BIS Report Health Of Banking

June 13, 2008

Elaine Meinel Supkis

The gnomes in Basel, Switzerland, the BIS, the 'Bank of International Settlements' that was set up after WWI to process the Himalayan mountain of interlocking debts from WWI, this group of ernest paper shufflers issue reports like clockwork. I paw through them because they have lots of neat graphs, charts and lists of numbers. One learns a lot from these things. Including how deluded everyone is at the very pinnacle of the global banking system. But then, the BIS didn't understand the collapse of the post-WWI banking system! They are too focused on keeping impossible constructs rolling rather than fixing obvious problems attendant to the collapse and fall of Great Empires. This quarterly report is full of business concerning the Derivative Beast as well as the problems with the dying Libor system run through London. As well as the dying dollar being artificially propped up by anxious traders who are swamping America with imports.

BIS Quarterly Review, June 2008

Overview: a cautious return of risk tolerance

Following deepening turmoil and rising concerns about systemic risks in the first two weeks of March, financial markets witnessed a cautious return of investor risk tolerance over the remainder of the period to end-May 2008. The process of disorderly deleveraging which had started in 2007 intensified from end-February, with asset markets becoming increasingly illiquid and valuations plunging to levels implying severe stress. However, markets subsequently rebounded in the wake of repeated central bank action and the Federal Reserve-facilitated takeover of a large US investment bank. In sharp contrast to these favourable developments, interbank money markets failed to recover, as liquidity demand remained elevated.

Mid-March was a turning point for many asset classes. Amid signs of short covering, credit spreads rallied back to their mid-January values before fluctuating around these levels throughout May. Market liquidity improved, allowing for better price differentiation across instruments. The stabilisation of financial markets and the emergence of a somewhat less pessimistic economic outlook also contributed to a turnaround in equity markets. In this environment, government bond yields bottomed out and subsequently rose considerably. A reduction in the demand for safe government securities contributed to this, as did growing perceptions among investors that the impact from the financial turmoil on real economic activity might turn out to be less severe than had been anticipated. Emerging market assets, in turn, performed broadly in line with assets in the industrialised economies, as the balance of risk shifted from concerns about economic growth to those about inflation.

I wish I was on the committee writing this report. It would not have come out in this fashion. These reports are like watching people trying to count and track a bunch of ping pong balls falling from the balcony above while ignoring a bunch of huge bowling balls crashing through the floor. They can be quite correct about the trajectory and velocity of the ping pong balls but totally clueless about the heft and destruction of the bowling balls! I suspect this is two fold: the BIS staff desperately want to believe that the floating currency/international debt systems are not fundamentally flawed and ready to crash like they did from 1933-1945. No, they want the BIS system to work, damn it.

Also, they want to please their bosses. These bosses want the system to work because it makes them rich. Hearing about flaws or terrible, screwed up trajectories is unpleasant. And we know that the messenger bearing bad tidings gets executed. For example, the above opening paragraphs of this latest report mentions 'emerging market assets...performe broadly...'---this is a reference to the surge in speculators pouring all their funds into commodity markets! Question: was this a good sign or a terrifying signal?

The BIS writers admit that this performance in the commodity markets has 'shifted...concerns...to...inflation.' Well, duh! Welcome to reality! I suppose the writers of this report are counting their pfennings and wondering how they will make ends meet. Does this motivate them to meditate on the topic as to how all wild lending periods end with massive inflation taking root in all commodities while the value of assets that normally rise in inflation, collapse in value? Does this report anywhere, mention the dread words, 'stagflation' or heaven help us, 'depression'?

Of course not! Nor does this report mention 'trade deficits in America' and the US budget deficits. Or a lot of important things. Nor do they chat about the rise and fall of empires. Nor is Iran mentioned at all. Certainly, the costs of the global boycott of Iran's oil and how this helped trigger a collapse of international banking and trade is also not mentioned. The US housing collapse is mentioned but thankfully, it is not blamed for being the cause. I do appreciate that tiny, itty bitty honesty.

