Banks insist they’re in much better shape than they were during the run-up to the 2008 financial crisis. This time, as the coronavirus lockdowns wreck output, lenders can be “doctors of the economy,” in the words of one industry executive. True, banks have much larger capital buffers and better access to funding than was the case 12 years ago. How smart they’ve been at running their trading businesses remains to be seen.

Some of Europe’s biggest banks have gone into the worst economic contraction since the Second World War sitting on huge piles of complex, risky trades whose fair value is hard to determine. These are the so-called Level 2 and Level 3 assets, the types of instruments that blew up in 2008.

Valuations of Level 2 assets — mainly over-the-counter derivatives and illiquid stocks — are derived from using observable external measures, such as the price of similar instruments traded in the market. Level 3 assets are the most illiquid instruments, whose prices depend on inputs that aren’t observable to outsiders. Unlike Level 1 assets, which have easily viewed market prices, investors have to rely on banks’ internal models, and own judgments, to get a handle on the Level 2 and Level 3 exposure. Fair values for the same instrument might easily differ from firm to firm.

The absolute size of these risky asset pots — totaling several hundred billions of dollars at many of the largest banks — is eye-watering. They dwarf the lenders’ capital by many multiples. Take Deutsche Bank AG: Its stock of Level 2 and Level 3 assets is more than 11 times its common equity Tier 1 capital. At Britain’s Barclays Plc, it is just shy of 11 times, at France’s Societe Generale SA it’s seven times and at Switzerland’s Credit Suisse Group AG it’s almost eight times. 

While plenty has been written about the inevitable build-up of bad loans in the Covid-19 downturn, these piles of interest-rate swaps and collateralized debt obligations need to be considered too. In the recent market rout, every major asset class was upended. U.S. stocks fell into a bear market at record speed, the dollar soared and safe-haven assets such as government bonds were rocked. 

How banks’ risky assets fared during the unprecedented turmoil is guesswork from the outside. All the banks listed in the table above declined to comment for this piece. One bank executive, who asked to remain anonymous, said the balances of banks’ Level 2 and Level 3 assets and liabilities may both have increased in the quarter, which would be a welcome sign that hedges have been working in the turmoil.

For example, the decline in long-term interest rates would have increased the present value of years-old derivatives that swapped fixed rates for floating rates. Interest-rate derivatives tend to make up the bulk of the portfolios, and they may have offset declines in the prices of equities and loans. (That said, some hedges would have been for interest rates and inflation to rise, so they could be heavily in the red.)

Less welcome is that banks will probably have to start moving things from Level 2 to Level 3 as price discovery becomes more difficult. Some may decide that observable measures through mid-to-late February are sufficient to keep assets in the Level 2 pot for the first quarter. Each bank has its own model. Lehman Brothers allegedly shifted mortgage-backed securities and other assets from Level 2 to Level 3 in 2008 in an effort to prop up their values.

The market became hugely skeptical about these instruments during the financial crisis. A 2015 study published by the Journal of Accounting and Public Policy showed that investors valued Level 2 assets at 85 cents on the dollar and Level 3 assets at 79 cents during 2008. More troubling for the banks sitting on large stocks of Level 2 instruments is that an analysis by Wharton Research Scholars shows they were discounted even more significantly during the crisis than the more opaque Level 3 stuff.

Investors should look at how frequently banks turn over their Level 3 assets, according to analysts at Berenberg, who published a report this week saying that France’s BNP Paribas SA, Credit Agricole SA and SocGen have the lowest turnover of Level 3 instruments among 12 banks they studied, which means the assets are probably “stickier and harder to sell.” Credit Suisse has the highest turnover among the group.

The French banks, Credit Suisse, Barclays and Deutsche each hold Level 3 assets that are as large as, if not larger than, those of Citigroup Inc. and Bank of America Corp., even though the latter have much bigger trading businesses.

The European Systemic Risk Board, the European Union body that monitors the financial system’s stability, has also noted the Level 2 and Level 3 threat — particularly the prospect for “opportunistic behavior” by managers and the overvaluation of assets. “If several banks were to be affected simultaneously at a time of acute fragility in the financial system, concerns could spread to the macroprudential domain and affect financial stability,” a February report from the board warned.

What’s more, banks no longer have to use the crisis-era filters that protected their capital positions from movements in the fair value of assets they hold for sale. Without these filters, fair-value gains and losses are directly recognized in banks’ income statements even if they’re unrealized. And as my colleague Ferdinando Giugliano noted, significant risks may lie in smaller banks that may not have been as transparent in their Level 2 and Level 3 disclosures.

Equally concerning is the faith being placed in banks’ risk management practices, especially since regulators started loosening the rules because of the Covid-19 crisis. In its 2019 review, the European Central Bank’s Single Supervisory Mechanism, its bank oversight arm, observed a worsening of internal governance, especially among the larger lenders. 

Regulator’s plans to tackle this area of weakness with a new set of capital rules for trading desks — known as the Fundamental Review of the Trading Book — was pushed back a year to January 2023 as part of the response to the coronavirus lockdowns. By then, it could be glaringly obvious how clever banks have been at managing risk.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News.

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