Unrecognized Lessons of the Archegos Collapse
(Bloomberg Opinion) -- The recent collapse of Archegos Capital Management revealed underappreciated and deeply embedded risks in the U.S. and global banking systems that need to be addressed more broadly than thus far contemplated.
Initial reactions to the failure have understandably focused on the lack of transparency at family office funds such as Archegos. Yet a strong capital requirement that meaningfully limits leverage — known as a supplementary leverage ratio — is also critical to protecting banks against the risks that such investment vehicles present. And a recent change in the Volcker rule regarding family office funds may be the least recognized risk, opening the way for banks to bail out such funds in the future.
Family office funds — a type of privately held company that handles the investments of wealthy families — are estimated to number more than 10,000 and manage nearly $6 trillion in assets worldwide. They often follow a hedge-fund business model, engaging in highly leveraged transactions with major banks and other financial institutions as counterparties. The risks they pose are global and need to be addressed as such. The failure of Archegos, for example, precipitated large losses around the world, from Credit Suisse in Switzerland to Morgan Stanley in the U.S. and Nomura in Japan.
First, the issue of transparency. In the U.S., family office funds are exempt from most public registration and disclosure requirements. One consequence of this opacity is that each bank with exposures to Archegos had little, if any, knowledge of other banks’ exposures to the fund. Archegos’s high-risk investment strategy was thus multiplied over several counterparties, greatly increasing the impact of its eventual failure. The dearth of public disclosure has also made it difficult, if not impossible, for regulators to assess the risks that such funds pose to safety and soundness and financial stability.
Second, the failure of Archegos underscores the importance of maintaining strong supplementary leverage ratio requirements for the largest U.S. banks. Banks’ capital models, which seek to differentiate assets by risk, have consistently proven unreliable at preparing them for extreme loss. Even the best models are limited by the information that banking organizations have available to them. They cannot accurately assess risk if leveraged exposures, such as those at Archegos, aren’t fully disclosed, or are obscured by complex derivatives. Such “hidden” leverage can be hard to identify without a detailed examination of the terms and conditions of specific derivative contracts.
For very large banks, the supplementary leverage ratio — a simpler measure of capital as a percentage of total assets — provides an important backstop. For example, it incorporates derivative exposures, ensuring that they are funded with a minimum amount of loss–absorbing capital.
Derivatives make up more than 10%, or $1.6 trillion, of the total exposures subject to the supplementary leverage ratio for global systemically important banks in the U. S. For some such banks, derivatives account for almost a quarter of total exposures. Weakening the supplementary leverage ratio, as some have proposed, would make these financial institutions far more vulnerable to failures like Archegos.
Finally, an underappreciated aspect of the risks posed by family funds in the U.S. is their exclusion from the requirements of the Volcker rule. Designed to curb speculative trading by banks and to prevent the bailout of private funds, the rule originally imposed strict limits on the ability of a bank to hold an ownership interest in or sponsor a family fund. But last year, U.S. financial regulatory agencies removed those restrictions, in response to public comment letters from major U.S. banks and trade associations.
As a result, banks may more freely lend to and purchase assets from family funds. This exposes the banks and the public safety net to the risks of the funds, and lets the banks bail out the funds during times of stress — all of which undermines the central purpose of the Volcker rule.
Regulators further weakened the Volcker rule by allowing banks to make “parallel investments” alongside a related family fund or hedge fund — meaning banks can give assurances that they will invest in the same assets and use the same strategies. This magnifies banks’ risky trading and enhances both the means and the incentives for them to bail out leveraged vehicles such as family funds or hedge funds.
The lesson of Archegos is clear: Leverage and opacity amplify risks in the global banking system. In response, as a starting point, the following steps should be taken:
- Require greater public disclosure for family funds, so that market participants and regulators can understand the risks they pose;
- Maintain the current supplementary leverage ratio, which provides a critical cushion of capital to the largest U.S. banks; and
- Restore the requirements of the Volcker rule, to prevent banks from bailing out family funds.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Martin Gruenberg is a member of the board of directors of the Federal Deposit Insurance Corp., and a former chairman of the FDIC. The views expressed are his own. They do not necessarily reflect the views of the FDIC board.
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