As echoes of the global financial crisis reverberate through the market the banking sector has taken centre stage as the credit quality of issuers is back on the agenda and investors look for measures to mitigate counterparty risk.
The years that followed the Lehmann bankruptcy in 2008 became known as the global financial crisis such was the profound effect that the episode had on the world’s economy and banking system.
Years of leverage, risk taking and exposure in real estate and investments caused untold damage and took a decade or more to unravel. This period was also responsible for a raft of regulation as authorities around the world took drastic action to try to prevent such a situation happening again.
These included the Dodd-Frank Act in the US to control how banks operated and the European Mifid 2 that looked at market conduct and investor protection.
The period immediately after 2008 was characterised by continued credit concerns as investors tried to ascertain the strength of sovereigns and investment banks. This peaked between 2010-2012 with the European sovereign debt crisis affecting Greece and others. Regulation had made the system sounder by stricter reserve requirements and reporting burdens, but this arguably impacted innovation and competition.
“[A] major default would clearly be very challenging for the structured product market and its investors,” Tim Mortimer.
Strong economic growth followed in most countries until the Covid pandemic struck in 2020. Although this caused major economic problems worldwide the banking sector was deemed to be robust after the controls placed on them by regulators over many years. In fact, other corporate sectors such as airlines felt the effect of the pandemic more and companies cut dividends and hoarded cash as business dried up.
In the period post-pandemic attention has shifted to fears of inflation and interest rate rises, and these two related trends have dominated the economic narrative.
Yet suddenly the concern of the strength of the banking system has come back on the agenda. In early 2023 three US banks failed.
The demise of the start-up supporting Silicon Valley Bank attracted significant attention. SVB’s problems were exacerbated by worsening economic conditions and the rise in interest rates. Rate rises produced losses in some of the bank's investments such as long dated US Treasuries. The failures took the market by surprise.
The case of SVB was quickly followed by the renowned investment bank Credit Suisse, a bank with a proud history plagued by troubles in recent times. Trading losses and regulatory issues forced its sale to archrival UBS last week.
The name of Credit Suisse is well known in structured products. Although it has not issued any products in the UK retail market for over three years, it has remained active in the US issuing over 2,000 products in that time according to www.structrpro.com.
Bank credit worthiness is critical for structured products as it is for bank bond holders and depositors.
Proven measures
Structured products are generally intended as buy and hold investments and their secondary market prices can be impacted by equity falls, increased volatility and higher credit spreads. These three factors often occur together therefore bank credit strength is pivotal for an investor considering buying a long dated structured product.
However, the role of issuer credit in structured products has always been a two-edged sword. While no investor wants to entertain default of the underwriting bank it is also true that the extra pickup that credit risk gives to investment terms is very important, particularly in times of low interest rates.
After recent events we might expect some investors to prefer a flight to quality, for example by using AA rated banks even though headline investment terms may be worse than their A rated counterparts. For those prepared to give up more yield or upside it might make sense to seek a vehicle with some form of collateralisation. Just as some investors are happy to pay up for deep equity protection, there will also now be some who will become much more cautious from a credit perspective.
Proven measures to help mitigate credit risk involve adequate diversification across the investment banks active in the market. Credit diversification is usually strongly favoured by regulators. The problem can be that if the range of issuing banks with strong credit is quite limited then diversification would necessarily involve going materially down the credit curve.
Another strategy favoured by many is to invest in shorter term products. This enables investors to rotate banks on perhaps a three-year view rather a longer tie-up to allow for better control of credit risk. Additionally, such shorter dated products also tend to suffer less secondary market fluctuations when credit spreads widen.
The recent rise in interest rates has meant that capital protected products have become much easier to structure and with increasingly more attractive terms that boost their popularity.
This has meant a return to an active deposit market favoured in many jurisdictions such as the US and UK. Both of these markets benefit from generous state investor deposit protection schemes. For lower risk investors this recourse was always useful and in these times of credit concerns the re-emergence of this sector should prove timely for those institutions who possess the necessary deposit licenses.
The immediate future remains uncertain with some other big name international banks a cause for concern as demonstrated by their credit spreads and share prices although the sector as a whole appears much stronger than in 2008.
While governments will seek to prevent any major default such an event would clearly be very challenging for the structured product market and its investors.