In the previous blog, I tried to point out the role the regulators may have played in creating havoc for Home Capital. This made me think of the changes that the same regulators have imposed on the big 6 banks since 2008 and whether their stock prices should respond to this type of event in the same manner as they would have before the regulatory changes had been made or are they now more immune?
The large banks do not have any significant direct counter-party exposure to HCG, one or two of them may lose a client to whom they can dump their “turn-down” mortgages but overall they will not even see a ripple if the firm folds. The risk for the Big 6 is their significant exposure to the Canadian economy and the $1.4 trillion mortgage market that could be impacted by a housing correction possibly instigated by events like what is occurring at HCG. Moody’s is getting more concerned. They just announced a downgrade of the banks’ ratings citing their worries with deteriorating asset quality and weaker household balance sheets. So how worried should people be about the large banks, especially now that the regulators have tightened things up?
It depends on what your business is with them. The big 6 would enter into any housing correction in a strong position. The banking industry’s oligopoly structure, its large holdings of only insured mortgages, its meeting of higher regulatory standards, stricter underwriting, and its ongoing robust risk management, theoretically suggest that they can survive an intense shock.
So, if you are a retail depositor at the Big 6, no problem. (Ultimately your only exposure is to CDIC and whether they know what they are doing—not zero risk.) If you are a borrower, the risk is slightly higher, as the banks become more reluctant lenders, responding to their increased need for liquidity and to any deterioration in credit quality as a result of the shock.
But it gets more interesting and uncertain if you are a holder of common equity. In trying to ensure that the tax payer will never again be involved in bank “bail-outs”, the regulators have moved to increase the capital buffer that will absorb any losses before Mom and Pop are on the hook. This has resulted in significantly higher potential losses to holders of various tiers of capital and, at some point in the future, to holders of wholesale bank debt. Now, certain debt-like instruments that count as capital will have the potential to be converted into common equity either through various triggers linked to the market price of the stock or by the regulator’s magic wand. Thus between these debt-like instruments outstanding and its common equity, the regulators have determined that there is a higher probability that any loss can be absorbed by a bank in a time of crisis. Thus if you hold these new wholesale debt-like structures or common equity, you are now carrying more of the risk if there is a threat to a bank’s solvency. In finance jargon, the probability of a bank reaching insolvency is less given the increased liquidity and starting amount of capital, but if insolvency occurs, the estimated loss to the holders of common equity has increased as a result of the taxpayer not contributing to reduce any of the loss.
Moreover, the regulators have been working on adding a bail-in feature to wholesale debt that the banks issue. Again, in a crisis, certain triggers will allow this debt to be converted to common equity, further increasing the loss absorbency of the bank.
This raises a couple of questions. First, has the stock prices of the big 6 adequately discounted the potential amount of dilution that could occur from the conversion into equity from these other forms of capital and debt in a crisis? and second, supposedly with no taxpayer support coming, should stock prices now be more sensitive to the risk of contagion than they were prior to the regulatory changes?
My guess is that bank equity prices are not discounting the current regulatory regime adequately but continue to be priced assuming that the taxpayer will be forced into the mix when the rubber hits the road. Whether this is a good bet or not depends on the political will to do nothing, stay out and watch a major Canadian institution dissolve in an orderly manner.
In 2008, the Canadian banks were the victims of a drive-by-shooting. The crisis did not even start in this country, but that did not matter. Liquidity froze and their stock prices collapsed. To the market, it didn’t matter that Canadian banks had more capital, more liquidity and stricter guidelines than other jurisdictions. In a crisis, with fear as a motivator, perception trumps reality. The same will happen in the next crisis despite the regulators best efforts. The market and the depositors will not care that the regulators have forced banks to hold even more liquidity and more capital. As has always been the case, the next crisis starts when investors and depositors, for whatever unforeseen reason, want their money back—now—on demand.
Which takes us back to the bank stocks and whether they are now safer to hold post all these changes. The new regulations have not reduced the chances of another bank run in the future. They may have lowered the probability of a bank becoming insolvent, but not by as much as the regulatory gang in Basel would want us to believe and, without question, have increased the estimated size of a loss to a holder of common equity if a bank does become insolvent. As a holder of bank equity, do you feel safer?
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