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Mythbusting: Structured Products and Counterparty Risk

Ian Lowes, founder of CompareStructuredProducts.com - 09/12/2015

Whilst the likelihood of a major bank failing is remote, it is a risk as seen in the collapse of Lehman Brother in 2008. However, the claim that a bank going bust will leave structured product investors with no return of capital is a little extreme.

It is true that when you invest in a structured product, you are in effect lending your capital to the issuing bank and therefore should the bank default on its obligations, you could in theory, potentially suffer a total loss but this is by no means a foregone conclusion.

Structured products essentially function as a contract between the investor and the counterparty bank, facilitated by a product provider. In exchange for effectively lending the bank their capital for a pre-defined period, and in the event of the pre-defined circumstances set out in the terms of the product being met, the bank will reward the investor with a pre-defined return and their capital back in full. With the exception of structured deposits, this “loan” takes the form of senior unsecured debt and if the bank defaults, the structured product investors therefore rank quite highly amongst other creditors.

When any institution collapses it is not unreasonable for creditors to take a view that they are facing a total loss to the extent that anything they ultimately receive is a bonus. With Lehman Brothers, many investors had a claim via the Financial Services Compensation Scheme (FSCS) because, for example, the product literature did not properly explain the risk and so a liability fell against the regulated promoter which, in turn was unable to meet all liabilities to the extent that the FSCS had to step in. Other investors were left to the mercy of the liquidator who will have sought to sell of the bank’s assets to repay its debts. To date those with Lehman backed plans that fell into this category have received back more than 42% of their capital with more to come.

This still leaves a 58% loss which is far from welcome but certainly better than the total loss that was anticipated at outset. Therefore no one should have suffered a total loss and in any event less than 1% of all the structured products in the UK market at that time were backed by Lehman Brothers. The other 99% that represented the wider market was unaffected. This is not to belittle counterparty risk; another bank could indeed fail, but the context of the risk needs to be appreciated.

So what should one do about counterparty risk? The fact of the matter is no-one can reliably predict if a bank is going to go bust. While there can often be a number of potential indicators that a bank failure could be on the cards, indeed Lowes steered clients away from Lehman Brother throughout 2008, no one could truly predict the bank would collapse. Despite this, in the post-financial crisis world there are a number of measures in place, such as strict capital adequacy requirements now placed on banks, to protect against such an occurrence happening again. Obviously measures such as these cannot be foolproof assurances that a bank won’t default, but they are designed to protect the market.

Steps can also be taken by the investor to mitigate their exposure to counterparty risk. Anyone will tell you that a good investment portfolio should be effectively diversified to reduce risk, and the same goes for counterparty risk. By splitting capital up and placing it into a number of products that are backed by different counterparties, rather than just one, investors can significantly reduce the impact should one counterparty go bust. There are a variety of banks that now back structured products in the UK retail market, and so investors should not have any shortage of choice when building their portfolio.

Another point to consider when assessing counterparty risk is the protection provided by structured deposits. As the name suggests, these products are deposits with a bank meaning they are subject to FSCS deposit guarantee cover, which will pay compensation of up to £85,000 (£75,000 from January 1st 2016) per person, per institution, should the deposit-taker default. As deposits are considered to be lower risk, they typically offer a lower return than other structured investments. However, for those extremely cautious about any potential headwind, this essentially removes the risk of loss in the event of a counterparty collapse.

Ultimately, all investments carry some form of risk and counterparty risk should be considered when investing in structured products. It is a legitimate possibility that a bank could go bust and investors should consider that when selecting which products to invest in. It should of course be acknowledged that where a bank or banks collapse few investments would be immune and go unscathed.

It is however arguable that, amongst the different risks attached to structured products, a bank default whilst potentially catastrophic, is the least likely to occur and the risk of a significant fall in underlying index or measurement to the extent that the protection barrier is breached always needs to be given due consideration.