Thankfully, this BIS report is filled with graphs. Here is an example:

The numbers on the right are insane. We are not looking at spreads of these assets that are 160 points apart, they are 16,000 points apart! All the numbers here are totally insane. They really mean that the fiction of these ABX instruments being anything useful or reasonable is false. The ABX market has gone totally haywire and off the cliff and basically, has crashed. To admit this means admitting to vast losses within the banking system. So they pretend there is still some tiny value to these 16,000 basis point spread flophouses.

Below is yet another chart from this report:

Monolines have been in the news lately. They are dying, too. They are actually rather on the dead side more than the living. But since they are only at a 800 basis point spread, this isn't considered to be too horrid. We can see the spread is widening, not narrowing. The North American and European banks have this huge jump in the spread, too, from January to March with the crest being right where Bears Stearns gave up the ghost. The US System went crazy trying to fix this hike in the spread and sort of succeeded. But to fix it required destroying what little reserves the Federal Reserve holds. Far from the banking system being set to rights, we can see it is going off the cliff. The Fed has saved, sort of, only one aspect and this, the 'public' parts, not the parts that can grind down our economic system into dust.

Below is the FRED© graph showing how bad things have become.

From 1914 till 2007, except for a few very tiny blips, the BORROW system the Federal Reserve uses to keep the banking system afloat barely rose above $5 billion. Then, starting in August, 2007, it begins to shoot straight upwards. The amount is now above $150 billion and will climb to over $250 billion by July. The red line is the 'new' BORROW system because the Fed has to keep opening new windows as it exhausts its capacity in other areas.

This graph is screaming proof that our entire banking system is dead. It is bankrupt. The fixes which the BIS staff alludes to in this report are all FAKE. They exist only to paper over the obvious, not repair financial damage. Let's look at another BIS graph from this report:

Two things: in 2004 when the flood of Funny Money™ came pouring into the banking system via goofy loans to obvious deadbeats, the AAA tranches were slightly smaller than AA tranches. Suddenly, the AAA sector took off and grew far, far, far faster than all the other tranches put together in just 2 years. It grew 4 times greater in that short span of time. Was this due to there being a sudden surge of good credit prospects in the markets in just 2 years?

Or was it rank fraud, lies about the prospects of debtors being a good risk? Secondly, note how, when the volume of these MBS instruments declined, it was nearly all in the AA or lower tranches. The AAA is still overwhelming. This graph is a fraud. The AAA rank is fake. This is why the monolines are in trouble, this is why all the organizations that rate these pieces of paper are in deep trouble and should be investigated and the heads of Standard & Poor, for example, should be arrested. The graph next door to the MBS graph shows that AAA tranches lost value nearly as steeply as the AA, A and BBB ones. The losses are over 30% overall and even though this has stabilized since the huge central bank rescues in March, this was due to the central bank isolating these dying AAA instruments by locking them up inside the vault at the central banks where no one can evaluate them or trade them in the open market. In other words, the value has been frozen at a totally fake level.

BIS: A turning point for equity prices?

Global equity markets broadly tracked events in credit and bond markets during the period under review. After falling from the start of the year, stock prices bottomed out around mid-March and began a gradual recovery . The S&P 500 Index, which by 17 March had lost 13% compared to end-2007 levels, gained almost 10% between 17 March and end-May. Equity markets in Europe and Japan, which had seen losses in excess of 20% between the turn of the year and 17 March, subsequently also displayed a strong recovery, with the EURO STOXX gaining 11% and the Nikkei 225 rising more than 21% until end-May. Reflecting the improved situation in financial markets during this period, financial stocks outperformed other sectors. By end-May, the investment banking and brokerage subindex of the S&P 500 had risen by 16% compared to mid-March levels, while similar subindices in Germany and Japan were up by almost 20% and 34%, respectively. These gains occurred despite announcements by several banks of record losses during the first quarter amid continued credit-related write-offs. Investors obviously took solace from the fact that losses – although big – were no worse than expected, and that a number of banks had been successful in their recapitalisation efforts…

This whole section is pure hogwash. The European and Japanese stocks rose on the idea that both the dollar would get 'stronger' due to concerted interventions by the hostile trade partners of the US and the US would then allow a new flood of imports. This in addition to the flood of Funny Government Money™ which flowed out of the printing presses in DC and into pockets of eager voters who go into the polls this year. Over a hundred billion has been added to the budget deficits and the news today is 'good': consumers are taking this free money that has many dire strings attached and are spending it on...imports! Isn't that just lovely?

