In the last few years, Morgan Stanley’s balance sheet has changed almost beyond recognition. From having almost $2 trillion in assets in 2010 (measured on an IRFS basis), the bank now has a third less. Derivatives notional fell to $14.9 trillion from $26.2 trillion, a 43% decline. And corporate debt in the bank’s trading book plunged by 58% from $69 billion to $28 billion.
Under Basel rules, these changes have had a huge impact on Morgan Stanley’s capital requirements. Market risk-weighted assets declined by 60% since the end of 2012, contributing to an 11% decline in capital requirements overall, the most of any large US bank. That helped boost Morgan Stanley’s return on RWAs to an average of 2.4% last year, ahead of its peers.
The bank achieved this return across different business segments, but noteworthy was fixed income sales and trading net revenues, which were $5.1 billion in 2016. That is the highest figure since 2012. Somehow, despite reducing fixed income assets in the last five years, and employing fewer staff, Morgan Stanley is still making money in this asset class.
This has led to some laudatory press coverage. Recalling the old days when Morgan Stanley’s proprietary trading desk could lose $9 billion in a single quarter, observers praised the bank’s ability to make more with less, particularly given the impact of Dodd-Frank regulations. It’s being argued CEO James Gorman’s strategy of ‘velocity’ – holding assets for shorter periods – has been vindicated.
Let’s look at this in more detail. Some of the fixed income resurgence comes from foreign exchange, where Morgan Stanley has taken market share from commercial banks such as Deutsche Bank or Barclays which have retrenched after paying FX rigging fines. Then there are some kinds of fixed income business that the bank doesn’t seem to want any more, such as high yield bond origination.
In 2014, Morgan Stanley was ranked in 4th place as bookrunner for US high yield, but in 2016 had slipped to 9th place, behind Wells Fargo, according to Thomson Reuters. Since originating banks typically have to hold loans or commitments on their balance sheets while they sell the bonds, that retreat helped cut Morgan Stanley’s capital requirements.
But the bank remains a leading market maker in debt, and there may be something more behind the scenes than improved compliance staff and better teamwork among traders. It might be that Morgan Stanley is using exchange-traded funds (ETFs) as a means of trading bonds without the regulatory constraint.
How does this work? Bond ETFs, such as Blackrock’s iBoxx $ High-Yield Corporate ETF (known by its ticker HYG), are funds that own a basket of bonds and issue shares that effectively track the basket, providing much better liquidity than traditional bond funds. Traders that once used credit default swaps to hedge bonds or position trades now use ETFs to do it.
It turns out that Morgan Stanley is one of the biggest holders of bond ETFs, according to data compiled by Morningstar. For example, for the HYG, Morgan Stanley is the biggest institutional holder after Blackrock, with a $863 million position, or 6% of ETF assets. Among the 12 biggest junk bond ETFs, Morgan Stanley owns $3.4 billion, or 2.7% of total assets.
Does this amount to anything? Some ETFs, such as $480 million in shares of the HYG fund, are held directly by the bank. Some of the holdings are with Morgan Stanley’s Smith Barney subsidiary, meaning that they are probably held on behalf of wealth management clients. However the documents that the bank typically asks these clients to sign allows Morgan Stanley’s trading desk to borrow assets from the client’s account and repledge them as much as it likes.
Either way, it looks like Morgan Stanley is heavily involved in trading bond ETFs. Now this could be innocuous. If asset managers and hedge funds are already using bond ETFs then Morgan Stanley’s equity desk might just be standing in the middle as an intermediary.
However, it has also been suggested that bond ETFs are being used as a liquidity buffer or warehouse for primary bond offerings. If Morgan Stanley is doing that, it could amount to a regulatory capital arbitrage.
Here’s how it might work. Holding bonds or loans on the trading book incurs a heavy RWA penalty, because of Basel requirements such as the incremental risk charge, which harmonise their capital treatment with the banking book. However, if you hold them in ETF form, then they are treated for accounting and regulatory purposes as equities. Economically, you have the same exposure if you held the bonds but a much lower capital charge.
However, there is a risk involved. If ETFs are being used to hedge or provide liquidity to Morgan Stanley’s fixed income positions, a sudden dislocation of the ETF market could drive the bank back into the bond market at a volatile time, affecting its capital ratios. Thus ETFs could contribute to bank systemic risk.
So is Morgan Stanley doing this? From the bank’s 10-Q filings, we learn than the bank has almost tripled its trading book holdings of equities in the last five years. More than that we don’t know, and a Morgan Stanley spokeswoman declined to comment on its bond ETF activity beyond what it already discloses in SEC filings.
Given the history of Wall Street in arbitraging bank capital requirements, it would hardly be surprising if it was true.