Are you familiar with the term “bond math”? It’s a phrase that has been buzzing around the financial industry lately, as US banks face challenges in maintaining profitability amid changing economic conditions. In this post, we’ll dive into why bond math is becoming increasingly important for banks to understand, and how it’s driving both opportunities and risks in the world of finance. From boom to bust, join us on this journey as we explore how bond math is changing the game for US banks.
How banks used to make money
Banks used to make money by collecting deposits and making loans. The difference between the interest rate paid on deposits and the interest rate charged on loans was the spread that generated profits for banks. But, in recent years, this simple business model has come under pressure as competition from non-bank lenders has intensified and margins have been squeezed. In response, banks have increasingly turned to riskier activities, such as derivatives trading and securities lending, to generate profits. This change in strategy has been driven by a need to find new sources of revenue as well as by changes in the regulatory environment.
The first sign that something was changing came in the early 2000s when a series of mergers created a small number of giant banks. These megabanks had unprecedented power and size, giving them an outsize influence on both the economy and the financial markets. The consolidation among banks reduced competition and allowed the surviving institutions to charge higher prices for their products and services.
At the same time, a series of deregulatory measures implemented in the late 1990s enabled banks to take on more risk. The Gramm-Leach-Bliley Act repealed key provisions of the Glass-Steagall Act, which had separated commercial banking from investment banking since 1933. This repeal allowed commercial banks to enter into new businesses, such as underwriting securities and selling insurance products. The Commodity Futures Modernization Act exempted certain derivatives contracts from regulation. And the SEC’s decision to allow firms
The new bond math
The new bond math is turning out to be a big headache for US banks. For years, banks have been able to rely on a simple formula to value their bonds: the present value of future cash flows, discounted at the interest rate on the bond. But now, with interest rates rising and the outlook for future cash flows uncertain, that formula is no longer working.
As a result, banks are having to mark down the value of their bonds, which is taking a toll on their bottom lines. In the first quarter of 2018 alone, US banks took more than $10 billion in write-downs on their bond portfolios. And as rates continue to rise, those write-downs are likely to keep coming.
What’s behind this shift? In a word, math. Specifically, the new bond math is based on a different discount rate than the old one. The old discount rate was simply the interest rate on the bond; the new discount rate is what’s known as the risk-free rate plus a risk premium.
This may not sound like a big change, but it makes a big difference in how bonds are valued. The reason has to do with something called “duration.” Duration is a measure of how sensitive a bond’s price is to changes in interest rates. A bond with high duration is very sensitive to changes in rates; a bond with low duration is not as sensitive.
In the past, when interest rates were low and falling, duration didn
The impact on US banks
In the aftermath of the 2008 financial crisis, many US banks were left reeling from heavy losses. In response, lawmakers instituted a series of reforms designed to make the banking system more stable and less susceptible to shocks. One key reform was the introduction of new regulations governing the way banks calculate their capital ratios.
Under the old rules, banks could count certain types of debt as part of their Tier 1 capital, which is a key metric that determines how much buffer a bank has against losses. But under the new Basel III rules, introduced in 2015, that debt can no longer be counted towards Tier 1 capital.
This change has had a significant impact on US banks, who have had to scramble to adjust their portfolios in order to meet the new requirements. Many have been forced to sell off assets and raise additional capital, which has put pressure on profitability. In some cases, these changes have been so disruptive that they have led to mergers and acquisitions among US banks.
What this means for the economy
The new rule essentially says that banks must set aside more money to cover potential losses on their bonds. That’s because the old way of calculating risk, called the “risk-weighted asset” method, underestimated the danger of certain types of bonds. The new method, which is based on the actual losses that occurred during the financial crisis, is called the “standardized approach.”
For banks, this means that they will have to hold more capital in reserve to cover potential losses on their bonds. This will make it more difficult and expensive for them to lend money, which could lead to a slowdown in economic growth. In addition, the new rule could encourage banks to sell off some of their bonds in order to raise cash and meet the new capital requirements. This could cause prices for those bonds to go down, which would further hurt the economy.
Conclusion
While the improving economy has led to fewer bankruptcies among US banks, the bond math game continues to be played. This means that banks must be careful in how they approach their investments and leverage ratios. Ultimately, understanding and utilizing proper risk management techniques is key for a bank’s success. With this knowledge, US banks can make informed decisions about their own interests and those of their investors while avoiding unnecessary losses from volatile markets.
