In the wake of the Archegos fiasco, Malcolm Hurlston and Mark Northway, the chairs of the UK Shareholder Association and Sharesoc respectively, wrote to the Governor of the Bank of England on April 14th to express concerns that this case raises for shareholders. We reproduce the core of their letter:
The situation which has unfolded at Archegos Capital Management recently raises serious concerns not only for private investors, many of whom own bank shares, but for any member of the public with a bank account and particularly those with savings in excess of the FSCS £85,000 threshold. We have learnt that Credit Suisse, one of six banks acting as counterparties to Archegos, may have lost $4.7 billion from the collapse.
We are aware that regulators in Europe and America are looking closely at discussions between the six banks linked to Archegos to decide whether any acted inappropriately during the recent fire sale of shares that exceeded $20 billion. We understand that the shares in question are not UK stocks, and that none of the banks involved are UK banks. However, we have two specific concerns related to the possibility of a similar event happening in the UK, involving UK stocks and / or UK banks. We would be grateful if you would comment and provide reassurance about these concerns.
Firstly, we believe that there is a serious lack of transparency surrounding large share transactions by private offices and hedge funds executed through their prime brokers in derivative form. This is of particular concern where leveraged trading imparts volatility to the assets. There appears currently to be no means for private shareholders, or any other saver or bank-account holder, to know whether a particular share is the subject of the type and size of trade seen in the Archegos case mentioned above. We understand that only the Bank (or the Prudential Regulation Authority) would be aware of such leverage, … We would like to know whether the relevant regulator is addressing this disclosure issue and the associated lack of market transparency.
Secondly, we are concerned about the size of the reported losses suffered by the banks in this instance and the apparent concentration of lending risk to a small number of stocks and to a single counterparty. The reported loss to Credit Suisse is estimated to be in the region of 12% of total capital. It is of concern that the capital of such a large bank was so exposed to the price movements of a single stock. This suggests a major weakness in the models used to calculate the risk and associated capital adequacy.
The risk of unexpected losses is a major concern for our members who have holdings of banking stocks. We therefore seek your assurance that no similar weaknesses exist in the capital models applied to UK banks and to activities undertaken by foreign banks within the UK, and that your own supervisory processes effectively prevent similar risk concentrations. (Our emphasis)
Governor Bailey responded on May 20th. He wrote:
The Archegos incident was a significant market event which, as has been seen from public disclosures, generated material losses across a number of financial institutions. It raises some serious questions for funds, prime brokers, shareholders and regulatory authorities to consider, many of which you raise in your letter.
The owners of the business, i.e. shareholders, also have an important role in holding the firm’s management to account. Shareholders are amongst the first to benefit from the prosperity of a successful, sustainable, business. But that entitlement comes with a responsibility to shoulder the first losses the business makes. A firm’s ability to absorb losses through equity is central to its safety and soundness, as well as providing a valuable cushion to protect customers’ deposits.
As your letter highlights, the incident raises questions about the transparency of funds like Archegos and risks posed by non-bank financial institutions more generally. This is subject to work internationally and these issues will be raised and discussed there.
I hope you both, and your members, find this reply useful …
Let’s unpick this correspondence. The first point to note is that Bailey does not respond to their request to give an assurance
… that no similar weaknesses exist in the capital models applied to UK banks and to activities undertaken by foreign banks within the UK, and that your own supervisory processes effectively prevent similar risk concentrations.
i.e., Bailey did not give the reassurance they asked for.
To be fair, it would have been difficult for Bailey to have credibly done so. We had a situation where Credit Suisse, supervised by the Swiss National Bank, which enforced the Swiss version of Basel 3 rules to limit the extent of counterparty credit risk exposure, had lost 12% of its capital through a large exposure to one single counterparty. So how could Bailey offer a credible (as opposed to the usual boilerplate) reassurance that no UK bank, supervised by the Bank of England, which enforces the UK version of Basel III rules to limit the extent of counterparty credit risk exposure, could not experience a similar or worse loss? To ask that question is to answer it.
We should also keep in mind that the regulatory models are calibrated to give a 1 in 1,000 years probability of default, so the suspicion arises that the models might not have been calibrated properly. In any case, it would be wise for Bailey and his fellow regulators overseas to look into this issue. Granting a little time to investigate, Bailey then needs to make a statement that he is either confident in the effectiveness of UK regulation in this regard or he is not: the Archegos/Credit Suisse episode is a warning shot across the bow.
One presumes that Governor Bailey must have intended to promise such an assurance, but had forgotten to include it in his letter.
Bailey’s letter also failed to address Messrs Hurlston’s and Northway’s concern that
There appears currently to be no means for private shareholders, or any other saver or bank-account holder, to know whether a particular share is the subject of the type and size of trade seen in the Archegos case mentioned above. We understand that only the Bank (or the Prudential Regulation Authority) would be aware of such leverage …
Bailey’s failure to respond is disappointing because their concern would seem to be well founded. The PRA is responsible for auditing these models via an ‘expert’ supervisory process plus an internal model audit that is accountable to the PRA, but the results of this exercise are confidential so shareholders cannot access them.
Instead, Bailey puts the onus on shareholders. To quote
The owners of the business, i.e. shareholders, also have an important role in holding the firm’s management to account. Shareholders are amongst the first to benefit from the prosperity of a successful, sustainable, business. But that entitlement comes with a responsibility to shoulder the first losses the business makes.
Ordinarily we would agree with such a statement, but how can shareholders be expected to exercise this responsibility if the regulators withhold from them information they would need to exercise this responsibility? On the other hand, if that information is not needed to exercise this responsibility, then what is the point of collecting such information in the first place? In which case, what purpose do these counterparty credit risk exposure rules serve?
Governor Bailey’s letter is also odd in light of the many reassurances the Bank has given since the Global Financial Crisis, e.g. here:
In the UK and internationally, laws have been developed to make senior management in banks more accountable. Remuneration rules better align incentives and rewards to discourage excessive risk-taking and misconduct.
Or
Toxic forms of shadow banking at the heart of the crisis – with their large funding mismatches, high leverage and opaque, off-balance sheet arrangements – no longer represent a financial stability risk.
This last passage could be a perfect description of Archegos. Perhaps Governor Bailey could run that one by us again.