Lessons from Archegos: Have investors become complacent about banks?

In late March 2021, the collapse of Archegos Capital Management, a previously little-known family office in New York, triggered massive selloffs by several of the world’s largest investment banks, rocking financial markets and causing large losses for the lenders. Acting as prime brokers for Archegos, the banks had provided it with combined leverage of up to $50 billion, no doubt lured by the fees this entailed. This alarmed many investors, raising questions as to banks’ risk exposures, despite strict regulations introduced after the global financial crisis.^1,2

At the same time, in a tentative return to normality, UK banks have resumed dividend distributions, albeit restricted, while their European counterparts are expected to do the same in the coming months.

“A maximum amount has been allowed by regulators to keep things ticking along and keep shareholders happier than they would have been last year,” says Oliver Judd, co-head of credit research at Aviva Investors.

“The return of dividends is healthy for the sector, and for making sure there isn't too much capital in the system. Keeping stakeholders happy is important, but depending on how it is deployed, excess capital could lead to riskier activities,” he adds. “Banks’ capital ratios have been increasing because they haven’t been paying out. This is great for credit investors but, even from a credit perspective, the consensus view is that banks could and should now operate at lower levels of excess capital.”

That said, as the biggest risks gradually move from the pandemic and geopolitical concerns towards environmental, social and governance (ESG) factors and more familiar operational risks, the macroeconomic path will determine if and how banks accelerate dividend distributions and deploy capital to grow in the coming months.

“It’s all about the interplay between fears around operational risk, what regulators allow for dividends, and the macro path,” says Judd.

It won’t all be plain sailing, as the Archegos drama highlights. Regulators may decide to probe riskier activities and banks’ exposures to lightly regulated areas such as family offices.

Identifying risk

“Perhaps the market got a bit blasé as banking became so heavily regulated and felt over-regulation protected us from any cyclical increase in risk taking,” says Judd. “Generally speaking, banks’ management teams have had very low risk tolerance for such prime brokerage businesses but, even in that environment, certain institutions have seen large hits.”

However, risk-taking is intrinsic to banking, and occasional losses are inevitable. Despite its losses from Archegos, Swiss banking group Credit Suisse remains profitable and still has excess capital, while regulators have allowed it to continue its share buyback programme.

“No banks went bust, no investors were hit with defaults, so it’s not comparable to the global financial crisis,” says Judd. “In that sense, the regulation put in place since then is working, but what this does show is that greater regulatory scrutiny needs to continue.”

For instance, it is likely none of the banks involved knew how much leverage the others had provided to Archegos, even though the overall issue never came close to posing a systemic risk. Regulators need to find a way for banks to work together to avoid such risks, albeit while being able to conduct their business.

“There is a need for more transparency on some derivatives positions,” says Justine Vroman, senior global investment-grade portfolio manager at Aviva Investors. “The losses were relatively contained, partly thanks to stronger capital buffers, but there are legitimate questions on how many similar strategies could be susceptible to this kind of problem; and on whether this could at some point become a broader systemic risk.”

She adds that, while banks have seen tougher rules enforced, hedge funds – and even more so family offices – remain lightly regulated.

“These institutions don't have to register with the SEC, report on their relationships with banks or report operational information,” says Vroman. “This light regulation has even convinced some hedge funds to convert to family offices in the last decade. There is a need for greater scrutiny on that part of the market.”

However, when it comes to banks, there is a legitimate question as to why some were so exposed to Archegos. In a world of low interest rates and margins, some may be tempted to take on higher risk and overlook or stretch their risk tolerance in a bid to attract clients. Credit investors need to understand where this was the case and whether measures have been implemented to mitigate such risks.

“Your typical investment bank is probably safer than a higher-risk-taking investment bank, but if the higher-risk-taking bank also has higher capital, it should even out from an investor’s perspective,” says Judd. “And if the relative spread on the higher-risk bank’s bonds is higher still, we should be taking that risk; that is what asset managers do. But without transparency, it's very difficult to get in front of.

“Should you be investing in Credit Suisse at this time, given its strong capital, relatively limited earnings impact (at least for now), and relative spread versus other European banks? There is an argument to buy, but the easy counter-argument is that we don’t know whether we have seen the end of it or what the second quarter will look like. And that is unacceptable in terms of decision-making, so it comes down to transparency again,” he adds.

This raises issues of risk management, oversight, and execution within each bank. “That is what we try to evaluate through our meetings with management and our assessment of a bank’s culture and business ethics,” says Vroman.

Culture or vulture?

Richard Butters, senior ESG analyst at Aviva Investors, says quantifying a bank’s culture is tricky, not least because the relevant data is not always accessible. Referencing a recent Bank of England report on the link between banks’ culture and their risk appetite, he explains regulators often have better insights than investors, thanks to their ability to survey and stress test banks directly.³

“We see the results at a sector level, but we don’t get them on an individual basis,” he says. “If we were provided with that level of transparency, we could factor it into our investment decision-making process, and that in itself could create safer capital markets.”

Investors do have tools at their disposal, however. First, Butters explains culture needs to be owned by the board, filtering down throughout management and the remainder of the organisation. This begins by ensuring there is sufficient independence on the board to provide challenge and oversight, but high enough tenure to safeguard continuity.

“Bill Hwang, who headed up Archegos, had been previously blacklisted on Wall Street for being involved in other riskier activities,” says Butters. “That meant a number of banks did not conduct business with Archegos. But over time, we saw a general relaxation in banks’ controls, and more of them started conducting business with Archegos.

“As banks become more constrained on margins, they may pursue riskier activity. But what this demonstrates as well is potentially a change of guard over time, in management and boards, and with that a loss of continuity and appreciation of certain risks,” he adds.

Auditor rotation is also important to guarantee their independence. “Some banks have had the same auditors for up to 100 years. That leads to familiarity risks, where auditors and banks have become too closely related,” says Butters.

Remuneration is another crucial factor, ensuring compensation is not just based on financial targets and metrics, but also on a qualitative judgement on improving areas like risk and controls. “This is probably where equity investors will have more influence, but credit investors can benefit as well,” explains Butters. “On an annual basis, investors can engage with banks, identify areas of improvement within those risks and controls, and make sure remuneration captures that sufficiently.”

In terms of assessing culture, investors should look closely for warning signs like high employee turnover or redundancy rates. On the positive side, they can look for diversity of thought within the workforce, for instance through gender or racial representation, ensuring people bring different insights and challenge groupthink.

Where culture feeds into operational risk tolerance, banks’ view of their risk threshold and comfort zone can also offer useful insights.

“Where do they see their risk tolerances and thresholds? Who do they want to do business with? And if the world around them is changing so rapidly, how can they then determine what that risk threshold will be? All these questions feed into a bank’s culture,” says Butters.

An opportunity for consolidation?

Judd reiterates the need for greater transparency around these questions but says what the Archegos failure has highlighted is the potential for consolidation in the banking sector.

“The banks that got out first were the major players, while second or third-tier banks were slower and took a much bigger hit,” he says. “That shows it’s the ability of the individuals undertaking these transactions that is important, and second or third-tier banks just won't get the calibre.

“We should be seeing consolidation. An oligopoly in the industry isn't necessarily bad in that case, provided we get the right outcomes from a risk perspective,” he concludes.