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Evaluation of the effects of too-big-to-fail reforms

Alberto Gallo, CFA

Portfolio Manager, Algebris Macro Credit Fund (UCITS), Head of Macro Strategies

Financial Stability Board

September 2020

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Page 2

Inefficient Banking Systems Increase Fragility

Source: Algebris (UK) Limited, ECB, BoE, World Bank, OECD, BIS

Capital Ratio Profitability Asset Quality Costs Fragmentation Diversification Size

Bank Capital to

Assets Ratio

(%)

RoA, bps Gross NPL%Bank Branches

per 100k People

Number of Credit

Institutions per 100k

People

Bank Financing as %

of Total Credit to

Private Corporates

Bank Total

Assets as %

National GDP

US 11.7 120.0 0.9 30.9 1.6 34% 94%

Netherlands 6.2 47.3 1.9 11.0 0.5 44% 328%

Finland 9.3 32.4 1.4 3.1 4.3 59% 305%

UK 6.8 28.0 1.1 25.1 0.6 70% 368%

Ireland 14.9 50.5 5.7 20.5 6.2 19% 391%

France 6.5 39.7 2.7 34.9 0.6 53% 440%

Spain 7.6 51.3 3.2 55.1 0.4 68% 235%

Germany 6.5 15.6 1.2 11.1 1.8 78% 264%

Italy 6.3 38.1 8.4 40.9 0.8 74% 218%

Portugal 7.0 45.1 9.4 36.0 1.4 65% 196%

Australia 6.9 84.0 0.9 28.2 0.5 50% 273%

Canada 5.3 88.6 0.4 20.0 0.3 42% 311%

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Historical Bank % Losses During the GFC, as % of Balance Sheet

Source: Algebris (UK) Limited, RBS Credit Strategy, Bloomberg, company filings

3

Losses can Exceed 10% of Assets

0%

5%

10%

15%

20%

AIB Anglo NBG Banki Amag Monte HBOS ML BoI WaM B&B Wach Nrock SNS UBS Dexia

Losses as % initial loans Losses as % initial assets

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Page 4

Forward Guidance and Short Volatility: A Feedback Loop

Low Volatility and Asset Bubbles

Source: Algebris (UK) Limited

Low Yields

QE

Forward Guidance

QE Exit

Inflation Returns

Selling Volatility

Is Profitable

Dealer Delta-Hedging,

Dealers Sell Protection

Lower Risk Premium

Lower Realised Vol

Implied Volatility

Declines

Implied Volatility

Rises

Realised Volatility

Rises

Unwinding with Dealers,

Dealers Buy Protection

Volatility Sellers

Lose MoneyHigher Real Yields

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Page

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

5-10 10-15 15-20 20-25 25-30 30-35 35-40 40-45 45-50 50-55 55-60 >60

Pre QE Post QE

5

VIX Pre and Post QE

Markets: The New Too-Big-To-Fail

Source: Algebris (UK) Limited, Bloomberg. Data as of 28.08.2020

Length of High Vol Periods Proportion of Days When VIX Falls in the Range

Longer periods of low

volatility…

… but also a fatter tail

of very high volatility

0

10

20

30

40

50

60

70

80

90

100

2008 2010 2012 2014 2016 2018 2020

Periods during which VIX>20 VIX Index

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Equities used: SX5E, SX7E, SPX, EEM, FTSEMIB, UKX and BKX; Rates used: OE1, RX1, TY1; Credit used: Xover, CDX HY, Senior Fin and EM local sovereign.

Source: Algebris (UK) Limited, Bloomberg. Data as of 03.09.2020

6

2200

2400

2600

2800

3000

3200

3400

3600

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20 Jul-20 Aug-20

+/- 1 Standard Deviation Risk-Risky Correlations LTmean SPX (RHS)

