The Archegos case must serve as a wake-up call for banks

(op-ed by Andreas Dombret originally published in German by Capital as of 7th April 2021: https://www.capital.de/geld-versicherungen/der-fall-archegos-muss-den-banken-als-weckruf-dienen)

The collapse of Archegos Capital is an isolated case that does not trigger a systemic crisis. However, one cannot simply return to business as usual, as the capital markets are currently fragile and vulnerable, warns former Bundesbank board member Andreas Dombret.

High-risk, leveraged bets by the relatively unknown investment firm @Archegos on about a dozen American and Chinese stocks triggered a massive shockwave in international financial markets. When the New York-based firm with about 50 employees could not provide additional collateral or new funds following stock price declines, banks liquidated their positions in emergency sales.

Analysts at JPMorgan estimate the total damage in the banking market at up to $10 billion. The U.S. Securities and Exchange Commission (SEC) has launched investigations, and President Biden is reportedly being briefed regularly, according to a White House spokesperson. The biggest margin call in Wall Street history has sparked memories of 2008. Therefore, it is worth examining this case more closely.

Three aspects are particularly noteworthy:

1. The investor behind Archegos, Bill Hwang, is well-known in professional circles. His career includes a scandal where Hwang was found guilty of insider trading in Chinese stocks, leading to a four-year trading ban in Hong Kong and a settlement with the SEC for over $40 million. Thus, Hwang is a negatively predisposed market participant.
2. Given his background, it is surprising and incomprehensible that leading, reputable capital market institutions provided Hwang and Archegos with billions of dollars. The list of affected institutions reads like a Who's Who of international investment banking. The total stock positions of Archegos amounted to up to $50 billion, largely financed by credit and secured with stocks. The bets ultimately turned against Hwang, especially with the American media company Viacom.
3. Since Archegos was registered as a family office, it was subject to minimal regulatory oversight and operated largely in secrecy. The family office structure and heavy use of derivatives helped Archegos evade disclosure requirements applicable to hedge funds and other institutional investors, hiding the true extent of its stock risks. Archegos frequently used total return swaps, speculating on price changes without owning the underlying stocks. Outsiders, given the high leverage, found it challenging to discern the extent and nature of Archegos’ activities.

So far, this appears to be an isolated incident that, while unsettling the financial world, does not destabilize financial markets or involved banks. Despite the large investment sums, Archegos is not systemically relevant. A direct comparison to 2008 is inappropriate since banks today have significantly higher and better-quality capital, ensuring short-term financial stability. Markets have responded calmly, not panic-stricken, to the incident. However, mid- to long-term lessons must be heeded, as early warnings in 2007 were largely ignored but contributed to the 2008 crisis. Returning to business as usual is not a viable option.

The capital market is fragile and vulnerable

The current state of the capital market is fragile and vulnerable, not just due to the pandemic. Supported by low interest rates and massive fiscal stimuli, stock markets have hit record highs, driven by expectations of a booming post-pandemic economy. Market crashes like Archegos can occur in such optimistic environments. In a climate where a reversal in interest rates is more likely, the risks of a market downturn must be adequately assessed, and caution is necessary.

Certain financial instruments pose higher risks than others. In 2008, it was securitizations that helped spread risks, only to reappear on the balance sheets of financing banks during the crisis. This is typical of shadow banks, and Archegos parallels these securitizations. Central banks will likely scrutinize the shadow banking system even more closely. Regulators will push to close loopholes for family offices to ensure sufficient transparency, ensuring all market participants operate on a level playing field with similar disclosure requirements.

Finally, it’s essential to monitor not only financial markets but also individual market participants. Risk managers in banks should regularly review potential dangers and act conservatively. Financing risky bets by an aggressively leveraged investor with a tarnished reputation—how did Hwang evade strict compliance regulations?—is not prudent banking. The Archegos case must serve as a wake-up call for banks to scrutinize their partners better and closely monitor their risks.

Dr Andreas Dombret was the first banker to join the Executive Board of the Bundesbank and the ECB's highest supervisory body, only to return to the private sector after his regular retirement. He knows the international financial markets inside out from both perspectives. Today he is a Global Senior Adviser at Oliver Wyman.