For proof that events in emerging markets can influence capital markets in the rest of the world, one need only look at the developments of the last few weeks.
Global markets plunged Monday as investors grew increasingly alarmed over China's economic slowdown. Early this month, Chinese authorities devalued the yuan by almost 2%, arguably to begin letting the currency float freely. This move has already put pressure on South Asian countries to devalue their currencies in order to remain competitive with China. Meanwhile, Moody's Investors Service downgraded Brazil's sovereign rating by a notch to just above junk bond status. This will increase the country's borrowing costs at a time when it is struggling to implement macroeconomic and fiscal policies to turn around a struggling economy. These events are likely to compound capital flows out of emerging markets, which in the last 12 months have reached almost $1 trillion. The outflows will adversely impact all asset managers with exposures to emerging markets.
It is probably too early to predict the long-term effect of the events in Brazil and China on the broader global economy and the Federal Reserve's plans to raise interest rates. However, it is not too early to scrutinize the extent to which many U.S. banks are exposed to emerging markets. Yet it is difficult to get an accurate picture of banks' exposures to emerging markets because of their opacity.
In order to improve banks' risk management, they should be required to release detailed information the level of credit, market, operational, and liquidity risks they have by country, industry, and largest counterparties. Only with transparency can the market make rational investment decisions.
Banks are influenced by both primary and secondary effects of volatility in emerging markets. Primary effects are caused by banks' direct exposure to currencies, bonds, and stocks of emerging market governments and corporations. Banks may also be exposed to loans, repurchasing agreements, and derivatives with emerging market public- or private-sector entities.
Banks may also be vulnerable to secondary effects when their counterparty, such as an international corporation, is exposed directly to emerging markets. The Chinese economic downturn, for example, is having a particularly adverse impact on commodity producers such as oil, pulp and paper producers. These types of companies are significant counterparties to large banks, either via the loans they take out or through derivatives.
Federal Financial Institutions Examination Council data show that when it comes to loans, securities and derivatives, U.S. banks are much more exposed to Latin America than to any other emerging market region. In fact, U.S. banks' exposure to Mexico is more than double their exposure to any emerging market. After Mexico, U.S. banks' largest exposures in order of size are to China, Brazil, South Korea and India. The challenge with this data, however, is that it does not include individual banks' exposures to emerging markets as measured by credit or market risks
Recent financial disclosures show that Citigroup has the most significant exposure to Latin American and Asian loans and currencies of any U.S. bank, as it is in more foreign countries than other large domestic banks and generates significant revenue from its foreign exchange portfolio. Other banks in the U.S. with significant Latin American exposure are the Spanish banks BBVA and Santander.
From a bond, equity and derivatives markets perspective, the U.S. banks most sensitive to recent Brazilian and Chinese events are the six largest U.S.-headquartered banks, since they have the largest trading portfolios in the U.S. HSBC and Deutsche subsidiaries in the U.S. are also very exposed to volatility induced by emerging markets.
Then there is the matter of banks' exposure to the foreign exchange market. Bank holding companies in the U.S. generated revenues of $18.7 billion by trading interest rate, foreign exchange, equity, credit and commodity products in the first quarter of 2015, according to the latest available data published by the Office of the Comptroller of the Currency. Foreign exchange transactions account for over a third of that amount. Although banks do not disclose details about their risk mitigation techniques, we know that in notional volumes Citigroup, JPMorgan and Bank of America are by far the most exposed banks to foreign exchange volatility. Based on my analysis of foreign exchange portfolios, Citigroup has the largest foreign exchange exposures at over a trillion dollars. JPMorgan has over $705 billion, and Bank of America has over $500 billion.
Volatility can be a bank's best friend. In the coming months, we will find out which banks benefited from the effects of the Brazilian downgrade and the Chinese yuan devaluation and which banks took losses. Unfortunately, due to the opacity of banks' risk metrics along with their complexity, we cannot tell how liquid their emerging market positions are, how they are hedged, in what legal entities they are booked and how they are collateralized. This information would be invaluable in helping investors, analysts, and journalists scrutinize banks' credit, market and liquidity risks. As such, regulators should require that banks disclose this information to the public.
Also of concern is large banks' poor risk data aggregation that is, how they define the data needed to measure credit, market, operational and liquidity risks and how they collect, validate, cleanse, calculate and report important ratios to boards of directors, senior executives and bank regulators.
The Basel Committee on Banking Supervision has recommended that bank supervisors make ad hoc requests of the most internationally active banks to see if they can measure specific exposures by country, industry or counterparty. I have significant doubts that large U.S. banks would be able to show that they can measure completely, accurately, and in a timely manner what their exact exposures are to Latin American and Asian currencies, securities, derivatives, and counterparties impacted by emerging market volatility. Indeed, surveys by the Basel Committee and the financial services company Markit confirm that banks, especially in periods of stress, do not trust their information technology to measure exposures accurately.
Some of my bank contacts have told me that they hope they will improve their risk data aggregation and risk measurements. But I do not think that American taxpayers should be satisfied with "hope" as a strategy to make banks safer.