ECB warns of risks posed by shadow banking sector
James Shotter in Frankfurt and Claire Jones in Dresden
The rapid growth of the shadow banking sector poses a risk to financial stability in the eurozone, the European Central Bank has warned.
The lightly-regulated sector, which includes a broad array of institutions engaged in banklike activities, such as investment funds, could be part of “future systemic events”, due in part to its “increased size and remaining opaqueness”, the ECB said.
“The greater the leverage, liquidity mismatch and size of certain intermediaries, the more likely they are to amplify shocks,” it said in its twice-yearly financial stability review, adding that the sector’s risk exposure could be higher than widely assumed, due to the use of derivatives.
The shadow banking sector has grown dramatically in the years since the financial crisis as banks have been hit by tough new regulations that have squeezed some of their traditional activities. Over the past decade the sector’s eurozone assets have more than doubled to €23.5tn. However, the accumulation of risk in this more thinly-policed part of the financial system has prompted growing concern among regulators.
One way that trouble in the shadow banking sector could spill over into other parts of the financial system would be in the event of a sharp fall in asset prices, the ECB said. This could prompt investors to pull their money from investment funds, forcing the funds to sell their holdings, in turn pushing asset prices even lower.
“Large-scale outflows cannot be ruled out in the event of adverse economic or policy surprises over the medium term,” the central bank concluded.
A sharp sell-off in financial markets was one of three other risks the ECB identified in its report. While the central bank’s aggressive monetary easing has helped boost hopes of a more meaningful recovery in the eurozone, it has also led to concerns over inflating asset prices.
Vítor Constâncio, ECB vice-president, said that he did not think eurozone assets were generally overvalued, but conceded that there were “pockets” of “rich” valuations. Mario Draghi, ECB president, said this month that aggressive monetary easing, including mass bond-buying, could lead to financial instability.
The third risk outlined by the ECB was the lacklustre profitability of banks and insurers, both of which have seen their earnings crushed by the low interest rates that have prevailed since the financial crisis.
The ECB’s landmark €1.1tn quantitative easing programme, unleashed in January, has dramatically lowered yields on sovereign debt, and the paper of several eurozone governments, including Germany, now trades at negative yields. Such yields make it hard for insurers to earn enough from their investments to cover the claims they must pay out to clients.
Last June, the ECB became the first major central bank to introduce negative interest rates. It imposes a levy of 0.2 per cent on banks’ reserves parked in its coffers. Few banks have been able to pass on these costs to their customers, and have seen their margins squeezed as a result.
The ECB also warned about the sustainability of corporate and sovereign debt burdens, if economic growth does not pick up.
Shadow banks push for easing of loan caps
Ben McLannahan in New York
A band of lenders within the shadow banking system is making a new push on Capitol Hill, seeking an easing of rules capping their loans to middle-market companies across America.
Since the financial crisis, regulators have made it more difficult for the biggest banks to hold loans to the most debt-laden companies, pushing much of this activity into special tax-free investment vehicles known as business development companies (BDCs).
Loans managed by public and private BDCs total more than $70bn, according to analysts at Wells Fargo, more than triple the levels of 2010. But lobbyists for BDCs argue that their support to small and midsized companies — the engine of the US economy — could be even stronger, if regulators changed decades-old rules that require them to hold $1 in equity for every $1 they borrow. A new bill, due to be presented to Congress in coming weeks, would allow a BDC to borrow up to $2 for every $1 of equity.
The push comes amid a surge of interest in the sector by big institutions such as Goldman Sachs, which launched a $120m BDC in March — the first to be backed by an investment bank — and Credit Suisse, which filed for a $500m offering around the same time.
It also comes amid concerns over the rapid development of the lightly supervised realm of shadow banks, in which a broad array of institutions carries out banklike activities. Last week the Financial Stability Oversight Council, a body created in the wake of Dodd-Frank Act of 2010, said in a report that the migration of leveraged lending away from banks could lead to sloppy underwriting, resulting in “larger losses in stressed conditions”.
Industry executives note that moves to loosen rules on BDC leverage have foundered in the past. In June 2013, Mary Jo White, Securities and Exchange Commission chairwoman, objected on the grounds that it would expose retail investors — who hold the bulk of the stock of listed BDCs — to a greater risk of losses. Another effort last year faded when one of the bill’s sponsors, New York congressman Michael Grimm, was entangled in charges of tax fraud.
Chart: Comparison of yields across selected US asset classes
This time, executives say they are more sensitive to the SEC’s concerns. They will argue that loosening restrictions could actually alleviate risks to investors by giving BDCs the option to hit return targets via leverage, rather than extending higher-yielding loans to shakier borrowers. They may also propose a year-long cooling-off period after a shareholder vote to increase borrowing, according to people familiar with preliminary discussions. The SEC declined to comment.
