A roadmap to the next financial crisis

The industry may have moved on from the 2008 financial crisis, but the potential for the next one could be closer than anticipated if attitudes to risk remain unchanged.

Having been involved in the industry for over 40 years, I have to admit that it has been liable for being ill prepared in managing event risks. In some cases, the event proved fortuitously beneficial such as with the unexpected abandonment of UK Exchange Controls way back in 1979. In other cases, we all suffered from our lack of preparedness. To name a few, these adverse risk events include Black Monday of 1987 when the DJI fell 22% in one day; the 1992 UK exit from the ERM when the Bank of England base rates in a single day moved from 10-15%; the 2008 default of Lehman Brothers; and even the 2016 EU referendum in the UK when the pound slumped against all other currencies.

Some events have had lasting effects on markets, either by leading to market turmoil or by heralding a bear period with ramifications for the ad valorem charge, which is the bedrock of our industry’s revenue, flow. So what other potential event risks are facing the industry?

There are a series of known unknowns, namely issues that we are aware of but whose true consequences we cannot gauge. They include political instability across the world; disruption across the EU and UK with Brexit; cyber security challenges and the impact of disruptive technologies; structural fault lines in markets including the scale and nature of many ETFs, highly leveraged investment strategies, and liquidity risk especially in respect of unlisted or inactive securities.

There are also a series of ignored unknowns, effectively extreme catastrophe planning issues that nobody really wants even to talk about in our industry, although banking regulators have paid lip service to them by instituting stress tests albeit with parameters that are too close to business as usual to have too much meaning. There is potential for a systemic financial sector collapse, there is a risk of infrastructure meltdown and the legal system globally is not consistent. How can one plan for all these events; those that are deemed possible and those that are deemed the ramblings of fantasists?

The short answer is that one cannot truly pre-plan for them other than to ensure that ones business model can sustain a substantial fall in revenues and avoids heavy exposures in high risk fields. That, as memories of the last crisis fade and competition remains fierce in an oversupplied market, is no small challenge. And the cost income ratio, the key measurement of a custodian’s health, is, in most cases, well north of the 60-70% level I would expect at this stage of a bull market. In short the risk profile of our industry is too high and the financial buffers are too weak for this stage of the cycle. And even if one cannot really pre-plan for event risks, some scenario planning would help all to better respond to crises as and when they occur.

 

Political instability could be regional with the North Korean and Iranian situations being currently the most concerning. Both are ignored by markets but could become mission critical, and potentially cataclysmic, if they lead to conflict or material tensions between the major powers. In Europe, Brexit at its worst could lead to a bear market in the major trading nations of the current EU. But, if the EU also adopts a politically inspired and extreme protectionist approach in financial services, we could see severe EU wide financial and liquidity strains as well as disruption from other third countries taking counter measures to potential EU barriers.

Given the current financial performance of our industry, we need to remember that a 25% fall in global markets would eliminate the profit buffer assuming nobody acts fast enough to cull costs, namely people and compensation packages which account for 60% of the industry cost base.

However, political risk pales into insignificance against the risks from technology and markets. Cybersecurity is a major risk, as custodians are liable for asset safety and experience has shown that even alleged fail-safe technologies such as blockchain are vulnerable to risks, especially from gateway risks. But disruptive technologies create a further challenge. They can compound costs during any lengthy migration period if firms need to operate duplicate IT platforms and they can, concurrently, seriously disrupt pricing models if a major player or new entrant gets first mover advantage to an entire process, or a meaningful component of that process. Price disrupters in other industries have peeled off 50% plus of the cost of a function. What would happen if that scale of price attrition happened in one of the core revenue sources of ad valorem or transaction charging?

Markets also are vulnerable to internal risks. We are seeing the return of opaque instruments, not only in the structure of synthetic ETFs but also in the re-emergence of new surrogate hedging tools such as with the contracts for difference markets. History tells us these are easy to create but difficult to unwind in volatile markets. Our major risk remains liquidity, which was the driver for many of the crises we have seen in recent decades. The liquidity threat comes from the scale of market exposure to potentially illiquid instruments. Such risk could spread to major counters in troubled times as a result of the current penal capital cost of carrying trading positions and the resultant shrinkage of principal trading books. We also need to factor in the historic shrinkage in risk appetite from key market players, especially institutional providers of stock loans or swaps, at times of crisis. The recent material increase in collateralisation adds to those risks as access to prime collateral has yet to be tested in downturns of the scale we have experienced in previous extreme events.

The stress tests of central banks are too directed at capital adequacy and loan loss provision. Catastrophe planning for our industry has to consider the risks of financial nationalism where a market may prioritise domestic players and their safety over cross-border ones. We need to question the impact of a failure of asset safety in a major country, whether through bankruptcy of a major custodian or CSD or through a legal black hole such as occurred in the re-hypothecation problems of the last crisis. And finally we need to think of the impact of CSD or ICSD failure as they extend their product ranges and assume risk whilst often precluding liability in their terms of business.

The idea that governments will step in is fallacious as it is doubtful that this could happen again after the political fury that the last such intervention created. But what are the alternatives? Will the private sector bail out the delinquents? In the crash of 1987, I sat in a credit committee and the driver for our actions was the simple equation of the cost of supporting delinquent or liquidity challenged clients versus the cost of walking away. That time the former prevailed but central banks also influenced thinking in a way that is unlikely to re-occur in today’s much more global market place.

So what planning should be undertaken? First, there needs to be more internal discipline and more risk aversion, not only in the onboarding process, but also during the life of a contract for clients, which can evolve quite dramatically during the six to eight year plus cycle of the average relationship. And defaults must cease to be a forbidden topic; all suppliers, including infrastructure, must have meaningful living wills that also identify their core risks including extra territorial and major client or client segment risk. Finally the industry needs to undertake joined up stress tests especially for extreme cases of an ICSD, CSD or CCP failure or longer term outage, the default of the largest single sub-custodian in each continent and the outage of one or more of the participants’ own live and backup systems.

And we all need to remember that revenues can slump overnight; how do we tackle costs in such an event or do we really all have benevolent parents or godfathers willing to bail us out in times of crisis?

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