Optimism or complacency: The Fed’s Basel capital buffer decision

Under US President Donald Trump, federal agencies have implemented a broad program of financial deregulation. New measures have limited the number of banks deemed systemically important and freed the de-designated banks from the need to undergo stress tests or submit insolvency plans. The Federal Reserve has lowered the minimum liquidity coverage ratio for some of the country’s larger banks and, more recently, has voted not to impose the countercyclical capital buffer (CCB) created by Basel III. These measures have helped boost bank profitability. Some, however, worry this deregulation agenda may create new risks.

In March, the Federal Reserve voted to keep the CCB for large banks operating in the US at 0%. The CCB is a mechanism introduced by Basel III to require banks to increase their capital reserves during periods of strong economic growth so that they are adequately capitalized when the economic cycle turns.

As the US enters the tenth year of its economic recovery – now one of the longest in US history – some have suggested that the Fed should activate the CCB to encourage banks to increase capital ahead of an inevitable downturn.

However, according to a recent speech on the CCB by the Fed’s Vice Chair for Supervision, Randal K. Quarles, the Fed sees “many reasons to expect relatively strong growth in the coming years, supported by gains in the productive capacity of the economy,” and, therefore, is comfortable maintaining a zero CCB in what amounts to “a normal risk environment.”

According to Quarles, then, the Fed sees no sign of a potential slowdown in the coming years and, thus, no need to require banks to build up their reserves.

However, the Fed also voted in March to hold interest rates steady and announced it would be slowing the process of unwinding its sizeable balance sheet, with the goal of ending the unwinding entirely in September. The Fed also released projections for the upcoming year, cutting its 2019 growth forecast to 1.9%.

Many observers interpreted this dovish decision as a sign of the Fed’s growing concern about the risks posed by slowing US economic growth, global trade disputes, and the end of the economic stimulus generated by the 2017 tax cuts.

Therefore, while the Fed’s decision to keep the CCB at zero suggests confidence in the strong economy, its decision to end rate tightening suggests significantly more uncertainty about the economic outlook. Some critics have pointed out that the CCB is intended for exactly such periods of economic uncertainty.

According to Gregg Gelzinis, a policy analyst at the Center for American Progress, “The Fed’s refusal to activate the CCB completely ignores the lessons learned from the 2007–2008 financial crisis. During positive economic times, as risks develop under the surface, regulators should strengthen financial safeguards to bolster the banking system in advance of the next economic downturn. As noted in the Fed’s own financial stability report… valuations across many asset classes are stretched, corporate leverage is near a 20-year high, and riskier firms have been increasing their debt the most. Now is the time for regulators to enhance the resiliency of the banking sector.”

In contrast, however, Quarles argues that the Fed’s current requirements are adequate.

“Because we set high, through-the-cycle capital requirements in the United States that provide substantial resilience to normal fluctuations in economic and financial conditions, it is appropriate to set the CCB at zero in a normal risk environment,” he said.

History shows that financial services regulation is cyclical. During times of financial crisis and recession, regulators enact new rules addressing the weaknesses that caused the crisis. Then, during expansions, complacency sets in and regulatory frameworks are dismantled until a new financial vulnerability ignites a new crisis.

As the US recovery continues, many believe that banks have put the errors of the past behind them and are on a firm footing, justifying further deregulation and monetary accommodation. Others worry that we are witnessing the complacency that precedes a fresh crisis. Developments over the next eighteen months may offer some clarity about who is correct.

Know-How

Intuition Know-How has a number of tutorials that are relevant to ALM and FinTech:

• Basel III – An Introduction
• Basel III – Pillar 1 & Capital Adequacy
• Basel III – Measurement Approaches
• Basel III – Liquidity & Leverage
• Basel III – Pillar 2 & ICAAP
• Basel III – Pillar 3 & Risk Reporting

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Tech IPO rush tests market appetite for unprofitable companies

This year promises to offer a flurry of tech unicorn listings – that is, the initial public offerings (IPOs) of privately held technology companies with valuations over $1 billion. Ride-hailing company Lyft and electronic bond-trading platform TradeWeb both listed in late March at $1 billion-plus valuations. In April, the markets welcomed social media site Pinterest. Other tech unicorn IPOs in the pipeline for 2019 include ride-hailing company Uber, data mining company Palantir, coworking giant WeWork, and workplace messaging service Slack. But early signs suggest that the market’s appetite for loss-making companies may be weaker than anticipated.