The old restraints on leverage might have been appropriate when the rules for BDCs were drawn up by the SEC in 1980, said Brett Palmer, president of the Small Business Investor Alliance, a Washington DC-based lobby group.
Chart – Publicly traded Business Development Companies: asset growth
But the rapid growth of the BDC sector since the crisis is “prima facie evidence of a need for capital and a need to get it out”, he said. “Dodd-Frank has put a crimp in a lot of banks. And I don’t see it going away any time soon.”
Poised for Revolution, Currency Trading Gets Veteran Combatant
Bats Global Markets Inc. is betting on a revolution in currency trading like the one in stocks 20 years ago. It began its crusade with a $365 million acquisition followed by a price war.
The currency market “over the next three to five years is going through a structural change that won’t come again,” Bats Chief Executive Officer Chris Concannon said in an interview in the company’s downtown Manhattan office. “It’s equities in the 1990s.”
Bats, via its Hotspot FX acquisition, faces rivals including Thomson Reuters Corp. and ICAP Plc’s recently rebranded EBS BrokerTec venue. Bloomberg LP also operates a market. The competition is formidable: Hotspot had average daily volume of $28.4 billion in April while Reuters had $369 billion, including $118 billion of spot trading.
Concannon, who became CEO on March 31, knows about revolutionary market changes. From 1995 to 1997, as electronic upstarts were taking on the long dominant Nasdaq Stock Market and New York Stock Exchange, he was a lawyer at the Securities and Exchange Commission. He then joined one of the firms, a technologically advanced trading platform designed by a programmer named Joshua Levine called Island.
The company cut out Nasdaq brokers by pairing trades electronically and automatically cheaper than the traditional market. By 2003 Concannon had landed at Nasdaq, where he helped engineer a deal that gave the exchange Island’s technology and market share.
Storefront Roots
Island’s story isn’t unlike that of Bats, which was founded in 2005 in a storefront more than a thousand miles from New York. It handles about one-fifth of all U.S. stock trading and a quarter of the European market with a fraction of the staff and costs of its rivals.
Bats upended the old order in the stock market with a trading engine built from scratch that today handles about 1.2 billion messages a day. Concannon is aiming to replicate his company’s success in equities in the foreign-exchange market by using former CEO Joe Ratterman’s approach: low-cost and customer friendly coupled with cutting-edge technology.
“The goal is to be No. 1 in every business,” he said.
Concannon is gunning for growth at a company that saw its profit rise by 34 percent last year.
“Joe built up this company with this enormous global footprint with very few people,” said Concannon, previously president at trading firm Virtu Financial Inc. “You won’t find a more efficient exchange operator on the planet, and he built that.”
Technology Edge
Earnings before interest, taxes, depreciation and amortization amounted to about $840,000 per person last year at Bats, which today employs about 250 people. Ebitda rose by 34 percent last year to $168 million, according to the closely held company.
Bats’s edge has been its technology, according to Ratterman, particularly the fact that they designed their system with a clear idea of where the market was heading.
“We kind of showed up at a point in time where it was feasible the entire marketplace could run completely from an automated, electronic platform, and both NYSE and Nasdaq probably had loads of legacy still in their systems,” he said in an interview.
While Concannon was the primary driver behind the $365 million purchase of Hotspot in February, it was the structure Ratterman built that made it feasible. As with the acquisitions of Direct Edge Holdings LLC last year and Chi-X Europe Ltd. in 2012 – each for about the same price at Hotspot – the newly purchased company’s infrastructure will shift over to Bats technology.
Unprecedented Scrutiny
“We’ve added to the Bats model the largest asset class on the planet with 40 people,” Concannon said.
The foreign-exchange market is under unprecedented scrutiny as six of the world’s biggest banks recently agreed to pay $5.8 billion tied to currency-rigging probes. It’s also becoming more electronic and more the domain of high-frequency trading.
Algorithmic trading was projected to account for 26 percent of currency turnover last year, compared with 65 percent for equities, according to consulting firm Aite Group LLC. In 2004, about 1 percent of foreign-exchange and 25 percent of stock trading was handled by programs.
Any success for Bats could also be a win for the biggest banks. Among the company’s owners are Credit Suisse Group AG, Morgan Stanley and JPMorgan Chase & Co. Technology-focused traders such as Lime Brokerage and KCG Holdings Inc. also own stakes.
To win market share, Bats is offering free trading at least through the end of the year for traders who take the bid or offer on 30 currency pairs including the Russian ruble and Swedish krona. The company began trying to extend its reach when it announced a new hub near London earlier this year.
While Concannon’s time in charge is only starting, he’s long been part of the Bats story. While at Nasdaq, he sent a customer order to Bats that ended up as part of the first trade on the fledging stock market. To thank him for making the trade happen, Ratterman sent his eventual successor a gift: a toaster, which Ratterman's wife Sandy bought at Wal-Mart.
