Bank risk in emerging markets

The past decade saw an unprecedented rise in the fortunes of emerging-market banks. Less affected by the global financial crisis than their developed-world peers, their collective revenue surged to $1,400 trillion in 2012 from $268 trillion in 2002. The future, however, may be a different story. Historically strong capital and liquidity positions have eroded, and operating pressures are mounting from a combination of factors including tighter US monetary policy, stronger growth in developed markets, a changing regulatory landscape, and increasing competition.

Profitability in emerging markets is still much higher than in developed markets: countries such as South Africa, for example, enjoy very high return-on-equity ratios and strong value creation. Yet revenue margins that have been double those in developed markets have already been hit in some regions, and further deterioration seems likely. The net result is that risk management has moved to the top of the agenda for emerging-market bank CEOs and their boards. Risk teams that once focused only on measurement, compliance, and control must now shift toward mitigating challenges on credit, capital allocation, and liquidity or funding.

Traditionally, banks in emerging markets have paid little attention to cultivating a risk culture, where employees feel encouraged to speak up when they observe new risks. In the current economic and banking environment — where banks must respond decisively to existing and emerging risks — it’s critical to develop a strong risk culture. Many banks have begun to take the initiative by setting up dedicated sessions with business, risk, and control functions to evaluate risk-response scenarios; explicitly defining what’s expected of all stakeholders; and engaging in tests to reinforce a strong risk culture. In addition, many emerging-market banks plan to introduce or upgrade institutional frameworks on risk to promote prudent decision making—an action strongly encouraged by regulators concerned about strengthening banks’ risk management and governance.

There is significant room for improving credit collections. For example, loan-loss impairments for emerging-market banks nearly tripled to €34 billion between 2007 and 2012. Addressing this issue requires two steps: identifying actions on nonperforming loans that can have an immediate positive impact on bank performance, and supporting improvements to credit management related to a defined recovery strategy, organizational structures and processes, and systems.

Emerging-market banks need to make better-informed credit decisions. There is simply not enough information on creditworthiness, whether in the form of reliable financial data about customers (especially for small and midsize enterprises), credit-bureau information, or historical performance data. Given these gaps, banks have strong incentives to develop their own innovative risk models that incorporate both qualitative and quantitative factors. Where credit bureaus are active, they are having an impact.

Bank capital will be increasingly scarce in most markets. Yet banks can support business growth and unlock profit potential by understanding where current capital is consumed and optimizing its absorption. We have seen some banks establish a capital-based threshold at which they retain a client’s business. Others seek more collateral or push for more favorable collateral from a risk-weighted-asset standpoint and add covenants to mitigate “rating drift.” Emerging-market banks can also optimize their product portfolio for capital consumption, steering customers toward receivables-based financing rather than working-capital financing.

Source: McKinsey&Company

Cyber-terror attack on banks — a devastating possibility

Bankers and U.S. officials have warned that cyber-terrorists will try to wreck the financial system’s computer networks. What they aren’t saying publicly is that taxpayers will probably have to cover much of the damage.

Even if customers don’t lose money from a hacking assault on JPMorgan Chase & Co., the episode is a reminder that banks with the most sophisticated defenses are vulnerable. Not simply an effort to steal money, the attack looted the bank of gigabytes of data from deep within JPMorgan’s network.

US Treasury Department officials have quietly told bank insurers that in the event of a cataclysmic attack, they would activate a government backstop that doesn’t explicitly cover electronic intrusions. A worst-case event that destroyed records, drained accounts and froze networks could hurt the economy on the scale of the terrorist attacks of September 11, 2001.

The government might have little choice but to step in after an attack large enough to threaten the financial system. Federal deposit insurance would apply only if a bank failed, not if hackers drained accounts. The banks would have to tap their reserves and then their private insurance, which wouldn’t be enough to cover all claims from a catastrophic event.

AIG in May began offering a new line of insurance in addition to previous policies for the costs of data breaches, hack investigations and business interruption. The new policies cover physical damages to people and property, such as inoperative computers or broken electrical grids. Still, even expanding product lines can’t solve the problem of a systemic crisis.

“Nobody has really been able to define what cyber-terrorism risk is,” said Mirel, now a partner at Nelson Levine de Luca & Hamilton LLC. “So even the companies that are offering these policies don’t entirely know what they are covering.”

Source: Bloomberg

Iraqi bonds gain on Maliki resignation optimism

Iraqi government bonds advanced, sending yields down the most in 11 months, on speculation Iraqi Prime Minister Nouri al-Maliki’s resignation will improve the country’s security situation.

Maliki’s move ends a political impasse and may enable Prime Minister-designate Haidar al-Abadi to pull together a more inclusive government better able to counter Islamist militants advancing in the north.

