How systemic risk is shaking the market’s foundations
Adversity, like necessity, is the mother of invention.
Firms are seeking novel ways to adapt to the challenges of Covid-19 and the likely increase of remote working even after the pandemic subsides. Some problems are easier to solve than others.
In the easier category, new solutions are needed to replicate the spontaneous interactions that arise in the workplace. Management and compliance must develop methods to control and develop their cultures from afar. Legal issues must be addressed, enabling remote working from elsewhere in Europe without tripping EU rules on branches and business taxes. And regulators will need to focus afresh on the discipline of public, statutory disclosure, given reduced face-to-face dealings.
However, more difficult issues also abound, arising from the impact of coronavirus on systemic financial risk.
It was only recently, in 2007–8, that the world discovered the importance of identifying build-ups of systemic risk. Then, it was the risk arising from sub-prime debt in California, Florida, Nevada and elsewhere. This time, the build-up of extraordinary Eurozone financial risk has become an unresolved issue as EU authorities dance, increasingly openly, around the top of that volcano. Covid-19 has brought an eruption ever closer.
And that is not the only systemic risk arising. Many risks previously seen as firm-specific now have systemic elements, as a report published by my company today explains.
Four such risks are worth particular consideration
First, firms will need to monitor their non-performing assets closely, with a view to dynamic adjustment of their capital and collateral positions if there is a rapid deterioration. The practical judgement calls required can be tricky. In the UK market, government guarantee schemes mean that this is less of an issue than it otherwise would be. Nevertheless, difficulties will arise when companies which cannot sustain more debt seek yet more financing.
Indeed, lending to such over-indebted companies forms the second key risk to manage. Protection can be obtained through preferred equity shares or other solutions that do not involve piling on more corporate debt, but accounting conventions (under IAS 32) do not help. They can require such shares to be classified as “liabilities” akin to debt rather than “equity”, and UK laws on the ability to pay dividends on or redeem (buy back) preferred shares are restrictive.
The counterparts to these rules in other jurisdictions can be more generous. For instance, under Delaware law dividends can be paid out of net profits in the year the dividend is declared, whereas a dividend is prohibited in the UK unless all accumulated profits exceed accumulated losses, irrespective of the profit (and cash position) in the relevant year. This may prompt a UK legislative change, to assist UK lenders and investors, but until then such nuances are vital to understand.
Separate attention is needed for those portions of banks’ loan portfolios which have only light protections (“covenant lite”) facing companies backed by private equity funds, particularly when, not benefiting from government bailouts, those funds could walk away from numerous existing investments.
Third, firms will need to consider the enhanced risk of litigation arising out of their contractual relationships. Some parties to contracts are experiencing difficulties in performing their obligations, resulting in an increasing number of legal disputes that may end up in the courts. In the US, this can involve punitive damages.
Finally, firms will need to pay particular attention to their compliance practices. Having some people in the office and some working from home is likely to stretch oversight processes to new limits. There is unlikely to be regulatory flexibility if there are breaches of market practice requirements as a result of these difficulties, even in the current climate, but the appropriate application of such rules should nevertheless be considered.
Overall, systemic risk concerns go to the foundations of the market and call for unusual management efforts. Firms are in the front line in addressing these matters and will need to master the implications of their interactions like never before. The post 2008 regulatory framework is superior to its predecessor, but it is management which falls ultimately to deliver.
“Navigating Systemic Risk: Protecting Financial Institutions from Avoidable Losses” is published today by Shearman & Sterling.
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