Defaults and delinquencies haven’t risen even after many government programs and lender deferrals granted have ended.While the government isn’t offering new support to consumers and companies, some backing continues through older schemes such as the Paycheck Protection Program, known widely as PPP, which provides forgiveness of loans when certain criteria are met by borrowers and guarantees payment of amounts that are not forgiven. To see the effect of unemployment on delinquencies, refer the pdf.
Loan loss models have had to incorporate the impact of massive government stimulus and bailouts during the last 18 months. At the onset of the COVID-19 pandemic, spurred by new loan loss reserve accounting rules (Current Expected Credit Losses, or CECL) introduced in response to the slower recognition of losses that occurred in the 2008 crisis, U.S. banks increased reserves by $88 billion. They subsequently began to release those starting in Q3 2020 as projected losses failed to materialise. Of course we could still see rising defaults as all debt moratoriums end and the economic recovery softens, but clearly, what was initially feared was prevented with government help.
Even though the public’s ire was at the government rescues of failing banks during the 2008 financial meltdown, central banks’ support for financial markets and the economy for many years following it has altered the dynamics of economic activity, going beyond crisis response to consistent backing with low interest rates and asset purchases. And during the pandemic-induced crisis, the U.S. Federal Reserve and other central banks provided even greater support for financial markets while governments in some countries bailed out airlines and a multitude of other sectors hurt by economic lockdowns as well as subsidising small businesses, workers and consumers through multiple trillion-dollar packages.
The possibility of bailouts and massive financial support for every corner of the economy becoming habitual presents a dilemma for risk managers, at least when it comes to unexpected shocks. Should they start including such government backing in their loan loss models each time there’s a sharp downturn that governments might consider as worthy of stepping in? What if some governments don’t follow the script next time? Or what happens if support wanes over time, exposing weaknesses in the economy eventually? Easy monetary policies in effect since 2008 have created zombie companies that are able to survive thanks to near-zero interest rates. If and when rates were to rise, there could be a flurry of corporate failures that could raise loan losses. Yet the developed economies of the world might be stuck in a low-rate environment that they cannot easily get out of, perpetuating the inefficiencies as well as the low delinquencies for years or decades to come. Quantitative Easing, known as QE, where central banks buy government bonds and other debt securities to prop up financial markets and the economy, might be here to stay as well.
“With all the stimulus packages one after another, government debt keeps piling up, so central banks cannot increase interest rates, or governments would have a hard time paying,” says Alberto Gallo, head of global credit strategies at Algebris Investments and a longtime critic of easy money. “That creates a QE-infinity trap. That means we’ll have zero interest rates forever, zombie companies kept alive and some of the workforce that left never coming back.”
Fed officials are debating when to ease off on the accelerator. The so called tapering of the Fed’s monthly purchase of Treasuries and mortgage backed securities might start as early as November, Chairman Jerome Powell said following the September meeting of the central bank’s rate setting committee, though he said it was possible they could wait longer if needed. He also said the Fed would watch the potential economic impact of new virus strains and wouldn’t rush to raise interest rates following such tapering. Even if the U.S. central bank manages to reduce the amount of securities it’s buying monthly, that still won’t mean the end of QE, just a lighter version, according to Gallo. The European Central Bank said in September it will “moderately lower the pace” of its bond buying in the last quarter of the year. While some emerging market central banks have reversed easy money policies and even started jacking up interest rates, the developed world seems to be stuck in QE forever.
The never ending monetary and fiscal support from Western governments hasn’t only hampered the predictive ability of banks’ loan loss models. The combination of heavy monetary and fiscal support and low interest rates has also led to increased risk taking by investors. Crypto currencies, which were born after the 2008 crisis, have benefited from this constant flood of money, repeatedly breaking price records as more and more people jump in to take part in the rapid price appreciation. With interest rates stuck at zero (or below zero in some cases the amount of negative yielding debt exceeded $16 trillion globally in August 2021), investors are forced to turn to riskier bets for positive returns. Some of those result in staggering losses, as we’ve seen in the last six months with Archegos and Greensill, two financial failures that may cost investors billions of dollars. Such risks have rehashed the importance of counter party credit risk management in a highly volatile and risk prone world.
Understanding crypto assets and FOMO
By repeatedly reaching stratospheric highs and then collapsing somewhat before going for the next high, Bitcoin has drawn the attention of wide swaths of the public worldwide, making cryptocurrencies a household concept and attracting millions of people as investors. Or rather, Bitcoin has become a household name and is still the most popular cryptocurrency, but its wide popularity has also helped other crypto assets gain some following and investment along the way. More than 30 million Americans have invested in Bitcoin, and the number of cryptocurrency investors worldwide has surpassed 100 million as the pandemic boosted their popularity. Lending based on crypto has also picked up in the last 12 months. Although it’s still a very insignificant portion of the loan market, the tenfold growth within a year (from $2 billion to over $20 billion) hints at a much more crucial place for crypto lending in the near future.
