How Much Have Banks Really Cut Their Risks?
The Trump administration is looking to ease financial-strength requirements for big banks, on the grounds that they’ve already done enough to avert another crisis. But how much safer have they really become?
In recent posts, I’ve offered some less-than-encouraging evidence. Levels of loss-absorbing equity, although higher than before the crisis, still fall far short of what’s needed. And despite the added equity, the market doesn’t appear to believe that the largest U.S. banks are much healthier than they were a decade ago.
This time, I want to focus on a different part of the balance sheet: the banks’ trading operations, where they buy and sell securities and derivatives. These should have become a lot less risky in recent years, in part because the Volcker Rule -- adopted by Congress as part of the Dodd-Frank Act in July 2010 and in effect since July 2015 -- forbids the kind of speculative trading that cost the big banks billions of dollars in the market turmoil of 2008.
Indeed, conventional risk measures have declined sharply compared with 2009, the year before Dodd-Frank was passed. 1 Although total trading assets at the six largest U.S. banks were pretty much unchanged (at about $1.6 trillion), the combined value at risk -- that is, the most they expected to lose on any but the rare day 2 -- stood at just $279 million, down from about $1 billion in 2009. Here’s how that looks:
Value at risk, however, can be misleading. It estimates potential losses based on what has happened in the recent past -- typically the last year or so. If markets have been calmer, it will register less risk even if the nature of banks’ assets hasn’t changed. And markets are a lot calmer than they were in 2009. Here, for example, is a measure of volatility in the U.S. stock market:
So what if we adjust for this trend in volatility? What if we strip it out to get a sense of whether risk-taking has really declined, independent of the broader market? The result won’t be perfect, 3 but it should give us a rough idea. Here, then, is the adjusted value at risk for the six largest U.S. banks:
It indicates that, relative to the broader market, the banks’ trading operations are only about 25 percent less risky than they were in 2009 -- and have actually become a bit riskier over the past year.
Make no mistake: Banks should take risks. Lending to people and companies is both inherently risky and crucial to the economy. But they don’t have enough equity to absorb the inevitable losses from bad bets, and they’re still taking plenty of risk in areas -- such as the trading book --where they should be safer.
This might suggest that financial reform needs some rethinking. It doesn’t suggest that now is a good time to gut the protections so recently put in place.
Various mergers and reporting changes make it difficult to go any earlier.
Some banks use a threshold of one in 100 days, others one in 20. This means I'm mixing measures, but this should be OK for my purposes because they remain consistent over time.
For one, banks' trading assets tend to include more bonds than stocks. That said, I got roughly the same result using the volatility of a corporate-bond index.
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