Underpricing or Overpricing of Risk ??

A Chinese curse says, “may you live in interesting times”. Indeed the financial landscape in two regions of the world are going through very interesting times these days. In UK Greensill Capital is looking for rescue and in China PBoC (People’s Bank of China) has taken stringent measures to truncate the feathers of the Ant Group.

The whirlpool ,in which Greensill Capital finds itself enmeshed, is much wider and deeper than the technicalities behind the collapse of a financial institution. The circumstances leading to rise and fall of Greensill Capital raise serious questions about the state of crony capitalism in UK, the vigilance of regulators and the link between financial innovation and risk.

Greensill Capital (GC) was founded in London in November, 2011 by Lex Greensill, an Australian by descent. Greensill Capital soon became the poster boy of supply-chain finance, a financial tool that has been in existence since last two centuries at least. Supply-chain finance basically involves trading of invoices and in its contemporary version the model enables suppliers to large companies such as Walmart, Vodafone etc to get paid by a bank against the invoice to the companies. The banks pay these suppliers little lesser than the invoice amount and the banks then charge the companies the total invoice amount. The suppliers benefit because they get paid much before their customers (Walmart, Vodafone etc) would have paid them and these suppliers take into account the time value of money by agreeing to the lesser than the invoice amount. The companies negotiate with the banks for an extended credit period sometimes as long as 180- 210 days and this is because they wait for the inventory to be sold before they need to pay to the banks. The banks profit from the difference in the payment to the suppliers and the receivables from the companies.

GC is an intermediary between an investor , Credit Suisse, and the companies such as NMC Health, Bright house ,to name a few, apart from other big companies . GC used to bundle invoices of hundreds of suppliers[ to these companies] in a bond –like securities and sell it to Credit Suisse and GC had control over the assets being created out of the 8 billion USD pool earmarked for supply-chain finance of Credit Suisse. The invoices were insured against default by insurance companies and thus the risk-exposure of Credit Suisse was minimal and hence no question was asked about the heightened exposure of 8 billion USD to a single entity- GC. Credit Suisse sold these securities to its professional clients as low risk products with higher returns than cash-deposits. These professional clients were in hundreds in numbers.

It had been a smooth sail for GC till  Brighthouse , Agritrade and NMC Health went into administration (bankruptcy proceedings) . Credit Suisse has an exposure of .75 billion USD to these three firms. In March this year the insurers refused to insure the bond-like bundled invoices that led to Credit Suisse to freeze 10 billion USD funding to GC. As on March 25th 2021 Credit Suisse has already returned 3.1 billion USD to its professional clients and the net exposure [almost on default] today stands at around 3 billion USD, higher than its net income of 2.9 billion USD last year.

Where did it all begin and where was to epicenter of this financial earthquake? It [collapse] began in 2019 actually when Interserve, one of the biggest contractors of the government of UK fell into administration. Its control was given to the lenders including HSBC, RBS and a leading hedge fund. This collapse was followed by Carillion, a construction services company in UK, getting liquidated. These two had masked their debts to the government controlled supply-chain finance fund. Interestingly, after finding GC in 2011, Lex Greensill had served as an advisor to the PM David Cameron, who after leaving 10, Downing Street went to become the adviser to GC . It was Lex Greensill , while being the advisor to the government , instrumental in creating this supply-chain finance for the government.

The victims of their own doings, Interserve and Carillion had masked the debts owed as accounts payable rather than debts. The regulators did not take cognizance of this at that point of time and the accounting protocols were not changed. Also David Cameron, as an advisor to GC, lobbied with the government and The Chancellor, Rishi Sunak to let GC secure access to a Covid 19 loan scheme by the Bank of England. Bill Crothers, Chief Procurement Officer of the UK government overseeing 40 billion pounds budget, joined GC as an advisor in 2015 just two months before leaving the civil services.

The events, I have mentioned above, remind me of the 2008 financial crisis and the learnings out of it. Let me adapt my learnings into the GC or supply-chain finance scenario.

1.      Credit Suisse took default risks associated with highly rated invoice backed securities. It took these risks because the risks associated with default were tail risks because they occur in the tail of the probability distribution – very rarely.

2.      Securities were made of diverse pool of invoices and these securities were highly rated ones so defaults had to be numerous to lead to default. But Credit Suisse conveniently forgot its own exposure of around 1 billion USD to the four companies including Brighthouse and NMC Health.

3.      It also ignored the fact that through GC it was funding the companies of Soft Bank’s Vision fund and that Soft Bank Vision Fund was the largest shareholder in GC . Soft bank had invested around 500 million USD into the funds and the same fund through Credit Suisse was used to finance the clients of GC. If any of the Soft Bank Vision Fund’s companies defaulted the effect will be on the invoices backed bond-like securities, which were composed of invoices from hundreds of small suppliers and big suppliers.

4.      Credit Suisse took the tail risks to achieve higher return; more than the benchmark return, which is the return on a benchmark portfolio consisting of similar securities. Compensation systems in banks/financial conglomerates is such that it pays hefty bonuses when employees make profits but does not penalize them when they incur losses.

Concludingly, financial system is central to economic growth and a twin paradox needs to be achieved. The ability of finance to do damage has to be controlled while harnessing its creative energies. Its high time that the financial landscape moves away from underpricing of risk and putting a very distorted price, as a reward, on risk . A one in a 1000 year flood can happen and when it happens as it did in 2008 cataclysm occurs and many financial civilizations are wiped off. We should not go on rewarding reckless risk -taking thinking that it’s a one in 1000 year flood that will never happen. Financial innovation is, of course, needed to broaden access and spread risk and not merely creating complex securities. Last but not the least – no implicit or explicit protection of any private institution from the government because the government eventually uses the taxpayer’s money to bail-out. Are we that obdurate and stubborn that we refuse to learn from our own mistakes?