The financial markets had largely priced in this change as we witnessed a 2.5 point rally in Iraq 2028 bonds during the week. The bonds continued their impressive rally on Friday and the yield on the dollar-denominated debt maturing in January 2028 fell 27 basis points to 6.88% at 6:10 p.m. in London, the biggest decline since September 2013.

The Iraqi bonds joined the continued strengthening we’ve seen elsewhere in Emerging Markets and Russia in particular. The rate decreased 61 basis points in the past five days, the first weekly retreat this month. Yields on the government’s 2028 securities have risen 59 basis points since the Islamic State militants captured the northern city of Mosul on June 10.

Who buys bonds with a negative yield?

Bloomberg today reports that German bond gains sent the two-year rate below zero for the first time since May 2013 before the European Central Bank announces its latest decision on monetary policy today. The two-year note rate was at minus 0.002 percent, and touched minus 0.004 percent, the least since May 24, 2013. A negative yield means investors who hold a security until it matures will receive less than they paid to buy it.

Another way to look at it is that Germany is not only able to borrow money from the market but they are earning a small amount of interest on top of it. This rare but realistic phenomenon is being driven by only one thing – fear. Investors in other parts of Europe are so worried about getting their money back that they are willing to pay a little for the peace of mind of knowing that they will get back their full capital later.

Now one may wonder why investors in Europe are willing to pay interest on German notes/bonds when they can buy the US, UK or Australian bonds and still earn some interest and the reason is foreign exchange risk. Investors don’t want to have to worry about changes in the value of the EUR/USD or about the cost of converting their currency back into euros in the future if it means paying a small amount of interest.

Central banks of countries like Denmark on the other hand cut their interest rate to zero because so much money have flowed into their countries and currencies that they have to actively try make their assets unattractive. The European Central Bank has already brought their deposit facility rate to zero, which means banks will earn nothing for parking their money overnight safely with the central bank. And at this point, negative deposit rates are no longer unimaginable.

Why did Argentina default now?

Argentina is famous for defaults on sovereign bonds. In the early 20th century, the South American country was one of the world’s richest, thanks to its production of beef, wheat and other farm goods, plus an educated workforce made up mostly of European immigrants and their descendants. But the constant crises, often attributable to government mismanagement and fluctuating commodities prices, have plunged millions into poverty.

To understand Argentina’s default in 2014, you need to go back to its 2001 default. That default, in turn, had its roots in Argentina’s earlier monetary policy. The country had abandoned the idea of an independent exchange rate instead of a fixed peg to the dollar. That dollar made foreigners more inclined to lend to Argentina and fueled a credit boom. But eventually fallout from the economic crisis in East Asia in 1997 made investors more skeptical. As their money left the country, Argentina fell into a deep depression.

After several years of economic decline, things came to a head in 2002 when the country finally abandoned its currency peg and defaulted on its outstanding debts. In the very short-term, that only seemed to increase the chaos. But the new currency policy led to strong bounce-back growth in 2003 and 2004 that continued on for several further years.

By 2005, Argentina was back on its feet and looking to normalize its relationships with the outside world. Part of that was trying to do a deal with the holders of those bonds it had stopped payment on. In January, Argentina made an offer. Holders of old debt could abandon their non-performing claims and in exchange get new bonds — less onerous than the old ones, but where interest would actually get paid.

About 75% of outstanding bonds were exchanged. Then in 2010, there was a new offer to the remaining holdouts that brought participation in the swap all the way up to 93%. In the meantime, the market value of the holdout bonds had sunk quite low. Hedge fund manager Paul Singer came to own a large share of the non-performing bonds via his distressed debt fund. And he began pursuing a variety of strategies — including seizures of Argentine assets abroad — to try to get his money. But his boldest strategy was litigation in a New York federal court.

Singer got District Court Judge Thomas Griesa to rule that under New York law, the arrangement whereby Argentina paid some of the people to whom it owed money but not the others was illegal. And violating the traditional principle that there’s no real way for courts to enforce a ruling against a sovereign debtor, Griesa ruled that there was a legal mechanism available to force payment. Most of the exchange bonds were paid via financial institutions that did considerable business in New York. Griesa could — and did — order those institutions to refuse to have anything to do with handling Argentina’s bond payments until Argentina began paying the holdouts the full original amount of money they owed.

The case was appealed up to the Supreme Court, which declined to hear it, and then there were several last-ditch efforts at a settlement. But yesterday it became clear that the parties are sticking to their guns. Argentina will not pay more to Singer than it pays to the people who accepted the terms of its debt swap, Singer will not accept that, and Griesa will not let Argentina pay its bondholders if it doesn’t have a deal with Singer.

Hence, default.

