The Chapter 11 filing of Lehman Brothers on Monday may have been a seismic event in the global financial markets, according to a report from Standard & Poor’s Ratings Services, but the
The Chapter 11 filing of Lehman Brothers on Monday may have been a seismic event in the global financial markets, according to a report from Standard & Poor’s Ratings Services, but the damage to European banks is likely to be limited, at least in the short term.
‘The information that we have received so far indicates that European banks’ direct net exposures to Lehman Brothers Holding and its subsidiaries are generally moderate and manageable,’ says the report’s author, Standard & Poor’s credit analyst Nick Hill. ‘This conclusion principally reflects the widespread use of credit mitigation techniques such as netting, collateral management and margin calls.’
A more significant factor is likely to be a fall in asset prices as Lehman entities unwind trading positions and manage down their balance sheets, which could lead to further material write-downs in some European banks’ third-quarter earnings, but it is too early to assess the scale of this effect. ‘In certain cases, it could result in rating actions once further information becomes available,’ Hill says.
By contrast, Andrew Liegel, a product management specialist at FRSGlobal, a provider of risk and regulatory reporting solutions, argues that Lehman Brothers’ fall may save investors billions of dollars.
By letting Lehman Brothers fail, he says, regulators are forcing investors and the independent boards that represent them to take a fresh look at their risk measurement, risk management, risk reporting and communication policies. Measures are already being put in place by both regulators and investors that will hopefully prevent a similar meltdown in the future, although the immediate pain to investors will be extremely acute.
Christoph Riniker, a senior strategist at Swiss private bank Julius Baer, argues that through the bankruptcy of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America, the US regulators and central bankers have sent a clear signal: ‘Financial institutions that do not bring an immediate economic benefit and have irresponsibly engaged in the credit bubble should not expect any support.
‘The market subsequently takes on systemic risks. This could have been the case if AIG, which represents a counterparty to many credit hedges, had crumbled. At present, it is hard to predict a meltdown in the financial market.’
Riniker says that with the disappearance or acquisition of three of the five major independent US investment banks dropping out, a massive realignment is underway that in the medium term could lead to the stabilisation of the financial markets.
‘The winners are clearly the consolidators like JP Morgan, Bank of America and European giants that have not been substantially affected by the credit crunch,’ he says. ‘Although caution is still the order of the day in the financial sector, the winners resulting from the downsizing are starting to emerge.’
Liegal agrees that reports of the demise of the financial system are greatly overblown. Derivatives operations that package and sell real estate debt obligations will remain an important way to mitigate and spread risk to different markets, he predicts, but they won’t be the huge profit machines that they were between 2003 and 2007.
‘Similarly, investment banking operations will continue, most likely moving back to their traditional roots of underwriting debt and equity offerings and advising mergers, rather than relying on their global trading operations that were their huge profit machines of the last decade,’ he says.
Liegal predicts a number of moves by regulators, especially in the US and UK, in the months ahead, including stronger pressure on financial institutions to elevate the role of chief risk officer. ‘No longer just the interpreters of mundane and esoteric VaR calculations, tomorrow’s chief risk officers will be given the mandate of reviewing operations and making key decisions that affect the operations of the front offices,’ he says.
Scenario analysis will be strongly emphasised in the context of reporting and communication to regulators and investors. Instead of being a closely guarded internal capital calculation tool, scenario analysis will be demanded by regulators in supervisory reviews and communicated to public investors with much more depth and clarity. The notion of ‘proprietary internal information’ will become far less common for banks that have public investors.
Liegal believes principle reporting will gain a much stronger following amongst regulators, most obviously in the Internal Capital Adequacy Assessment Process in Pillar II of the Basel II Accord. Even if reported numbers meet current capital adequacy requirements, he expects regulators to hit financial institutions hard, by limiting lending from central banks, if they cannot point to a sound and dynamic risk management system that can quickly change the current banking and trading operations of a commercial or investment bank.
He also forecasts more detailed disclosure to the investing public on risk and capital adequacy issues, meaning that Pillar III Basel II reports that have been weak in Europe and not even under discussion in the US will come under much more focus in the coming months.
While the US authorities decided not to save Lehman Brothers and let the market take its course, Liegal expects them to ensure that market participants have appropriate information, notably robust and timely Pillar III market disclosures for capital adequacy, to make decisions on the extent that they are willing to invest in and trade with a financial institution.
In the long term, he concludes, it means investors and executives will have to ‘temper their long-term growth prospects and take money off the table a little – or a lot – sooner than in recent bankruptcy and buy-out events’.
