The collapse of Lehman Brothers last September made both private investors and distributors of investment products suddenly more aware of counterparty risk.
“For the first time ever, private investors now realise that there is such a thing as counterparty risk,” says Lea Blinoff, managing director at HSBC private bank’s wealth management and investment division. “Before Lehman collapsed, counterparty risk was not really perceived to be profound, as it was just unimaginable that a major investment bank would go bust.”
In structured products, counterparty risk is borne by the investors and refers to the risk of the underlying issuer of the financial instruments which back the structured investment defaulting on its obligations. Hence, factors that influence the issuer’s credit quality have come under scrutiny. In the past, private investors tended to favour those providers which offered cheaper fees, says Ms Blinoff, but they are now more willing to take the time to discuss in great detail the factors that may affect the price and the quality of the counterparty.
“Pricing is still an important factor in determining best execution,” she says “but private clients, and the industry in general, have had a stark lesson that counterparty risk is real, and needs to be factored into the pricing of these instruments.”
Credit ratings are a recognised indicator of the financial strength of an institution and a measure of default risk. “It is easy to point to all the failures or errors of the rating agencies,” says Ms Blinoff, “but independent credit ratings provided by professional rating agencies remain very valid, although they cannot be, and should have never been, the single source of information to form a view,” she says.
Investors now understand better the implications of the risk-reward trade-off of the counterparty. “The cash remuneration paid by a bank having a high credit rating is less attractive than that offered by a bank having a lower credit rating, but risk is lower too,” explains Emmanuel Naïm, head of equity structured products at Société Générale Corporate & Investment Banking. But while before the financial crisis, the strong French provider would find itself to compete with banks which, having a lower credit rating, offered better prices, Lehman Brothers’ bankruptcy “has changed the rules of the game,” says Mr Naïm.
“Investors are no longer indifferent to who is issuing the product. There has been a flight to quality, in particular towards structured product issuers that are universal banks.” The typical Anglo-Saxon business model of investment bank has suffered greatly, he says. “Clients rely more on much diversified kinds of banks, which have diversified business models.”
Société Générale is a big player in the universal banking world, says Mr Naïm, as it is built on three different streams of business – the retail bank, the investment banking and the asset management – which have different sources of money generation.
Damaged reputations
Distributors of structured products suffered huge reputational damage from Lehman Brothers’ bankruptcy, particularly in Germany, says Kemal Bagci, structured products specialist at DWS. Many banks used to sell certificates issued by third-party investment banks branded with the distributor’s own name, in white-labelling fashion, but this no longer happens. Increased focus on transparency, which has become the mantra for the whole financial industry, has driven distributors to state clearly the issuer’s name on their product brochure.
Due diligence has increased remarkably, notes Mr Bagci. Credit ratings from top agencies such as Standard & Poor’s, Moody’s and Fitch Ratings are now widely used in combination with credit default swap (CDS) spreads, which measure how much the market is willing to sell insurance against default for the issuer. Moreover, certificates rating agencies have grown in popularity in Germany, he explains. These agencies carry out analysis of the credit spread, evaluate the fairness of pricing and are able to give an overall grade to the certificate.
A trend that has clearly emerged is that distributors now tend to use more their in-house structured product providers, although some saving banks are focussing more on diversification, he says. “A key rule to reduce your exposure to credit risk is to diversify your structured product providers,” he says.
But diversification may prove slightly more challenging than in the past, as the number of investment banks has shrunk. Moreover, with the exception of few firms, top players stepped back from their very large and aggressive, proprietary trading issuance, especially in the aftermath of Lehman’s collapse, says Ms Blinoff at HSBC.
Today, the situation has improved. “Issuance volume and trading levels have improved enormously from the dark days and extreme risk aversion that we saw back in the autumn last year and in March this year,” she says.