So stocks in Tokyo and Berlin soar. This is pure gold for both. They want this status quo to run forever and ever, if possible. But we are going bankrupt. Something this report never mentions. The return of the Japanese carry trade is hammering US markets and destroying incomes in the US. It is flooding the world with Funny Money™ that is causing all commodities to shoot upwards in response to this reckless lending of money to a nation that is far too deep in debt.

BIS:

After a relatively smooth turn of the year, interbank market tensions had appeared to ease somewhat until early March 2008, and Libor-OIS spreads had shown some signs of stabilising. However, as the financial turmoil suddenly deepened in the second week of March, following an acceleration in margin calls and rapid unwinding of trades, interbank market pressures quickly increased. With market rumours proliferating about imminent liquidity problems in one or more large investment banks, banks became increasingly wary of lending to others. At the same time, their own demand for funds jumped as they sought to avoid being perceived as having a shortage of liquidity.

Like all the other banking charts, this is like a thermometer. It shows there is a fever raging. It doesn't diagnose the disease. But at least it lets us know this is one very sick puppy.

We can see from this time table of events, the mess that began last fall has grown worse, not better. The happy stock markets, etc, are due entirely to goofy overspending, deficit spending, over blown borrowing that is all purely red ink, not anyone saving money or attracting money. The attempts to get China and the Arabs to pour all their wealth into the black pool of the collapsing US markets had failed.

BIS:

Difficulties faced by European banks in obtaining US dollar funding remained a characteristic of the ongoing interbank market tensions. Indeed, results from ECB 28-day dollar auctions suggest that, if anything, demand for dollar funding has been rising further recently. In the auction on 20 May, both the amount bid ($58.9 billion) and the number of bidders (54) reached the highest levels since the auctions were introduced in December 2007. To some extent, the persistently elevated dollar demand seems to have been due to a need for frequent rollovers by European banks of short-term dollar borrowing in the interbank market, which they have used to finance longer-term dollar investments in non-banks.

Adding to the tense situation in interbank markets, the reliability of the Libor fixing mechanism, in particular for US dollar loans, was increasingly questioned by market participants. Suspicions were voiced to the effect that some banks in the Libor panel had been reporting rates lower than their actual borrowing costs. It was alleged that they did so in order to hide their true demand for dollar funds, and hence to appear less vulnerable than they actually were. As the media focused on the issue and the British Bankers’ Association began investigating in mid-April, US dollar Libor rates suddenly adjusted upwards by 15–40 basis points.

The see-sawing between the euro and the yen with the US dollar as the fulcrum has become wild swings up and down. The truly wild part is the seemingly detached portion which is being expressed in wild bubbles in nearly all commodities, moving from one to the next, down the line. The oil commodity markets being one of the most persistent. Oil has somewhat stabilized at a very high level as speculation shifts swiftly towards corn futures as the damages from the floods and tornadoes take their toll on corn growth in the US bread basket.

Now onto the real monster here, the strange and vapid Derivatives Beast:

BIS: Derivatives markets

The first quarter of 2008 saw a large rebound in activity on the international derivatives exchanges. The total turnover based on notional amounts increased from the previous quarter’s $539 trillion to $692 trillion in the latest quarter, the highest turnover on record. This resulted in year-on-year growth of 30%. Most of the increase was observed in derivatives on short-term interest rates. Gains in turnover were also seen in derivatives on long-term interest rates and foreign exchange. In contrast, turnover in derivatives on stock indices showed a slight decline, possibly reflecting overall weakness in stock markets in the first quarter of 2008. Furthermore, turnover in derivatives on commodities – which are not included in the above total since only the numbers of contracts are available – increased substantially, recording a year-on-year growth rate of 52%.