Argentina defaults on foreign currency debt triggering $1bn swaps

For the second time in 13 years, Argentina is in default on foreign-currency debt. But this time around the default was different. A federal judge in New York has ruled that Argentina must pay a small group of creditors in full — about $1.3 billion — even though it got 93 percent of its other bondholders to accept partial payment in a debt restructuring after its 2001 default.

Argentina has about $200 billion in foreign-currency debt, including $30 billion of restructured bonds, according to S&P.  The nation isn’t in a position to participate in a settlement with the hedge funds because doing so would require the country to similarly sweeten terms for the 93% of investors who went along with the country’s debt restructurings in 2005 and 2010. Those investors got about 30 cents on the dollar. The requirement, known as the RUFO clause, could trigger claims of more than $120 billion, dwarfing the country’s $29 billion of reserves, he said. The clause is set to expire at the end of 2014.

Argentina was supposed to pay $539 million in interest by July 30 on its bonds due in 2033. The deadline passed after two days of negotiations at a court-appointed mediator’s office in New York failed to produce a settlement with the hedge funds.

Standard & Poor’s declared default yesterday. Fitch Ratings lowered Argentina’s foreign debt rating to selective default, following S&P’s decision to do the same a day earlier. However, Moody’s Investors Service placed the country’s rating on negative outlook. Moody’s said in a statement that the “non-payment of debt obligations to creditors after a grace period has expired is a default.” As much as $29 billion of securities are subject to so-called cross-default clauses, allowing holders to demand immediate repayment. The amount is equal to the country’s foreign-currency reserves.

Argentina’s failure to pay interest on its bonds is a credit event that will trigger settlement of $1 billion of default insurance, according to the International Swaps & Derivatives Association. Argentina denies it is in default. It says it has the money to pay the vast majority of its creditors and has not done so only due to the court’s ruling.

ISDA’s determinations committee made the ruling in response to a question posed by Swiss bank UBS AG after the government missed a July 30 payment deadline on $539 million of interest. ISDA’s determinations committee was formed in 2009 and makes binding decisions for the market on whether contracts can be triggered. The 15-member group includes representatives from Bank of America Corp., Elliott Management, Morgan Stanley and JPMorgan Chase & Co.

There were 2,652 contracts covering $1 billion of Argentina bonds as of July 25, according to the Depository Trust & Clearing Corp. Following the credit event ruling the trades will be settled at an auction. The process sets a value for the defaulted bonds, and then swap sellers pay buyers face value in exchange for the underlying securities or the cash equivalent determined at the auction administered by Markit Group Ltd. and Creditex Group Inc.

The ruling was seen by traders as complicated because Argentina made the required payment to the trustee for the bond, Bank of New York Mellon Corp. The bank said yesterday that a U.S. judge’s ruling bars it from passing the money to bondholders without a resolution of the nation’s dispute with hedge funds led by Elliott Management Corp., which sued the nation for $1.3 billion. It may encourage other creditors to demand full payment, scuttling the debt deal and make future debt restructurings elsewhere impossible.

Geopolitical risk rising for global investors

Brian Bremner and Simon Kennedy quotes Raj Hindocha in Bloomberg: “Geopolitical risk is being underestimated and volatility suppressed, thanks in large part to the open monetary spigots at the U.S. Federal Reserve, European Central Bank and Bank of Japan.” Hindocha is a managing director with Deutsche Bank Research in London.

Since the start of the year, conflicts in Syria, Gaza and Iraq have escalated, China has become more assertive in pursuing territorial claims against Japan, Thailand reverted to military rule, Russia annexed Crimea and separatists in Ukraine downed a civilian airliner.

These crises have had little lasting impact on major financial markets in the U.S., Europe and in Asia. The investors and money managers could be in for a rude awakening later this year.

Though it’s nowhere near the levels of 2011, when the U.S. recovery sputtered and Europe was in the grip of a sovereign debt crisis, volatility is starting to make a comeback.

The Chicago Board Options Volatility Index — which rises in times of market stress — is up 8.56% so far in July and poised for its biggest monthly jump since January. The U.S. and Europe agreed to escalate their pressure on Russia with a new set of sanctions targeting the country’s financial, energy and defense sectors. Russia is planning to ban some imports from US and Europe.

Investors are taking the recovery in US, Europe and Japan more seriously than geopolitics, however if there’s a major escalation then the geopolitical risk premium will rush back into the market,

Yields on Iraqi bonds starts retreat after jump

Iraqi bonds plunged the most in two years after fighters from ISIS, a breakaway al-Qaeda group took control of Mosul.

