When Archegos Capital Management blew up, it saddled Credit Suisse Group with $5.5bn in losses. One reason investors and regulators were blindsided: a gap in the regulatory oversight of big international banks.
That is the conclusion of financial risk consultants who have sifted through the wreckage.
It is taken for granted that banking is an international business, with trillions of dollars flowing through firms and across borders every day. But banks operate, and are often regulated, locally. That contradiction can obscure the view of regulators and investors into what is happening inside sprawling global firms.
Archegos revealed “some pretty significant gaps in the oversight of internationally active financial conglomerates,” said Jeremy Kress, an assistant professor at the University of Michigan’s Ross School of Business and a former Federal Reserve lawyer. “When you have different pieces being booked in different entities, the supervisors may not even know what they’re looking for or what questions to ask.”
Archegos was one of the biggest international financial disasters in a generation, unleashing sudden losses on banks in Switzerland, the US and Japan. Regulators in all three countries, as well as the UK, have launched investigations looking into the origins of the failure.
The way Credit Suisse dealt with Archegos is a prime example of the complexities of cross-border banking. The family investment office is based in New York and the bank managed its day-to-day relationship with the firm through teams based in the US.
Yet Credit Suisse booked many Archegos trades through its London arm. It did so because these were mostly trades involving derivatives tied to stocks known as total-return swaps, which require little money upfront or public disclosure.
Banks like swaps because they incur lower capital charges than direct loans to clients. London is a trading hub for these instruments, and having them all processed there creates economies of scale, as well as the opportunity for banks to reduce capital charges by offsetting risks from multiple clients in one place.
There is a regulatory impact, too. The trades going through London weren’t in the scope of Federal Reserve stress tests of Credit Suisse’s US trading arm this year, according to a person familiar with the matter. Credit Suisse’s US arm passed the test without any problems.
The practice of recording trades for a client in a different country, known as remote booking, “creates an issue where no single supervisor has oversight over the risks and therefore no one has responsibility for the risks,” Kress said. “We have $10bn of losses to show that international collaboration is not working,” he added, referring to the amount lost across several Wall Street banks from Archegos’s unwinding.
If the positions had been included in the US stress tests, considered to be the gold standard globally, regulators might have gleaned that there were concentrated risks lurking, said Andreas Ita, a former UBS Group executive and co-founder of consulting firm Orbit36, advising banks on how to avoid similar blowups.
It said the potential capital blow from the Federal Reserve’s 2021 stress scenarios on $20bn in Archegos positions could have been around $3.7bn, based on Orbit36 estimates.
“This complex booking structure, where the client risk is in London and the positions are booked back into the US, means it’s one of those cases where the gaps weren’t being watched by regulators or anyone,” he said.
A report Credit Suisse’s board commissioned into the Archegos loss blamed a “lackadaisical attitude towards risk and risk discipline” for the failure. The report, written by law firm Paul, Weiss, Rifkind, Wharton & Garrison, said numerous employees reported that the remote booking structure added complexity. But it concluded remote booking didn’t obscure Archegos’s risks internally, since risk managers in the US and UK collaborated on monitoring Archegos.
Banks have pushed back against regulators taking a cross-border view of their operations. Credit Suisse and other international banks lobbied the Federal Reserve to remove them from a group of large banks requiring more oversight, saying they didn’t warrant closer examination because their US businesses had become smaller since the financial crisis. They were shifted off the list this year.
They also kept their overseas derivatives and trading activities out of their US resolution plans, or “living wills,” after the Federal Reserve backtracked on proposals to include those from this year. Industry groups said the Fed would be extending its reach too far outside its borders, and that work would be duplicated with international regulators.
In US Senate hearings in May, Senator Elizabeth Warren called out the regulatory gap.
“We dodged a bullet with the Archegos collapse this time,” she said. “But what slipped through the net by regulators to contain these losses when things go wrong was relatively small to what could have slipped through. It could have been an even bigger failure.”
The Federal Reserve declined to comment. Its chairman, Jerome Powell, in April interviews said the Archegos losses indicated risk-management breakdown at some banks, but hadn’t threatened financial stability. He said it wasn’t an indictment of the Fed’s supervision of the banks involved, which included big US lenders.
In the UK, the Archegos positions were in the purview of an annual capital-planning exercise at Credit Suisse’s UK unit with the Bank of England’s Prudential Regulation Authority, the person familiar with the matter said. The PRA doesn’t disclose the results of those exercises, which include applying stress scenarios. A PRA spokeswoman declined to comment.
In July, the PRA upgraded rules around remote booking for international banks, saying it is open to hosting a diverse range of booking arrangements but that risks need to be transparent to the PRA and home regulators.
“With a global business line, risks may crystallise anywhere in the group. Given the UK’s role as a global centre for trading, those risks are often observed first in the UK,” the PRA said in the July guidance.
Nick Dunbar, founder of Risky Finance, which tracks banks’ risk disclosures for investors, regulators and other clients, said the Archegos trades exposed the tip of a derivatives machine running through London, “hidden in plain sight.”
He calculates large US and European banks have more than $3tn in equity-swap trades at their UK arms, based on his analysis of their UK units’ regulatory filings.
The Archegos reverberations were felt strongly in Credit Suisse’s London unit, Credit Suisse International. Its balance sheet had swelled 38% in the year leading up to Archegos’s implosion, even as the bank’s overall risk-weighted assets fell 5% in 2020, according to bank filings.
After the Archegos collapse, to shore up the London unit, the bank’s Swiss headquarters provided extra liquidity and put a $3.5bn capital commitment on standby, according to a first-half filing by Credit Suisse International. Its balance sheet was slashed by a third.
Write to Margot Patrick at [email protected]
This article was published by Dow Jones Newswires’