Turnover in derivatives on short-term interest rates rose from the previous quarter’s $406 trillion to $548 trillion in the first quarter of 2008, representing a year-on-year growth rate of 32%. The increase was mostly accounted for by currency segments that had recorded a significant retreat in the fourth quarter of 2007. The US dollar and euro segments showed a substantially large rebound, while the sterling segment grew slightly. In particular, turnover in futures and options on three-month eurodollar rates picked up sharply again in the first quarter of 2008. This suggests that liquidity conditions in the term money markets might have recovered to some extent after the stressful 2007 year-end. In contrast, turnover in futures and options on federal funds rates fell, despite the policy rate cuts in the United States.

Again and again, I see this: reporters who should be very alarmed while writing stuff like the huge numbers above, should be alert to the fact that they are no longer on this planet earth but are astronomical. And since they are in the heavens, they have to also understand it is very dark. And they are now in the Realm of Mythology, they are with the Gods and Goddesses, not with bankers or sensible people here on this side of the Gates of Death. Instead, they think this 'growth' is good since 'growing' is good, ergo, all growth is great. But we know that cancer cells grow much, much faster than healthy cells. Cancer is a sign of death and disease. The bubble we are seeing this last 7 years are all cancerous growths, not healthy at all.

And horrors! Look at the numbers for commodity derivatives! They grew a whopping 52% in one year? The 'interest rate' gamblers have created this dark pool of have a quazillion dollars. But if we add the gigantic commodity pool, this is well over a quadzillion. Which isn't even a name or a number. We are making up this name since we have to have some way of tracking these hundreds of zeros. Anyone with a sense of history should figure out that when commodities shoot upwards, we get terrible inflation and societies collapse.

More graphs. The rate of growth is obscene.

BIS:

Despite the continued turmoil in global financial markets, the over-the-counter (OTC) derivatives market showed relatively steady growth in the second half of 2007. Growth was particularly strong in the credit segment, due possibly to heightened demand for hedging credit exposure. Notional amounts of all categories of OTC contracts increased by 15% to $596 trillion at the end of December, following a 24% increase in the first half of the year. Other segments, including markets for foreign exchange, interest rates and commodity derivatives, were also robust, each recording double digit growth, while the equity segment posted a negative growth rate. Gross market values, which measure the cost of replacing all existing contracts, increased by 30% to a total of $15 trillion at the end of December 2007. In particular, gross market values of credit default swaps (CDS) almost tripled to $2 trillion. Gross credit exposures, after netting agreements, also rose, by 22% to a total of $3 trillion.

Notional amounts of CDS continued to expand, by 36% in the second half of 2007 to $58 trillion, slowing from the 49% growth rate recorded in the first half of the year . Gross market values of CDS registered a growth rate of 178% in the second half of the year, rising to $2 trillion, which was much higher than the growth rate of 53% in the first half of the year. This unprecedented rapid growth in gross market values presumably reflected both higher valuations for existing CDS contracts and new CDS contracts in the second half of the year, amid the turmoil in global financial markets.

Notional amounts of OTC foreign exchange derivatives grew solidly at a rate of 16% in the second half of 2007, slightly below the 21% recorded in the first half. By currency, contracts with one leg denominated in US dollars, euros, yen or Swiss francs showed particularly robust growth rates of between 16 and 21%. By maturity, contracts of over five years increased substantially, by 104%. Gross market values of OTC foreign exchange derivatives in total recorded a growth rate of 34%, significantly above the 6% in the first half. By currency, euro, sterling and US dollar derivatives grew rapidly, by 73%, 50% and 32% respectively, while yen contracts fell by 5%. For other categories, the notional amounts of OTC interest rate derivatives grew modestly, by 13%. By contrast, the notional amounts of OTC equity derivatives decelerated rapidly, from a growth rate of 15% in the first half of 2007 to –1% in the second half of the year, the lowest pace of growth since the second half of 2004.