PriceThe yield on Iraq’s $2.7 billion of bonds due in January 2028 climbed 60 basis points to 7.03% on June 11 after ISIS militants seized the country’s second-largest city, Mosul. It’s the biggest jump in a year on a closing basis. The spread over 10 year US treasuries jumped by 59 basis points to 438 basis points. The yield again climbed 24 basis points on June 16 to 7.50%. It increased to 7.77% on June 19 with the premium over US treasuries shooting up to 506 basis points.

IQ 2028 BondsThe bond yield, however, started a retreat as nation’s army sought to check rapid advance of militants who seized some major cities. The yield declined  by 28 basis points on June 24 to 7.42%. It further declined to 7.26% on June 27, which is 472 basis points higher than US treasuries. The spread over US treasuries was 653 basis points on June 26 last year, the day before the UN decision to ease the sanctions.

The Iraqi bonds have been the best performers in the Middle East and Africa region for the past six months, with 15%, JPMorgan Chase & Co. indexes show.

The International Monetary Fund forecast economic growth at 5.8% this year, up from 3.7% in 2013. Foreign-currency reserves rose 33% in the fourth quarter of 2013 from a year earlier to $88 billion as oil output surpassed Iran.

The issue size of the bond is less than 2.7% of Iraq’s oil export revenue and is just 3% of Iraq’s foreign currency reserve.

Big changes planned for Iraqi stock markets

Melissa Hancock says that while Iraq’s elections have been the focus of international news, the country’s considerable progress in developing its stock markets has gone largely unnoticed.

The Iraq Stock Exchange (ISX) is currently in the process of upgrading to the latest Nasdaq trading platform after signing an agreement with Nasdaq OMX in June 2013. The new platform, currently used by more than 25 exchanges globally, is capable of supporting multiple asset classes, although the ISX concentrates mainly on cash equities.

The ISX is also assisting the Erbil Stock Exchange (ESX), the first exchange in Iraq’s semi-autonomous Kurdistan region, in setting up its Nasdaq trading system. It is due to be fully implemented in July, and the ESX hopes to see around five to 10 listings by the end of 2014, including a major telecom company. The ESX has $8 million in initial capitalization and 56 shareholders, primarily from the private sector.

With 84 listed companies, the ISX has a market capitalization of $9.5 billion to serve a population of 30 million, an amount substantially smaller than other oil-dependent markets in the GCC, which range in size from $208 billion in the United Arab Emirates to $479 billion in Saudi Arabia.

The biggest challenge is the custody issue. Big institutions are shying away from the market, as they don’t have a custodian they can work with. JPMorgan and Citibank had expressed their interest. Once the custody issue is resolved, the Iraqi stock market is bound to grow manifold.

US withdraws special immunity to Iraq

US President George W. Bush issued an Executive Order No. 13303 on May 22, 2003 to protect the Development Fund of Iraq and certain Iraqi properties against the threat of attachment or other judicial process. The coverage of this special protection was extended by Executive Order No. 13364 of November 29, 2004 to include Central Bank of Iraq also.

President Barrack Obama issued an Executive Order on May 27, 2014 terminating the prohibitions contained in the order No. 13303 and 13364 on any attachment, judgment, decree, lien, execution, garnishment, or other judicial process with respect to the Development Fund for Iraq and Iraqi petroleum, petroleum products, and interests therein, and the accounts, assets, investments, and other property owned by, belonging to, or held by, in the name of, on behalf of, or otherwise for, the Central Bank of Iraq. Henceforth, the Government of Iraq and its properties will enjoy general sovereign immunity under applicable law.

Sovereign immunity is a judicial doctrine that prevents the government or its political subdivisions, departments, and agencies from being sued without its consent. Until the twentieth century, mutual respect for the independence, legal equality, and dignity of all nations was thought to entitle each nation to a broad immunity from the judicial process of other states. This immunity was extended to heads of state, in both their personal and official capacities, and to foreign property.

With the emergence of socialist and Communist countries after World War I, the traditional rules of sovereignty placed the private companies of free enterprise nations at a competitive disadvantage compared to state-owned companies from socialist and Communist countries, which would plead immunity from lawsuits. European and U.S. businesses that engaged in transactions with such companies began to insist that all contracts waive the sovereign immunity of the state companies. This situation led courts to reconsider the broad immunity and adopt instead a doctrine of restrictive immunity that excluded commercial activity and property.

Western European countries began waiving immunity for state commercial enterprises through bilateral or multilateral treaties. In 1952 the U.S. State Department decided that, in considering future requests for immunity, it would follow the shift from absolute immunity to restrictive immunity. The Foreign Sovereign Immunities Act (FSIA) is a United States federal law that was into law by President Gerald Ford on October 21, 1976. FSIA provides the sole basis for obtaining jurisdiction over a foreign state. It specifies the conditions that must be met for instituting a lawsuit against a foreign state. It also provides specific procedures for service of process and attachment of property for proceedings against a Foreign State.