Amid much fanfare, Lyft beat arch-rival Uber to market on March 28, debuting at $72 a share, a price that valued the loss-making company at around $24 billion and raised $2.34 billion in fresh capital. The shares were reportedly up to 20 times oversubscribed and, on Lyft’s first trading day on the Nasdaq, closed at $78.

It seemed that, given Lyft’s 103% year-on-year growth in revenue for 2018, the market was willing to overlook its $911 million loss – a loss that was up 32% from 2017. Many interpreted Lyft’s strong IPO as a sign that the market was hungry for high-growth tech listings, regardless of profitability. This came as a relief – because a host of such unprofitable, multi-billion-dollar tech companies will debut this year, it’s important that there is robust investor appetite for them.

However, the initial optimism about Lyft seemed to sour after a few days. By mid-April, the shares were trading at closer to $60 as analysts’ notes pointed to an uncertain path to future profitability.

Lyft’s post-IPO performance was broadly in line with the historical performance of newly listed companies. US professor Jay Ritter, who studies IPOs, told the Wall Street Journal that, on average, IPOs perform well on their first trading day but underperform the market over the subsequent three years, by an average of nearly 20%. Facebook, for example, traded below its IPO price for well over a year after listing.

Nevertheless, Lyft’s struggles were a marked contrast to the performance of TradeWeb, which debuted on the Nasdaq in early April at a price of $27 a share and is now trading at close to $40.

Unlike Lyft, Tradeweb is already profitable, reporting net income of $160 million on $684 million in revenue in 2018. This contrast between the performance of the two IPOs suggests that investors may not be as indifferent to profitability as the Lyft IPO initially indicated.

Lyft’s struggles have had an effect on the IPO market. Pinterest, which started trading in mid-April, was initially expected to price its IPO close to the almost $22 a share at which it sold a stake to private investors in 2017. However, in the wake of Lyft’s weak performance, the company’s SEC filing documents priced it at an IPO range of $15 to $17 a share. Ultimately the IPO priced at $19 a share – higher than the indicated range but lower than initially hoped.

This may bode ill for the year’s other big listings. The initial valuation of Uber, for example, has been pegged as high as $120 billion, making it among the world’s 100 largest listed companies by market cap.

Now, some are wondering if the Uber IPO will live up to the hype. According to its April SEC IPO filing, in 2018, Uber reported a net loss of $1.8 billion on gross bookings (revenues before payments to drivers are deducted) of $50 billion. Uber’s topline growth slowed throughout the year, while its losses narrowed. With such large losses and slowing growth, some question whether Uber can sustain its lofty private valuation once publicly listed.

Questions have also been raised about the fate of other loss-making unicorns like Palantir and Airbnb. As private companies, neither of these have reported financial statements. However, both are reportedly unprofitable. And both are planning to list this year. With investors potentially wary of unprofitable businesses, their anticipated valuations may be lower than their private equity owners and founders hope.

Despite concerns about potential pricing weakness, the tech IPO bonanza is widely seen as a positive sign for US stock markets. The IPO market started the year on a weak note, particularly in Europe. In the first quarter of 2019, the Financial Times reports that proceeds from stock market listings in Europe were down 99%, while UK proceeds fell by 85%, and Chinese and US proceeds halved. The star-studded lineup of new IPOs in the US for the rest of the year is thus very good news.

Know-How

Intuition Know-How has a number of tutorials that are relevant to IPOs and equity markets, including:

• US Equity Market
• UK Equity Market
• European Equity Market
• Equity Markets – An Introduction
• Equity Markets – Issuing
• Equity Trading – An Introduction

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