Analyst Insights
Background
The interconnectivity of the global banking system and financial markets was made painfully clear over a decade ago in the Global Financial Crisis (GFC). This was observed as the failure of Lehman Brothers and Bear Stearns, and the near collapse of AIG shook the entire global economy. Since then, modern and robust banking and financial sector regulations have been introduced, including Basel III, Dodd Frank and other related regulatory reforms. Now, while the world has moved beyond this challenge, another, though less apparent, has surfaced in the form of shadow banks Broadly speaking, these are entities that are unregulated but tend to offer ‘ financial services and products as the regulated banking system. Since they aren’t subject to traditional banking regulations, in the event of a crisis or emergency, they can’t borrow from a central bank for liquidity purposes, which increases the likelihood of failure. Depending on the size of the entity and its indirect or direct interconnectivity to the overall financial system, its failure could have ripple effects that could shock the whole system.
A Crack in the System Family Offices
Among shadow banks, Family Offices, represent one of the least regulated and can present a significant risk to markets and potentially, the wider financial system. Family Offices are ‘investment vehicles’ whose operations are typically funded using the personal wealth of ultra high net worth individuals. Recently, once such family office, Archegos Capital Management, managed by an American investor, Bill Hwang, had a total meltdown that had a ripple effect on the wider market. To summarize the recent meltdown, Archegos held US 10 billion of its own money in assets, but the family office’s exposure to equities was 5 x more, at US 50 billion. How was this possible? Well, large portions of Archegos’ equity exposures were facilitated through complex derivatives known as total return swaps. In short, using these swaps, Wall Street banks allowed Archegos to buy massive amounts of equity with limited up front capital thereby borrowing the excess from the banks. In addition to increasing the leverage and risk, these swaps allowed Archegos’ equity positions to remain anonymous, though it held more than 10 in some companies, an exposure that would typically need to be reported to regulators.
Archegos’s Implosion and Implications
Archegos’ long position in ViacomCBS started to backfire as shares started to decline, putting strain on the family office as well as the banks that funded the leverage. To mitigate losses, margin calls were enforced by the banks and Archegos started to reduce exposure to several of its holdings. Of course, this only increased the selling pressure and drove stock prices down further. As a result, to cover their losses, the banks also began selling in massive blocks thereby creating a chain reaction for several of Archegos’ equity holdings while amassing losses for the banks. JP Morgan has assessed the conundrum and indicated that the losses to banks like Credit Suisse Group AG, Nomura Holding and several other banks could be as much as US 10 billion.
Lessons and Implications
The Archegos Capital Management debacle is simply a drop in the bucket of what can materialize if shadow banks are allowed to remain unregulated with no oversight. Additionally, it has shone a light on the hidden risk of the lucrative but opaque equity derivative business of large banks, that lever up these shadow banking entities. Importantly, the regulations of the banking industry are significantly more robust than 2007 2008 creating a foothold of capital and liquidity to buttress fallouts and stem the potential ripple effects across the broader market. However, what remains unclear is just how massive and interconnected some of these shadow banks may be and in turn, the fall out that could ensue if enough of them fail simultaneously. At present, however, the liquidity provided by the Federal Reserve, heightened optimism about the economic rebound and earnings growth continue to drive markets. The confluence of these could be masking potential risks, particularly surrounding derivative products that get very limited regulatory disclosures. The implication points to greater regulatory oversight which is already being touted by Elizabeth Warren and Treasury Secretary, Janet Yellen.
Concluding Thoughts
Importantly, Jamaica doesn’t have these shadow banks that are completely obscured from regulators. The closest we’ve come has been the microfinance industry and the new Microcredit Act, 2021 is a positive regulatory step towards mitigating potential risks through mandated disclosures and regulatory oversight. With that said, the main risk continues to stem from overseas exposures and the shadow banking industry’s connection to the wider system. This just means we must remain vigilant as the global shadow banking industry is massive, accounting for 48 of total financial assets at the end of 2018 according to Bank for International Settlements. Finally, this Archegos debacle merely underscores the importance of proper due diligence and proper asset selection, whether bonds or equities, at this stage of the cycle
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Written by Awah Muirhead, Senior Investment Strategy Analyst |
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