- The billion-dollar losses faced by the firm Archegos didn’t impact the volatility of the broader market.
- This is evidence that the banking system is safer because of regulations following the 2008 financial crash.
- By holding more capital, banks ensure that sudden losses don’t impact the entire system.
- George Pearkes is the global macro strategist for Bespoke Investment Group.
- This is an opinion column. The thoughts expressed are those of the author.
- See more stories on Insider’s business page.
Archegos, the family office of former Tiger Capital Management portfolio manager Bill Hwang, grabbed the attention of investors around the world in mid-March when the firm suffered catastrophic losses thanks to a portfolio that had two big problems: high leverage and intense concentration in a few stocks.
The Archegos mess grabbed global eyeballs not just for the size of the losses, but also for its distinct pre-financial crisis feel. There were derivatives, huge losses, exposure for large international banks, counterparty risks…all the echoes of the 2008-era blow ups.
But as disastrous as the unwinding of Archegos trades was, the billions of losses that ended up piling up at the banks (specifically, their prime broker units) facilitating the trades didn’t end up spilling into other markets. Specific stocks in the portfolio certainly got walloped – look no further than Viacom’s share price – and the dealers who took losses – like Credit Suisse and Nomura – saw a hit to their stocks as well, but broader market volatility did not tick up.
Indeed, the VIX (an index designed to measure stock market volatility) closed March at 52-week lows. Credit default swaps tied to large banks and brokers were basically unflustered. And there were no reports of contagion to other asset classes.
In other words, a multi-billion dollar blow up at a giant fund that some of the world’s largest banks had massive exposure to was basically shrugged off by the financial system at large.
That’s great news and evidence that reforms to raise the amount of capital banks hold following the global financial crisis worked.
The banking system is getting safer
As the US banking system approached the meltdowns of 2007 and 2008, US banks were highly leveraged. Borrowing by banks accounted for over 90% of risk-weighted assets and rising. Funding contributed by Tier 1 capital, that is first-in-line-for-losses equity and internally-generated earnings, was only about 8%. Post-crisis, that number is much higher at 12%, and very stable. Banks are holding more capital and are borrowing less relative to their assets. Leverage is lower, and capital is higher.
This is important because if a bank has capital equivalent to 8% of its assets, it is technically insolvent should assets decline in value by 8%. By raising capital levels, banks have raised the bar for insolvency should they suffer sudden drops in the value of their assets.
In addition to making it less likely a given bank goes bust, higher capital levels also ensure that a problem for one bank doesn’t spread. For instance, with less capital, the reported losses suffered by Credit Suisse (the worst-hit of the banks who lent to Archegos) might lead them to default on other obligations, passing on their problems to other firms.
This “contagion” was what led to a spiraling series of failures in the US financial system that claimed firms like Bear Stearns, Merrill Lynch, and Lehman Brothers. But in a well-capitalized system, a shock to one firm gets absorbed by its capital, without spilling to other dealers.
Put another way, Tier 1 capital is sort of like a wall holding back wastewater from a lake. As banks sustain losses, wastewater rises towards the top of the wall, and if it overflows, wastewater (a bank’s risky assets) that leak into the lake (the broader financial markets) can be dangerous and cause a mess.
Prior to the financial crisis, these walls were dangerously low and massive leaks of risky assets resulted in a broader contamination of financial markets around the world. But after that crisis, regulators made banks rebuild those walls to be much higher and able to hold back much more before leaking any of the waste into the larger lake. This has hurt banks’ profitability, but it’s also made the system safer.
Blow ups aren’t spreading anymore
Archegos is not the first time since the crisis that large shocks to the financial system failed to result in contagion. The 2014 to 2016 oil price collapse, 2016’s Brexit shock, plunging Treasury prices after the 2016 election, or the collapse in volatility-linked exchange-traded products in early 2018 all showed that the system has gotten more resilient.
In each of these cases, pundits speculated that the huge dislocations would create positive feedback loops of contagion that would spin out of control, something I’ve previously written about.
But a well-capitalized financial system makes positive feedback loops much less likely, because a given mess doesn’t extend beyond the institutions immediately exposed to it.
Economist Hyman Minsky identified a tendency for financial instability to repeatedly arise as participants are rewarded for speculative activity. He contended that preventing speculation was a fool’s errand – there would always be a new frontier for leverage and risk-taking to build up.
While instability may be inevitable, it can be contained. Regulators were not prescient enough to prevent investors from piling into short volatility ETNs, couldn’t have predicted the outcome of the initial Brexit referendum, and didn’t have the visibility to see how large Archegos positions were getting.
But if capital levels are sufficiently high, regulators don’t have to predict every possible disaster on the horizon. Should a given fund or dealer run into trouble, that would be bad news for investors directly exposed…but not for the financial system as a whole.
High levels of capital have worked well for the financial system since 2009, and that was proven again with the Archegos blow-up. Efforts to reduce minimum capital requirements should be viewed skeptically given their track record keeping specific meltdowns isolated and staving off the “Minsky moment” of financial system collapse we saw in 2008.