31 January 2002

FT: What goes around: Banks may not succeed to shield from bad debt.

As large companies on both sides of the Atlantic go into bankruptcy and restructure their debt, there is at least one cause for cheer on Wall Street. So far, the economic slowdown has not led to the failure of a big financial institution, or a crack in the financial system. Here, bankers like to boast, is proof of their growing sophistication. Rather than being caught with bad debt on their books, they have successfully sold much of their credit exposure to others. Here, too, is proof that the insurance industry has largely hedged its liabilities.

Financial engineers have devised sophisticated mechanisms to spread risk thinly throughout the system but only after Enron's collapse are these being fully tested. And there are growing fears that Wall Street's sanguine attitude could prove flawed. Sir Howard Davies, chairman of the Financial Services Authority, the UK's main financial regulator, meanwhile warned that general insurers could have taken on excessive credit risks from banks. He said banks could have passed these on in the form of complex financial instruments called collateralised debt obligations (CDOs). There was a danger either that 'insurance companies may not be pricing these risks appropriately, perhaps because they lack the sophisticated technology to price them which investment banks possess' or that the transfers simply amounted to tax or regulatory arbitrage.

Furthermore, the emergence of financial conglomerates such as Citigroup in the US, Credit Suisse in Switzerland and Allianz in Germany could have made it harder for them to distance themselves from credit risk. Such groups may have significantly stronger capital and earnings bases than their forerunners a decade ago but they also now own their own fund management companies and insurance groups. 'If banks are selling risk to asset managers and insurance companies, but they own an asset management or insurance company that is buying risk from other banks, are they really reducing their exposure to risk?' asks the head of investment banking at one financial group.

Ultimately, it is not clear whether mutual funds, pension funds, insurance companies or banks will be the ultimate losers from debt restructurings and corporate collapses. That adds a fresh element of uncertainty to the problems afflicting corporate America and one that could take a long time to resolve. But no matter which form of financial institution ends up suffering most, one lesson is already clear. The redistribution of credit risk does not mean the end of it.

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