Capital

Credit Suisse’s removal of several senior executives, including its top risk and compliance officer, as a result of reported $4.7bn losses incurred by trades with Archegos Capital Management raises serious questions as to whether banks have learned sufficient lessons from the global financial crisis. By Robin Henry, partner at Collyer Bristow

Questions have been raised as to whether the loss was a result of risk and compliance not doing their job or whether their views were ignored by business heads. Those in charge of the business may have been more attracted by the short-term benefit of not jeopardising a profitable stream of income than in considering the long-term risks associated with such transactions. Not only did that behaviour prove disastrous given the losses suffered by Credit Suisse from the affair (and many other banks, with estimated total losses of $10bn), but it has made a serious dent in the reputations of many of those banks.  

Of course, this is not how risk management is supposed to work. It is supposed to be an independent division of a bank which has an authoritative voice and is respected by all levels of management. But if that basic principle is not followed, then even the best identification of potential risks will not be sufficient. And there were clearly multiple warning signs associated with lending to Archegos. First, red flags will have been raised by the fact that Archegos was owned by a man who had been convicted of wire fraud in 2012 and subsequently banned from trading in Hong Kong. Second, the resources of Archegos did not justify the amounts which were being lent to it. Although it is described as a family office, it was more like a hedge fund operated for the benefit of one man and the assets it was reportedly managing of around $10bn were far outweighed by the $50bn positions it had built up in equities.   

Outsized risk 

Moreover, while prime brokerage has the reputation for not being the most exciting area of banking, the loans to Archegos had inherent risks: they were not straightforward loans, but total return swaps allowing Archegos highly leveraged access to stocks it would not have had the resources to buy outright (even with borrowed money). This leverage meant that while profits would be maximised on a rising market, so would any losses be highly magnified on a downturn.  

Next, the swaps were entered into not just by one bank but by several and it is not at all clear that each bank was aware of the total exposure of Archegos to those stocks (again as a result of the fact that the swaps allowed it to build synthetic positions without having to disclose them as it would had shares themselves been purchased). The positions Archegos took were also highly concentrated on a small number of stocks in US media and Chinese tech groups. It might be thought obvious that there was a high degree of risk investing so much in hi-tech stocks in the middle of a pandemic in which stock markets have lurched wildly with the fluctuating fortunes of the global economy. That concentration, combined with the leverage of the positions, meant that when one of those stocks, ViacomCBS, halved in value in one week in March, Archegos was not able to meet margin calls, which then forced the banks to unwind $20bn of their positions.  

Banks being caught out on risky trades is of course nothing new, but there are a couple of points which make these losses of particular concern. 

First, it suggests that the banks’ acceptance of stronger risk and compliance management following the 2008 financial crisis has not taken root strongly in their culture even though that has been one of the primary objectives of regulators since that crisis.

Second, it highlights the difficulty of regulating markets as complex as investment banking and asset management. No one yet has been able to say that Credit Suisse was in breach of regulations, but that may be because the Archegos trades occurred in one of the least regulated areas of the market. Since prime brokers lend to financial institutions, their disclosure and reporting obligations are a fraction of what would be required for retail investing, and because Archegos was a family office, largely left alone by the regulators, it did not have to disclose the trades. The rationale for this light touch approach has been that family offices, although they often look like hedge funds, do not typically manage outside investor funds. From that point of view, one might ask: what does it matter if banks and a rich investor lost money?

Systemic risk implications

Markets should not be too complacent, however. The problem is that Archegos shows how losses can arise in unexpected pockets of the market, and that those losses can be subject to a multiplier effect because of leverage, concentration of stocks and lack of transparency over the total sums lent. The greater concern is that such losses can create systemic risks right across the market. With many describing several stock markets as currently creating bubbles, that is a risk which should not be ignored. 

It is too early to tell what the fallout will be in terms of the legal implications of the Archegos losses. Regulators will be looking closely at whether any of the parties were in breach of regulations, and the banks themselves will be considering whether they entered into any of the trades on the basis of misrepresentations, but the primary victims here appear to have been bank shareholders, and they will be looking to see whether anyone can be held to account for their losses. 

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