Tuesday, April 06, 2021

Archegos debacle: do banks know what risk management is?

There we go again. Archegos, a hedge fund, has blown up and it's causing huge holes in the balance sheets of banks that were exposed to it. Credit Suisse is due to disclose losses, running perhaps into billions of dollars, due to its exposure to Archegos (and a finance company, Greesnsill). The head of risk at Credit Suisse is among the executives who will depart, reports FT.

LTCM all over again? Well, it's not quite as catastrophic in its impact as LTCM but it does reflect poorly on risk management at banks.

As in the case of LTCM, banks were exposed to Archegos through loans and derivatives, with the difference that the loan and derivatives exposures were intertwined in this caes. Banks made large loans to Archegos. Archegos invested these in stocks and entered into a total return swap with banks. Under the arrangement, banks would be paid a fee plus interest on their loans. The capital gain on stocks would belong to Archegos. As long as the stocks appreciated, no problem. But if they didn't, there could be a problem.

As it turned out, the stocks owned by Archegos did lose value. Banks thought they were protected by cash collateral. They also thought they were protected because the stocks were highly liquid. But we do know from LTCM that when any one entity has a large exposure to a security, liquidity can vanish quickly. As the stocks lost value, banks demanded more collateral. Archegos tried to sell its stocks to raise cash but the positions were so large that the very act of selling caused prices to fall steeply. This meant more margin calls, more sales... and then bust. Exactly as in LTCM.

In LTCM, the problem was that banks did not know the cumulative bank exposure to LTCM. The reform that followed was that banks' exposure to Highly Leveraged Institutions came to be monitored closely. Why didn't that work here? It appears that Archegos was run as a family office and did not have the same disclosure requirements. But if that was the case and banks had no means of monitoring total leverage at Archegos or total counterparty exposure to Archegos, they should not have got heavily exposed to it in the first place. There can be no excuses for the lapse after the lessons said to have been learnt from LTCM.

Archegos represents a colossal failure of risk management. If 14 years after the worst banking crisis in a century, this is the state of risk management at the world's leading investment banks, one has to despair. The fundamental problem at private banks hasn't gone away: incentives are asymmetric. If gambles taken by bankers work out, they gain enormously. If the gambles fail, it's the shareholder- and, often, the tax payer- who is left holding the can. 

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