2-Day Rolling Correlations – 10 Minute Intervals

Risk-free Assets: No Longer Balancing Portfolios

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Page 7

Cross-holdings and Systemic Risk Propagation

Italy

Generali

4.5% Fondo

Strategico

77.7%

2.57%

Mediobanca

12.2%

Intesa

1.4%9.88%

Toro100%

1.3%

Groupama4.9%

Veolia

5%

SocGen

0.1%

Natixis AM

0.52%

BNP

0.6%

France

2.51%

AXA

BBVA

0.52%

0.34%

0.1%

Monte

2.45%

Telefonica

3.65%

1.7%

5.75%

Caixa

Holdings

Gas

Natural

34.6%

Caixabank

5.6%

Repsol11.6%

Credit Agricole

Deutsche Bank

2.28%0.01%

Bankinter

Santander3.15%

0.15%1.18%

State Street

0.14%

Credit Suisse0.22%

1.21%

Commerzbank

POP

Mediolanum

3.4%

0.07%

0.19%

UBS2.8%

Norway Singapore

3.26% 6.4%

UniCredit

Allianz3.54%

0.11%

2.27%

Abu Dhabi Libya

6.43% 2.6%

BlackRock6.44%

Germany

17%

CRH

Caixa Geral

Portugal

Telecom

4.92%0.16%

4%

Qatar Iberdrola9.42%

Source: Algebris (UK) Limited. Bloomberg 2016

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Page

The Passive Investing Feedback Loop

Markets: Increased Fragility

Source: Algebris (UK) Limited, GS Research. Data as of 30.06.2020

8

Passive & Index investing increased to 50% of the

US Equity Market

ETF usage rises as market volatility increases(ETF Volumes as a % of the Total Tape, by Average Monthly VIX Levels)

19%

50%

0%

10%

20%

30%

40%

50%

60%

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

2005 2008 2011 2014 2017 2020

Active ($bn)

Index ($bn)

Passive ETF ($bn)

20% 21%

24%

26%

28% 28% 29%

33%

36%

10%

15%

20%

25%

30%

35%

40%

<12 12 -14

14 -16

16 -18

18 -20

20 -25

25 -30

30 -35

>35

ET

F a

s %

of C

on

so

lidate

d T

ap

e

Monthly Average Level of VIX

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Page 9

ETF Selloff During the Covid-19 Crisis

Markets: Increased Fragility

Source: Algebris (UK) Limited, Bloomberg. Data as of 02.09.2020

Note: EMB US - iShares J.P. Morgan USD Emerging Markets Bond ETF (EM Hard ccy ); JNK US - SPDR Bloomberg Barclays High Yield Bond ETF (US HY); AT1 LN - Invesco AT1 Capital Bond UCITS ETF (AT1 ETF); IHYG LN - iShares EUR High Yield Corp Bond UCITS ETF

(EUR HY); SEML IM - iShares JP Morgan EM Local Government Bond UCITS ETF (EM Local ccy)

Fund Percentage Premium/Discount vs NAV

10-Day Moving Average

-4%

-3%

-2%

-1%

0%

1%

2%

3%

Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Apr-17 Oct-17 Apr-18 Oct-18 Apr-19 Oct-19 Apr-20

EUR HY US HY AT1 ETF EM Hard ccy EM Local ccy

23 March 2020: The Federal Reserve established the

Secondary Market Corporate Credit Facility (SMCCF) to

support market liquidity by purchasing corp. bonds of US

IG firms and US-listed ETFs whose investment objective

is to provide broad exposure to the market for US corp.

bonds, appointing Blackrock as investment manager for

ETF purchases.

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Page 10

Fragility is Common, Anti-Fragility is Rare

Policy and Markets: Time Inconsistency and Fragility

Fragile Robust Anti-Fragile

Medicine Anaesthesia Vaccine Mithridatism

Pension System Defined Benefits Defined Contributions Social Shock Absorbers

Technology Centralised Hard Drive Underground Storage Cloud Storage

Mythology Damocles Ulysses Hydra

Nature Dinosaurs Land Turtle Ant Colony/Bacteria

Objects Tea Set Anvil Spring

Financial MarketsPassive Investing/Herding

Financial

Engineering/Complexity

Active Management Tail Risk Strategies

Monetary Policy Forward Guidance Rule-Based Approach Macro-prudential Policy

Capital Structure Debt Equity AT1

Sovereign DebtHard Currency External

DebtDomestic Currency Debt Growth-Linked Debt

Economic Agents Politicians RegulatorsLong-Term/Contrarian

Investors

Government Structure Eurozone Singapore Switzerland

Source: Algebris (UK) Limited. With reference and inspiration from Antifragile: Things that Gain from Disorder, N. N. Taleb (2013)

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Page 11

Bibliography & Additional Reading- Shambaugh J., Nunn R., Breitwieser A., Liu P,. The state of competition and dynamism: Facts about concentration, start-ups, and related policies, 13 June 2018

- Gallo A., How the American dream turned into greed and inequality, World Economic Forum, 12 October 2017

- Scars or scratches? Hysteresis in the euro area, Speech by Benoît Cœuré, Member of the Executive Board of the ECB at the International Center for Monetary and Banking Studies, Geneva, 19 May 2017

- Hassan, F., di Mauro, F., Ottaviano, G. Banks credit and productivity growth, ECB Working Paper Series, February 2017

- Corlett, A., Clarke, S. Living standards 2017: the past, present and possible future of UK incomes, 31 January 2017

- Understanding Populism: Inequality by the Numbers, Blog post by Pushan Dutt (INSEAD Professor of Economics and Political Science), 16 December 2016

- Jarociński, M., Lenza, M., An inflation-predicting measure of the output gap in the euro area, ECB Working Paper Series No 1966, September 2016