Ouch. When anything doubles in a year, this is bad, bad, bad. In banking, this should sound alarm bells. Regulators should see this is very bad. Just as a steam locomotive will blow up if the heat level goes up and up due to lack of water or if regulators at Chernobyl notice the gages shooting upwards...danger! Blow up! In this sea of numbers shooting upwards like crazy we see one number going DOWN: the yen! In all these charts, the yen is flat. Or declining. This is not due to Japan becoming a lesser power. Japan is either #1 or #2 in world trade profits. As well as just plain global trade. Japan is beating up the US and Europe in international markets! And this is due to the weak yen. And this last month, the yen has weakened significantly against rival currencies.

The yen is dropping because no one is buying them up now that China and Japan have reached a powerful consensus. China today has signed significant contracts with Taiwan and Japan has not only not interfered, Japan is waiting on the sidelines to join in.

The graph below looks like a graph that shows the expansion of the Universe after the Big Bang. This is not accidental. We are looking at a thing that apes the heavens, not the limitations of this planet.

These two graphs show clearly that commodities are now taking off because they are the last refuge for Funny Money™. And simultaneously, derivatives are shooting upwards since March, 2004, when the 1% lending from the Federal Reserve joined the .25% lending from the Bank of Japan in order to flood the world with easy credit. The number of contracts for derivatives went from only 20 million to nearly 100 million. In less than 4 years.

The bottom graph shows that the 2003-2007 bubble has a long, long way to go before it crashes through the floor into negative territory. The machinations of the central bankers coupled with their schemes to suck in all the fake AAA tranches and hide them from reality: this is keeping the graph in positive territory. Also the gigantic Derivatives Beast is doing this, too. But very destructively. It is like putting on make up on a cancer patient to make the cheeks glow. This lipstick application might fool non doctors but any good physician can see through this ruse.

BIS: The build-up of international bank balance sheets

International banking activity has in recent years expanded at the fastest pace since the mid-1980s. The year-on-year growth in banks’ total international claims, which had been accelerating steadily since early 2001, peaked at 22% in the third quarter of 2007, a level last approached prior to the 1987 stock market collapse. As a consequence, banks’ international balance sheets more than trebled over this period, with total international assets growing from less than $12 trillion at end-2000 to more than $37 trillion by end 2007.

Growth in credit to non-bank borrowers contributed greatly (39%, or $10 trillion) to this expansion. This development coincided with the rise of the structured finance industry, the expansion of banks’ proprietary trading activities and the growth in their hedge fund prime brokerage business. Banks’ claims (primarily loans) on non-bank entities increased from less than $4 trillion at end-1999 to $14 trillion by the end of 2007, with claims on non-bank borrowers located in the United States, the United Kingdom and the Cayman Islands accounting for 21%, 16% and 6% of these positions, respectively.

A substantial share (33%, or $4.6 trillion) of banks’ total international claims on the non-bank sector are holdings of international debt securities. While holdings of European government bonds account for much of this, holdings of securities issued by non-banks in major financial centres, including the United States, the United Kingdom and the Cayman Islands, make up nearly $2 trillion of the total. Many of the claims vis-à-vis the United States are international holdings of US Treasury securities and other claims on US government-owned entities. However, a rough estimate, obtained by subtracting claims on the US public sector reported in the consolidated banking statistics (IB basis), suggests that the share of banks’ cross-border holdings of debt securities issued by US non-bank corporates,… as did debt security claims which includes debt issued by investment vehicles and securitised mortgage products, has been on the rise.

Roughly one quarter of the overall increase in banks’ total international assets since end-1999 has been booked by banks located in the United Kingdom. Since then, net claims (claims minus liabilities) of these banks on non-bank borrowers have grown by more than $1 trillion (to $1.5 trillion), half of which is denominated in US dollars. At the same time, their net liabilities to banks increased by a similar amount (to $1.7 trillion), a sectoral transformation which is portrayed in Graph 3. The growth in net liabilities to banks in Switzerland, the euro area, Asian offshore centres and oil-exporting countries has been used to finance claims on non-banks, primarily in the United States.