Unlike fiat currencies and traditional assets such as a house, crypto assets are typically recorded in decentralised ledgers using blockchain technology. Dollar transactions are cleared against banks’ ledgers through a central bank’s clearing system. House purchases are recorded in a governmental agency’s books or in court records. The blockchain ledgers are collectively maintained by the participants in each crypto asset’s network. In addition to cryptocurrencies, whose values are determined by market forces, there are three other types of crypto assets: stablecoins, central bank digital currencies (CBDCs) and non-fungible tokens (NFTs). Stablecoins came out in response to the extreme volatility in the values of initial cryptocurrencies and are pegged against a fiat currency like the U.S. dollar or a basket of such currencies. CBDCs are being discussed by central banks around the world but have not been widely introduced yet by any. NFTs are used to provide a certificate of authenticity for digital artwork, music or videos.
As the market capitalisation of crypto currencies reached $2 trillion in 2021, banks and other traditional financial services firms are paying more attention to the market and considering opportunities for where they can jump in. For banks, the most natural way to do so is through lending. And there’s quite a bit of crypto-based lending already happening, though most of it not involving banks so far. One typical form of this lending comes from the desire of crypto asset holders to cash in some of their riches gained from rising values, without actually divesting any of their holdings. It’s similar to borrowing money using shares in a stock, such as Apple, as collateral when you want to buy a new car. You don’t want to sell any of your stock to buy the car since you expect the shares will be worth more in a few years, so you borrow against it. Since crypto currencies and other crypto assets have been on a rising trend in the last decade, many crypto holders also would like to do the same. Others borrow money to buy crypto currencies, in the belief that they can reap gains above and beyond the interest they’re going to pay on the subject loan. Crypto assets purchased with such a loan are typically used as collateral during the repayment period, just like a mortgage on a house.
Most of this lending is now being done by a recently emerged industry called Decentralised Finance, known as DeFi. These are basically application-based platforms using blockchain technology to match borrowers and lenders directly. Most of them are built on the blockchain of Ethereum, the second most popular crypto currency after Bitcoin, because Ethereum’s code structure enables smart contracts that allow this matching without humans involved. In addition to DeFi, centralised lending the traditional intermediation between borrower and lender also exists, and a few small banks have already started offering crypto-based loans.
One of those is Silvergate Capital Corp., a California-based banking organisation with $12 billion in assets. Silvergate started offering crypto loans in 2020 and in a little more than a year saw their share in its loan portfolio surge from 0 to 27%. As traditional consumer and corporate lending shrank in the last few quarters parallel to the industry trend, Silvergate’s crypto-based loan growth offset those declines. Silvergate offers two types of loans. In its direct lending product, the bank lends dollars for customers to buy Bitcoin, which is held at an exchange as collateral for the loan. In its indirect scheme, Silvergate lends money to third-party digital currency lenders, which then make loans to their clients and post Bitcoin collateral for their borrowing. In both schemes, the bank uses a custodian for safekeeping the collateral and a crypto currency service provider to monitor the collateral coverage ratio.
In deciding whether to follow Silvergate’s example and join the crypto asset party, there are several points banks need to consider. The returns from crypto lending are high, as there’s growing demand and few funding sources right now. But the digital currencies and other crypto assets in use today are highly volatile because they don’t have government backing like fiat currencies or other financial assets. That makes crypto assets inherently more difficult collateral, requiring constant monitoring of values and coverage ratios. Traditional banks might not have existing governance, controls or infrastructure to support such lending activity and may have to turn to third parties as Silvergate has. As regulators turn more of their attention to the potential money laundering that can be carried out through crypto currencies, crypto lenders are being required to implement Know-Your-Customer (KYC) standards. Most DeFi platforms lack such programs and are ill-suited to build them, as the origins of the concept of decentralised lending is based on anonymity of the customer. Banks can have the upper hand here, as they already have sophisticated KYC and anti-money laundering systems in place, which they can use to monitor their crypto clients.
FOMO, which stands for Fear of Missing Out, is a term popularised by crypto enthusiasts as the value of Bitcoin and other digital currencies surged in recent years, prompting many uninitiated investors to consider investing in crypto assets so as not to miss out on spectacular returns being enjoyed by others. FOMO is also forcing banks, asset managers and other financial firms to seriously consider offering crypto-related products and services. Even JPMorgan Chase CEO Jamie Dimon, initially one of the most vocal critics of cryptocurrencies in the industry, has changed his tune recently, acknowledging that clients want them, so banks have to provide access to them.
“My own personal advice to people is: Stay away from it,” Dimon said in the firm’s annual shareholder meeting in May 2021. “That does not mean the clients don’t want it. This goes back to how you have to run a business. I don’t smoke marijuana, but if you make it nationally legal, I’m not going to stop our people from banking it. A lot of our clients are asking, can we help them buy or sell cryptocurrency? And we’re investing in that as we speak.” Back in 2017, Dimon had described Bitcoin as a “fraud,” and for years criticised the asset class as having no inherent value. In July 2021, the bank started offering its wealth-management clients the opportunity to invest in a Bitcoin fund as well as four other cryptocurrency products.