Asian banks: Better insulated from contagion risks
- Liquidity strains stemming from deposit flight have resulted in some duress across Western banks
- However, we see limited risks to Asian banks, given different business models and risk factors
- Deposit funding for Asian banks is extremely resilient with a high number of insured depositors
- Lower interest rate volatility and smaller investment holdings also limit unrealized losses
- A greater degree of government ownership and sponsorship for Asian banks provides more confidence
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Liquidity strains rise for Western banks
Liquidity strains have mounted across US banks. Following the collapse of two regional US banks from sudden deposit flight, the Fed has quickly instated a new liquidity facility for the domestic banking system, known as the Bank Term Funding Program (BTFP). The BTFP provides longer-term 1y funding for banks compared to the normal discount window. Importantly, collateral will be valued at par and there are also no haircuts imposed. Such generous terms underscore the high level of policy concerns over liquidity risks faced by banks.
Tremors in the US banking sector have also surprisingly exacerbated banking risks beyond the country. A large Swiss bank also faced a deposit run after it reported “material weaknesses” in its internal controls. While markets might have been more forgiving ordinarily, the untimely failure of two US banks earlier amplified depositors’ concerns and triggered an unsustainable rise in the bank’s cost of funding in credit markets. To resolve concerns, the bank entered into a regulator-facilitated acquisition amid risks of becoming illiquid, even if it remains solvent.
Are Asian banks at risk amid liquidity strains faced by Western banks? We assess the possibility of contagion affecting Asian banks amid an uncertain backdrop for the banking sector.
Channels of contagion in banking
The mode of transmission for the current crisis is a far cry from the 08/09 Global Financial Crisis (or GFC). Unlike 2008, today’s financial shocks are not transmitted by connections amongst financial institutions, where the failure of large and highly connected institutions led to a freeze in funding markets. Rather, there may be herd behaviour among highly affluent depositors, culminating in liquidity stresses to institutions that are overly reliant on them for funding. The two US banks that had entered receivership, and another bank that received a USD30bn deposit through co-ordinated action by other US banks, operate business models geared towards highly affluent clients. This is also true for the Swiss bank, which needed emergency liquidity support from the SNB amid deposit outflows.
Liquidity distress stemming from outflows of depositors is famously described by the Diamond-Dybvig model (1983). Vulnerability lies in the short-term deposit funding needs of banks compared to their long-term asset holdings. As noted by Martin et al (2018), banks that face regulatory bad news typically see an outflow of uninsured deposits, while insured deposits prove sticky. Unsurprisingly, affluent depositors with large deposits above the threshold for insurance are more prone to withdraw in the event of negative news. Their re-assessment of banking risk following multiple bank failures is sufficient to tip the outcome from a good equilibrium to a negative equilibrium, given the existence of multiple Nash equilibria.
In other words, depositors, in anticipation of a flight of other depositors given bad news, will rationally choose to migrate their deposits to safer banks. Lenders of last resort are critical to support banks’ liquidity under such circumstance. The Fed’s new BTFP is an important liquidity support measure that serves such a purpose.
While there may be fragilities for some banks’ deposit funding, are there reasons to be concerned about contagion via interbank channels, as described by Allen and Gale (2000)?
Post the GFC, we think interbank contagion risks are now quite small, especially for Asian banks which are less dependent on offshore funding. For one, important regulations on counterparty risk management have been introduced with attention to the topology of links between banks, as mentioned by Yellen (2013). Second, large, systemically important banks also face higher capital, liquidity, and supervisory standards today. The global financial system is unequivocally more insulated compared to 2008.
It is still necessary to gauge whether Asian banks are exposed to the three risk factors that had raised uncertainty recently for Western banks, namely:
- a disproportionately large uninsured deposit base
- regulatory and legal issues
- mismanagement of interest rate risk and excessively large unrealized losses on their investment portfolios
Asia’s resilient deposit base
We see Asian banks’ deposit base to be highly resilient. All major Asian economies have introduced deposit insurance schemes since the 97/98 Asian Financial Crisis, with China being the last to implement this in 2015. Their coverage limits are also set high enough to ensure that the vast majority of deposit accounts (>90%) are fully insured.
For banks active in Asia USD credit markets, all have business models catered to the retail mass market, with limited dependence on affluent depositors. Their deposit base is thus closer to the country average in terms of the proportion of fully insured depositors, which should curb risks of deposit flight.
On top of that, a high proportion of Asian financial institutions are partially owned by state or local governments, or government sponsored. We estimate that more than half of Asian USD financial bonds are issued by such state-linked institutions. These institutions enjoy the perception of implicit government support. Existing state ownership also implies less political hurdles for Asian governments to intervene with direct capital injections if necessary, or to extend deposit guarantees to these institutions during duress.
Smaller regulatory and legal risk surface
Asian banks, as compared to Western banks, also have less market transactions and complexity given the limited depth and development of their domestic financial markets. This implies a smaller surface area for legal and regulatory risks. The extent of litigiousness may be different across Asia, given a myriad of political and legal systems. But the smaller degree of legal provisions for Asian banks are indicative that they are less at risk from regulatory or legal issues that could give rise to jitters among depositors.
Structurally lower interest rate risks
The initial crack for US banks arises because of capital shortfall concerns at a regional US bank, given high unrealised losses in its investment portfolio. Under FASB accounting rules that allow for HTM (held to maturity) assets to be held at cost instead of mark-to-market, these losses were not immediately recognized as threatening the viability of the bank, until it had to sell the securities for liquidity and is then forced to realize losses. The balance between securities in AFS (available for sale) and HTM portfolios has implications for interest rate risk management, which was less than ideal for the US bank in question.
For Asian banks, interest rate risk in the banking book (for long-term investments) are not too worrying. First, the interest rate hike cycle in Asia is far more gradual than in the US. Consequently, Asia faces a smaller rise in long-term rates and rate volatility. This poses less market risk for banks’ investment holdings, even in the event of inadequate interest rate hedges.
Second, Asian banks are not holding excessive investments in securities. Neither is there a large pool of very-long duration, high quality liquid assets to hold in Asian bond markets (as compared to the US MBS market). On average, investments amount to between 13% and 27% of total assets for Asian banks that we monitor in USD credit markets. There is little scope for large unrealized MTM losses on these investments. By and large, we see credit risk, not market risk, as the primary driver of Asian banks’ capital positions, given their high proportion of net loans (>50%) to total assets.
Last but not least, banks’ negative rate exposure on the securities side is usually balanced by positive rate exposure through rising net interest margins. Given the gradual rate hike cycle for Asia, average net interest margins have also expanded across most markets, providing a natural cushion against unrealized losses. Among the banks that we monitor, only Chinese and Philippine banks have reported a small decline in net interest margins.
Limited funding risks for Asian financial credit
Liquidity concerns that had struck Western banks should not be understated, making clear vulnerabilities related to funding. The Fed, Treasury and FDIC had invocated a “systemic risk” exception to provide deposit insurance for the two banks entering receivership. The crux of such policy actions is to support US depositor confidence, and pre-empt a destabilizing run of uninsured depositors from the US banking system. In particular, US investment banks have also grown to rely more and more on deposit funding from their wealth management business. In today’s connected world where misinformation can spread quickly across social media, policy adeptness in shoring up confidence is vital.
In contrast, large Asian banks are better positioned. Most possess a strong mass market franchise, have very high fully insured depositor numbers, and enjoy perceptions of implicit state support. Moreover, unrealized investment losses on Asian banks’ securities portfolio should not be large. Credit of Asian banks should thus stay resilient in view of their limited funding risks.
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