sector
Rising systemic importance of large complex financial institutions
Dependence of UK financial institutions on market infrastructure and utilities
Large financial imbalances among major economies
High UK household sector indebtedness
The first paragraph of the report is a splash of cold water (you seldom see anything this blunt from regulators):
The UK financial system remains highly resilient. But strong and stable macroeconomic and financial conditions have encouraged financial institutions to expand further their business activities and to extend their risk-taking, including through leveraged corporate lending, and the compensation for bearing credit risk is at very low levels. That has increased the vulnerability of the system as a whole to an abrupt change in conditions. Financial innovation and the growing use of credit risk transfer markets have increased the risk-bearing capacity of the system – but also bring some risks. Recent developments in the US sub-prime mortgage market have highlighted how credit risk assessment can be impaired in these markets and how participants can be hit by sharp reductions in market liquidity. Similar problem in a more significant market, such as corporate credit, could have more serious consequences.
Not surprisingly, the FT didn’t shy away from troubling content:
When the Bank of England released its latest, half-yearly Financial Stability Report yesterday, it featured an array of striking charts: leveraged lending is exploding, credit spreads are collapsing, securitisation is surging – and market volatility is hitting yet more lows.
Perhaps the WSJ reporter was inexperienced in bureaucrat-speak. But that is still a journalistic failing. Admittedly, the Financial Times article is more of an analysis, but the references to the report in other news stories gave the key finding: risk is on the rise, which the Journal endeavors to play down.
To see for yourself, here is the balance of the WSJ story:
Changes in the structure of the financial system and increasing use of credit derivatives have increased risk-bearing capacity. But such innovation also means that risks might emerge in new forms, the central bank said in its latest biannual Financial Stability Report.
“Financial markets have continued to be vibrant, core institutions are highly profitable and the economic outlook is favorable,” said John Gieve, deputy governor for financial stability at the central bank. “But risk-taking is increasing, including through higher leverage, lower margin requirements and relaxation of covenants.”
Mr. Gieve said the rapid growth of credit-risk-transfer markets is making more investors dependent on the continuation of market liquidity, which “could amplify the impact of shocks like a sharp reversal in credit spreads from their current low levels.”
It also might be affecting the depth and quality of risk assessment. Those organizing loans might be less concerned about credit quality if they bear little of the risk, the report found.
While the trading of credit risk allows for better diversification of risk, recent events in the U.S. subprime-mortgage markets have demonstrated that weaknesses can occur, the bank said.
Several vulnerabilities were judged to have edged up since the last report in July.
The bank cited a slight increase in the likelihood of significant stress occurring because of “unusually low” risk premiums.
“Benign current economic conditions, the greater dispersal of credit risk and confidence that market liquidity will remain high may have weakened risk assessment standards,” the report found.
Here is the rest of the Financial Times’ story:
But, for my money, the most thought-provoking image of all was a graphic I have never seen before – the size of global investment banks’ balance sheet. In recent years, this data has not attracted much attention, since analysts tend to focus on issues such as profits these days and measuring the banks’ assets is often hard.
However, the Bank has produced some estimates, based on reported accounts, and they make staggering reading; this decade, the assets of large complex financial institutions (LCFIs) have apparently swelled from $10,000bn to about $23,000bn. Most growth has occurred since 2003.
At face value, this looks extremely odd. After all, the golden mantra of the modern banking world is that LCFIs are currently removing risky assets from their balance sheets, in the name of improved risk management. Thus while banks used to hold loans on their books – leaving them exposed to associated default risk – they now often sell these to outside investors, either through direct loan sales or securitisation.
The consequence is a business model known as “originate and distribute”. And it should imply that the LCFIs are becoming slimmer beasts – not fattening up.
So what on earth is going on? Some of the Bank’s brightest brains have been puzzling about this recently, and think the main source of growth lies in an expansion of the banks’ trading assets. That may simply reflect the fact that the pool of tradeable instruments has grown this decade – giving bankers more toys to play with.
But the Bank also suspects that trading assets are rising because LCFIs are now taking much bigger trading bets, in an effort to boost returns in a low volatility world. The banks themselves deny this is any cause for concern since the time-honoured tools they use to measure trading risk – namely “value at risk” (VAR) models – are not signalling problems. However, the Bank, quite rightly, suggests these VAR models are being distorted by low market volatility. Moreover, the sheer speed at which banks’ revenues are rising implies that somebody, somewhere must be taking bigger punts. After all, it is hard to produce an annual 35 per cent rise in trading revenues on the basis of innovation alone.
In addition to this, however, the Bank also sees a second reason for the rise in trading assets: the “warehousing” effect. This is when banks use the “originate and distribute” model, they temporarily hold originated assets before selling them on. In theory, a warehousing period should be small. But if something ever made it hard to sell assets, these could unexpectedly back up on the banks’ books, giving them a nasty shock – of the sort that occurred, on a small scale, when the sub-prime securitisation market temporarily shut down.
Of course, any sensible bank would respond to this risk by carefully limiting the volume of business it originates and distributes. But that is not how Wall Street or the City works. After all, bankers win bonuses by making hay when the sun shines — not for crying wolf. Hence the pressure to keep ratcheting up risk. Or as the Bank says: “The incentive structures faced by managers may be contributing to a heightened emphasis on scale, revenue growth and market share.”
Since central bankers are an understated species, the Bank carefully avoids sounding too alarmist about this. Perhaps that is wise: right now I cannot see anything likely to spoil this frenetic credit party, at least in the short term. Moreover, a veritable army of bankers keeps telling me that innovation and risk transfer is changing how leverage works – meaning some of the old rules about the credit cycle no longer apply. Some policymakers appear to believe this, too, particularly in Washington. But whenever I listen to these arguments about how we have moved into this Brave New World, I also hear uncanny echoes of the last internet boom. It is hard to read today’s report from the Bank and not feel worried. Page 31 – and the chart titled “LCFIs’ total assets” – is a good place to start.