Here is yet another interesting graph. I think it echos all the graphs showing our increasing trade deficits:

Indeed, it is not accidental nor harmonic. This collapse into $750 billion in negative territory is exactly our trade deficits! The BIS staff don't bother to make us very aware of this connection. But it lies at the root of much of this ongoing collapse. There is NO WAY this graph can continue into negative territory to infinity! No way. So we must face the truth: it is unsustainable and thus, a thing desperately in need of fixing. But the BIS doesn't talk about any of this as we see in their joint conclusion:

BIS:Conclusions:

The report identifies the following underlying financial system weaknesses as having contributed to the financial turmoil: poor underwriting standards (especially in the US subprime sector); shortcomings in firms’ risk management practices; poor investor due diligence; poor performance by credit rating agencies in respect of structured credit products; incentive distortions, especially for originators, arrangers, distributors and managers in the originate- to-distribute (OTD) chain, as well as with respect to compensation schemes in financial institutions; weaknesses in disclosure; feedback effects between valuation and risk-taking; and weaknesses in regulatory frameworks and other policies.

To address these weaknesses, the report makes a number of recommendations, focusing on five main areas: strengthened prudential oversight of capital, liquidity and risk management; enhancing transparency and valuation; changes in the role and uses of credit ratings; strengthening the authorities’ responsiveness to risks; and robust arrangements for dealing with stress in the financial system.

In order to strengthen the prudential oversight of capital, liquidity and risk management, the report urges prompt implementation of the Basel II Framework. It also outlines specific proposals with respect to strengthening aspects of the framework dealing with securitisation and off-balance sheet activities and makes a number of ecommendations for improving the operational infrastructure for OTC derivative instruments.

In an effort to enhance transparency and valuation, the FSF strongly encourages financial institutions to make robust risk disclosures at the time of their mid-year 2008 reports using the leading disclosure practices summarised in the report. Further guidance to strengthen disclosure requirements under Pillar 3 of Basel II will be issued by 2009, including standards for disclosures regarding off-balance sheet vehicles and valuations. In addition, standard setters will take urgent action to improve and converge financial reporting standards for off-balance sheet vehicles, and develop guidance on valuations when markets are no longer active, establishing an expert advisory panel in 2008. Particular attention will be paid to transparency in structured products, as market participants and securities regulators will expand the information provided about securitised products and their underlying assets.

In respect of changes in the role and uses of credit ratings, the report recommends that rating agencies implement the revised IOSCO Code of Conduct Fundamentals for Credit Rating Agencies to manage conflicts of interest in rating structured products and improve the quality of the rating process. It further proposes that they differentiate ratings on structured credit products from those on bonds and expand the information they provide. Regulators will review the roles given to ratings in regulatory and prudential frameworks.

Among actions to strengthen the authorities’ responsiveness to risks, a college of supervisors will be put in place by end-2008 for each of the largest global financial institutions. Finally, within the context of establishing robust arrangements for dealing with stress in the financial system, central banks will enhance their operational frameworks and authorities will strengthen their cooperative arrangements for dealing with stress.

The BIS is a total failure. So they want to fix this by having more power to fail. So long as they are unable to be honest about what is going on, they are just as useless as all the other guardians who have snoozed at the entrance to this fine Cave of Wealth and Death. There is no earthly credit rating group or association that won't be thoroughly corrupted by anxious bankers and powerful interests all of whom want infinite Funny Money™ as fast as possible. No mere human can stop these people from trying to get to infinity. This is why we need a gold standard. As a straight jacket.

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Comments

[Don]

Elaine:
Great analysis as usual. When you say, "This graph is screaming proof that our entire banking system is dead", what can savers do in this type of environment? We played by the old rules by saving for rainy days, but sometimes we get the feeling it was all for nothing, just waiting for inflation or the government to take it all. I guess the best thing to do is expand the gardens...thanks again for all of the time and effort you put into your posts.

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