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Recessions come in many forms and it is self-evident the current
downturn is quite different from the slump in 2008-2009. But
economic history is emphatic that financial crises - whether the
cause or a by-product of recessions - result in far weaker and
longer recoveries than "normal". So European policymakers are
correct in taking measures that prevent bank frailty accentuating
the effects of the pandemic-induced fall in "real" economic
activity.
We will see the impact of those measures as Q2 results start to
trickle in over the coming weeks. As well as the "quick fix" to the
Capital Requirements Regulation and a variety of measure that
should dampen increases in credit and market risk charges, the EU
also gave some
relief on Prudent Valuation. The legislation passed into law
just before the crucial June 30 date (Prudent Valuation is
calculated at quarter-end). The European Parliament and European
Council decided not to use the full three month scrutiny period,
which proved crucial is hastening the approval process. The EBA
amendment increased the aggregation factor from 50% to 66%, which
will decrease overall Additional Valuation Adjustments all else
being equal.
But the key determinants of Prudent Valuation - dispersion
around mid levels and the bid-ask spreads for Market Price
Uncertainty and Close Out Cost AVAs - are not static. On the
contrary, they have changed dramatically during the first half of
the year.
Take the CDS market, for example. From the start of the year
until mid-February, spreads were range bound at relatively tight
levels. The dispersion of the market - as measured by min/max
ranges on market-making contributions to IHS Markit's pricing
service - was also relatively low.
But the onset of the pandemic in February and March had a
material impact on price formation, and this was reflected in an
increase in dispersion as spreads widened sharply. This was evident
across the curve but particularly at the short- and long-end, as
seen in the chart above.
Central bank intervention made a decisive contribution to
arresting liquidity issues, and the market rallied strongly from
late March. Spread dispersion also started to recover, though it
took until June month-end for it to revert to pre-crisis
levels.
CDX NA IG Liquidity
Source: IHS Markit Price Viewer
We can see that bid-ask spreads in the IHS Markit CDX.NA.IG
index - perhaps the most liquid CDS instrument - took some time to
revert to normal. At the peak of the crisis the bid-ask spread was
5bps, a dramatic increase from the 0.4bps immediately prior to the
stressed period. It stayed at historically elevated levels before
gradually compressing and is now around 0.5bps. The mean reversion
is not as strong in single name CDS. The weaker liquidity in this
segment of the market is contributing to a stubbornly large skew in
the index (negative skew means single names trading wider the
index).
CDX NA IG index skew
Source: IHS Markit Price Viewer
Perhaps volatility, or lack of, is the driving factor behind
spread dispersion. The scale of the market oscillations in March
certainly match the feverish commentary over this period. The
investment grade VolX indices, which track realised volatility in
the CDX and iTraxx, exceeded levels seen in the eurozone sovereign
debt crisis and, in the case of CDX, the Great Financial Crisis.
But June and July were relatively calm as spreads settled in a
tight range and 20-day volatility is now at unremarkable
levels.
The volatility, of course, benefitted the Q1 earnings of banks
with significant trading divisions and helped offset some of the
damage done by higher loan loss provisions. We can expect more the
same in Q2 if results in the US are replicated in Europe.
But buried in the banking results will be effects of Prudent
Valuation regulatory relief. The increase in the aggregation
factor, combined with the shrinking spread and price dispersion,
should result in significantly smaller Additional Valuation
Adjustments in Q2 compared to Q1. The impact may be relatively
small compared to other alleviating measures (see EBA paper) but it still preserves
CET1 capital and will continue to help banks throughout this year
(the relief is due to expire on December 31). Financial markets are
at a delicate juncture and it would be no surprise to see
volatility - and dispersion - return once again.
IHS Markit provides metrics for Prudent Valuation across several
asset classes, including CDS, bonds and derivatives. Please contact Sales@ihsmarkit.com for
further details.
Posted 28 July 2020 by Gavan Nolan, Executive Director, Business Development and Research, Fixed Income Pricing, IHS Markit
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