Friday, January 16, 2015

This Week in Bank Failures

The first U.S. bank failure of 2015 was found in Florida, where the O.C.C. closed First National Bank of Crestview, with three branches and $79 million in deposits. Monday is a holiday, so the closed branches will reopen Tuesday. The successor bank is First NBC Bank, based in Louisiana and acquiring its first presence in Florida with the purchase. First NBC Bank is purchasing more than three fourths of the failed bank’s assets.

The big upheaval in banking this week involved the Swiss franc. The central bank in Switzerland has for years tried to keep the Swiss franc stable in value relative to the euro, and in 2011 it set a limit of 1.20 francs to the euro. By 2014, though, the high costs of this strategy had put the bank under political pressure and a degree of financial duress. Yesterday things hit a breaking point, and the Swiss National Bank decided it had to float the franc, meaning it would let market forces determine the value of the currency. Traders weren’t prepared for the rapid changes that followed, which affected not only the value of the Swiss franc, but also of every related asset. The euro was affected, obviously, and the U.S. dollar, and there were ripple affects reaching to essentially every currency in the world. The value of the assets that the Swiss National Bank had been trading to rein in its currency were also affected, even though the central bank did not make any unusual purchases or sales. Gold especially showed shocking volatility yesterday.

The trading volatility continued into today, but for traders who gambled on the wrong side of the currency markets, the damage was already done yesterday. At least one currency broker each in New York, London, and New Zealand were crushed by the currency market moves.

Currency trading is done with high degrees of leverage, with traders typically covering only between 3 and 5 percent of their positions. Any trading day in which currency moves are larger than 5 percent, then, can cause a trader to lose more money than they originally put in. If this happens to more than a few of the customers at any one brokerage, it can leave the brokerage insolvent. In New Zealand, apparently about half of the customers of Global Brokers NZ Ltd lost everything, and after a few hours of this the broker was forced to close. Regulators in New Zealand are awaiting word as to whether the broker remains solvent and able to distribute funds to its remaining clients.

In London, Alpari says it is insolvent after more than half of customers yesterday suffered “losses which exceeded their account equity.” Total account losses occur to someone everyday in the unpredictable currency market, but it is extraordinary that this could strike more than half of a broker’s customers on the same day. It underscores the high risks involved in currency trading, where any trader, no matter how well informed and connected they are, has only a tiny fraction of the information they would need to predict changes in the values of currencies. In New York, FXCM, one of the biggest online trading platforms, was nearly wiped out after customers lost $225 million yesterday. It is seeking an emergency loan so that it can keep operating.

Another online currency broker, Swissquote, estimates that it took a hit of $24 million. In London, IG Group took a hit from delays in closing some of its hedged positions. It tried to keep its positions in sync with those of its customers, but in some cases was slower than they were in closing positions. It is safe to assume that these were delays of less than an hour, but they will cost the broker-dealer an estimated $46 million.

Some pundits took the opportunity to repeat the sensible advice that individual investors generally should not be gambling in the currency markets. That is true enough, but it was not only the retail investors who took losses. Several of the largest banks in the world made the exact same mistakes, but on a larger scale. According to published reports, Citigroup and Deutsche Bank each took estimated losses of $150 million on their currency positions yesterday. Barclays also is believed to have taken losses, though theirs were not as large. There were surely other banks that took extraordinary trading losses yesterday that we haven’t heard about yet, in part because it is not as easy as it sounds to tally up the gains and losses in an unusual day of trading.

Banks are by nature unprepared for this kind of unexpected market fluctuation. It is a vulnerability built into the financial risk models used throughout the global financial sector. These models typically look only at the last two years of trading to estimate the volatility of an asset, or how much its value could change. The Swiss franc had been rock-solid for four years, so all conventional risk models would report that the risk of holding Swiss francs was zero. By the same logic, other assets closely tied to the Swiss franc would also be assessed as having essentially zero risk. When these assets start to move, as they did yesterday, bank managers can only guess how large their exposure is. Most banks do not have accurate real-time information on their trading risks, so they have to rely on the presence of mind of the workers at the individual trading desks to scale back risks when markets turn volatile.

It is the kind of situation that makes a bank executive hope their traders got enough sleep last night. Realistically, especially in London, a lot of the traders are sleep-deprived essentially every day because of their long hours of work, and the lack of sleep inevitably leads to mistakes and bad decisions whenever something unusual happens during the trading day. Yesterday’s trading losses may revive the discussion of the losses that banks in London and elsewhere suffer because of the strategy of long hours of work and limited hours of sleep.