Has the first domino in the next banking crisis fallen?

Welcome to Finance and Fury

Snuck this episode in ahead of time – only reading about news yesterday – need to do some further digging – but is it Time to sell shares in anticipation of a crash?

Today – run through some news that you might not have seen – financial troubles of DB, but also China’s bank runs

First – A lot of elements to it – financial crashes are never due to just one event – chain of events –

1. think of it as an avalanche – snow builds up – eventually, there is too much – large vibration (sound, contact) = slow rumble at first, but as it takes off and wipes out most of what is in its path –
2. Share market crash is similar is there is often a run-up in value – if it has come from debt, derivatives, expansion of money supply, further driving irrational exuberance –
3. Then there is an event that requires a contraction in the money supply – i.e. how much is invested versus how much debt is owed on it
4. How connected they are is also a factor –
   1. Banks Largest shareholders are other banks or financial institutions, investment managers – probably cover next week
5. But the current concentration risk to the market comes from counterparties to financial obligations – i.e. derivatives – and what happens if banks default – and What would trigger a GFC domino effect –

What share are the most at risk – Banks and financials –

1. Not saying to run and sell bank shares – no idea if a crash is coming soon – but pay attention to events –
   1. individual isolated events – a massive increase in counterparty obligations since GFC, low-profit environments with banks due to low rates, further driving ‘innovated’ profit-making within banks (leveraging and speculating)
   2. now banks laying people off, China bank run (seized by CCP for bailout) – run through these step by step –
   3. these alone won’t be enough to trigger the avalanche – one bank becomes insolvent and goes into resolution proceeding – through bail-in and out strategy – may work to minimise the crash – but only if 1 or 2 banks need help
   4. what happens to the banks that have lent them money, or have created derivatives on that same loan = expansion of money stops due to derivative bubble popping – chain of events I’m worried about
2. The system is chaotic though – chaos theory
   1. butterfly effect describes how a small change in one state of a deterministic nonlinear system can result in large differences in a later state
   2. Markets and legislation work in this way – 1 policy is very deterministic – sets out with one set of patterns with its intended goals – but change a different law – also deterministic – this has an impact on the first due to complexity and connectivity
   3. If you understand how this relates to the risk in the system – understand why markets are so volatile
   4. More complex and more connected, greater the chaotic potential becomes – exponential

Quick backstory on recent events – and what the financial risk/connectivity look like

1. Rise of Derivatives – talked about this in some past eps – but what are they?
   1. Tell the truth – took me a long time to understand these – Uni – Derivatives and Risk Management (FINM3405) – I am a very literal thinker – don’t get sarcasm well – took me months to fully understand how derivatives were used – understood the theory, but didn’t understand how it could actually work
   2. one party could agree with another to write a contract where they promise to exchange one thing for the other in the future, at a certain price, rates – when you don’t own that thing even though the contract derives it value from it –
   3. Used as Tool for banks – either to hedge risks or make profits through leverage and speculations
      1. Won’t go too deep into it – but as an example – BHP and Chinese company –
      2. BHP things coal price will decline, so wants to lock in the price now on their coal exports – but they will be delivered in 2 years from – write a derivative – based on the market of coal – if you have to sell at a lower price, you can cash in your option as you bet again the price for a small premium or just counterparty contract – still derivative
   4. Banks usually derivatives because they can be highly leveraged – normally borrowing funds for the purchase of assets
      1. In derivatives – you can control a large number of shares for little upfront cost – Contract for shares worth $20 may cost you a $0.3 outlay but now have contractual ownership on assets that you technically don’t own
      2. Now – rather than having to outlay $2m it is $30k – profit potentials are huge through betting on the market -but so are the risks
      3. Also more efficient versions of trading the underlying instruments from which they are “derived.” – no reporting
         1. Example – a bank thinks the market will crash – may want to go short – but buy back in 12months – doesn’t have to sell shares then if you use derivatives – just flip from long to short – get into a new contract and reverse position
      4. Needed something to make some good profits on – plus – heavily deregulated in the early 2000s – Commodity Futures Modernization Act of 2000 – allowed banks to hold these off the books
         1. Massively increases risks – without anyone knowing – who was the counterparty to who – the value of contracts
         2. danger – a lot of derivatives are ‘marked to market’ – users have to put up cash to cover short term losses
            1. Form of margin call which is the leading cause of death for derivatives, and the death of the economy by derivatives