- Saito, I., Fading Ricardian Equivalence in Ageing Japan, IMF Working Paper 16/194, September 2016

- Democracy Index 2016: Revenge of the “deplorables”, The Economist Intelligence Unit, 2016

- Kuroda, H., “Comprehensive Assessment” of the Monetary Easing: Concept and Approaches, 5 September 2016

- Ball L., Gagnon J., Honohan P., Krogstrup S., What else can central banks do?, Vox, 2 September 2016

- Dauer U., German Savers Lose Faith in Banks, Stash Cash at Home, Wall Street Journal, 28 August 2016

- Jobst A., Lin H., The ECB’s Negative Rate Policy Has Been Effective but Faces Limits, IMF, 10 August 2016

- Stevens G., An Accounting: Address to the Anika Foundation Luncheon, 10 August 2016

- Gallo A., Our global financial system is broken. Here’s a plan for fixing it, World Economic Forum, 6 July 2016

- Williamson, S., Neo-Fisherism: A Radical Idea, or the Most Obvious Solution to the Low-Inflation Problem?, Federal Reserve Bank of St. Louis, July 2016

- Kuroda, H., Overcoming Deflation: Theory and Practice, 20 June 2016

- Corsetti, G., Feld P. L., Koijen R., Reichlin L., Reis R., Rey H., Weder di Mauro B.,Reinforcing the Eurozone and protecting an open society: Refugee bonds, 27 May 2016

- Haldane, A. G., The Great Divide, Bank of England, 18 May 2016

- Rajan R., Rethinking the Global Monetary System, Speech at the London School of Economics, 10 May 2016

- Jones, R., Innovation, research and the UK’s productivity crisis, The University of Sheffield, April 2016

- Standard & Poor’s, QE and Economic Inequality: The UK Experience, 10 February 2016

- Cochrane, J., Do Higher Interest Rates Raise or Lower Inflation, 10 February 2016

- Kothari, S.P., Lewellen, J., Warner, J. B., The behaviour of aggregate corporate investment, MIT, December 2015

- Borio, C., Labour reallocation and productivity dynamics: financial causes, real consequences, BIS, December 2015

- Gallo, A., Why ECB’s quantitative easing won’t work and how it can be fixed, Financial Times, 7 December 2015

- Blanchard, O., E. Cerutti and L. Summers, Inflation and activity – Two Explorations and their Monetary Policy Implications, IMF Working Paper No 230., November 2015

- Borio, C., Revisiting three intellectual pillars of monetary policy received wisdom, Luncheon address, Cato Institute, 12 November 2015

- Borio C., Gambacorta, L., Hofmann, B., The influence of monetary policy on bank profitability, BIS, October 2015

- Contessi, S., Kerdnunvong, U., Asset bubbles: detecting and measuring them are not easy tasks, Federal Reserve Bank of St. Louis, July 2015

- Belfied, Cribb, Hood, Joyce, Living Standards, Poverty and Inequality in the UK: 2015, Institute for Fiscal Study, July 2015

- Gallo, A., Rethink needed for monetary policy role, Financial Times, 1 July 2015

- Haldane, A. G., Stuck, Bank of England, 30 June 2015

- Borio C., Persistent unusually low interest rates. Why? What Consequences?, BIS, 28 June 2015

- IMF, Global Financial Stability Report, April 2015

- Gallo, A., Walker, R., Tyrrell-Hendry, L., Popovic, M., Grant, A., Pan, T., The Revolver | Divided Kingdom: Britain’s future beyond the election, 14 April 2015

- Sigurjonsson, F.; Monetary Reform, A better monetary system for Iceland, Report commission by the Prime Minister of Iceland, 20 March 2015

- OECD (2015), Economic Policy Reforms 2015: Going for Growth, OECD Publishing, 9 February 2015

- Milburn, Elitist Britain?, Social Mobility and Child Poverty Commission, 2014

- Kothari, S.P., Lewellen, J., Warner, J., The behavior of aggregate corporate investment, MIT Sloan Research Paper No. 5112-14, 19 October 2014

- Jahan S., Mahmud A. S., Papageorgiou C., What is Keynesian Economics?, IMF, September 2014

- Carrol, C.D., Slacalek, J., Tokuoka, K. (2014) The Distribution of Wealth and the Marginal Propensity to Consume, ECB Working Paper No 1655

- Sharpe, S.A. and Suarez, G.A. (2014) The insensitivity of investment to interest rates: Evidence from a survey of CFOs, Finance and Economics Discussion Series, FRB Washington DC

- Rotman, D., How Technology is Destroying Jobs, MIT Technology Review, 12 June 2013

- Koo, R., The world in balance sheet recession: causes, cure, and politics, Real-world Economics Review, issue no. 58, 2011

- Rajan, G. R., Let Them Eat Credit, New Republic, 27 August 2010

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