Deutsche bank in trouble

1. biggest quarterly loss in four years – a €3.1bn net loss – follows a €201m profit in the first quarter of 2019
2. but revenues and profits been declining for a while – trouble in 2008, 2015 – now slowly declining
   1. plans to reduce its global workforce by 18,000 and also massively restructure – about 1/5th of employees to 2022
      1. New business division – corporate bank – Global transaction and commercial banking business
      2. Existing the Equities Sales and Trading business – reducing capital used by Fixed-Income department
   2. turnaround strategy to cost a total of €7.4bn and is aiming to return to profit next year.
      1. Exiting the Equities Sales & Trading business and reducing the amount of capital used by the Fixed-Income Sales & Trading business, in particular Rates.
      2. Returning 5 billion euros of capital to shareholders starting in 2022 – But it is broke?
   3. Funds from their new Capital Release Unit (CRU) – transfer approximately 288 billion euros (20% DBs leverage exposure) and 74 billion euros of risk-weighted assets (RWA – derivative contracts) for wind-down or disposal
      43. but a bank with the €43.5 trillion in gross derivatives notional value and also risk
      44. Where regulators only measure RWA – uses the net value of derivatives – but no good if everyone is demanding the nominal values be paid –
   4. Bad sign – James Simons one of the world’s best performing hedge fund managers pulled account with DB –
      1. spots a trend or had inside information (likely the latter) – pulled just a few days before the restructure announcement
      2. it won’t be insolvent overnight – but there is no equity value there – everyone else has decided to cut their counterparty risk with – €45 trillion in derivatives – reports of a bank run, but by hedge funds, on DB – about $1 billion per day being pulled from the bank – not depositors but counterparties now with derivatives
      3. Cant force broker counterparties to stay with DB – massive pressure for a deal – bailout from other banks or Gov
   5. So far – BNP (other bank) – publicly telegraphing that they are providing “continuity of service” to DBs prime-brokerage
      1. the ultimate goal of the talks is for BNP to take over the vast majority of client balances, which are slightly less than $200 billion currently – BNP executives are meeting with European and U.S. hedge-fund clients to convince them to stay
      2. If the market found out they were about to go bankrupt and default – not good – so taking a gambit
      3. DB may just transfer its assets tied to the prime finance division into the newly formed Capital Release Unit
      4. Trouble is that almost every large bank in the world is a counterparty to a derivative
   6. failure of Deutsche Bank is viewed as unlikely – particularly since it is considered central to Germany’s banking system and will get bailed in and out – but those counterparty to DB may lose money in the process

What is more concerning – Bank runs in china –

1. Beijing has quietly had its hands full avoiding a bank run over the past few weeks – all in aftermath of Baoshang Bank’s failure
   1. While been hearing about Trump and China trade wars – Back in May – failure of China’s Baoshang Bank (BSB) – seizure by the government – putting a massive dent in the security of the Chinese financial system
      1. the first takeover of a commercial bank since the Hainan Development Bank 20 years ago
   2. the PBOC panicked and injected a whopping 250 billion yuan via an open-market operation – keeping the interbank market – which has been on the verge of collapsing – Had to keep up with the expansion of USA money supply –
   3. too little too late – Certificates of Deposit (NCD) and repo rates soaring (in some occult cases as high as 1000%)
      1. it looked to be a matter of time before another major Chinese bank collapses.
   4. Very recently – Bank of Jinzhou looks to be following Baoshang’s fate – may get seized by the government
   5. A common factor between both of these companies – delayed publishing their latest annual reports
      1. red flag suggesting an upcoming solvency event across some of china’s biggest banks –
      2. Ranking in asset list CYN bn – Hengfeng Bank 1,420, Bank of Jinzhou 723 (currently troubled), Chengdu Rural commercial bank 706, Baoshang Bank 576 (gone), Bank of Jilin 392 – 2 of the top 5 – time will tell for rest
   6. the PBOC – Beijing working fast to avoid panic- Siezing a bank is a Pandora box event for a system that relies on confidence
      1. replay of what happened with Bear Stearns back in 2008 – JPMorgan was gifted at cents on the dollar
      2. Assumption for banks backstopped by the government – where they “absorb” the bank – effectively nationalizing it = confidence – at least in one failure – but only so many that can be bailed out
   7. Chinese share market – banks are listed, but the biggest are technically already owned by Gov anyway – put a ban on selling shares
   8. But governments around the world want this – stem the flow of panic selling by shutting down exchanges, or blocking sales

Indirect manner of doing this – through the SIB and SIFI regulation covered in the bail in eps

7. they want to have banks (or SIBs) owned by Financial institutions like insurance companies or investment banks – These are SIFIs – both are heavily regulated
8. Gov will just ban the sale of the investments – so the SIFIs won’t sell the SIBS
9. Rules for higher margins or collateral for funds that use over-the-counter derivatives are already being phased in – but where will banks get this collateral from? The final stage of the implementation of these rules, which impact smaller funds, has been extended by a year to September 2021 – trouble is –
10. Interesting – really anyone’s guess where to from here – if I see another interesting event – will do an ep on the current concentration of ownership in share, and super fund investments

But in summary –

1. Banks around the world seem to have ramped up risk since GFC – size of debt and debt obligations to make money in a low interest rate environment
2. DB is running into troubles – trying to sell its derivatives and other debt instruments in a bundle to other banks
3. China banks are needing help – And China hold a lot of derivative obligations with DB – hard to get actual numbers, but ICBC, Bank of China, Construction Bank, and others are counter party
   1. ICBC taking on 11% of Bank of Jinzhou and these banks hold lower capital reserve ratios (if even accurate) – 12%
4. That is the connection – the butterfly flapping its wings – one spark in Germany – puts financial pressure on top of an already fragile China banking system, when then flows on to other massive banks, insurance companies

Nothing to be massively worried about unless something further happens from here – but will keep a closer eye on bits and pieces and do updates

Just isn’t a great idea to hold investments in mostly banks/financial companies –

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