Credit risk and choosing counterparties

 Visit LinkedIn ProfileGary Dale, 30 January 2015

Credit risk and choosing counterparties

Much has been made of this topic following the collapse of Lehman Brothers in 2008, probably the key moment of the financial crisis, and rightly so; we witnessed a fundamental change in the way that advisers and investors thought about making investments.

No longer was the key consideration linked to market direction but a new risk metric, admittedly always a consideration, had come to the fore; counterparty risk. This very permanent dynamic has remained with us since, with additional regulatory guidance looking to ensure that investors are fully aware of the 'additional' risks they are taking when investing in any financial products which, let's not forget, all include credit risk of one shape or another. The issue of course for investors and advisers alike was and still is how to value credit risk and establish what additional premium, if any, they would need as compensation.

The industry, including ourselves, responded by offering collateralised investments with credit exposure to more than one financial counterparty and in some cases the UK Government. Collateralisation of course merely reduces and does not eliminate credit risk but the very act of diversification is the bedrock of any well managed investment portfolio and should not be limited to Structured Investments. Collateralising a Structured Investment offered by a bank may seem counter-intuitive to many given that one of the key components of value within that products shape will include the very risk that the counterparty may default, a necessary evil some might say in creating the products value so why 'over insure' that risk which can only serve to reduce the potential pay-out on offer? This would of course imply that all investors are rational and invest without emotion however given what I have noted above, we already know this not to be the case.

Providing a sensible choice of risk weighted Structured Investments has always been at the core of what Investec Structured Products make available to clients hence our decision to now offer a Gilt backed option on our FTSE 100 Enhanced Kick-Out Plan, one of our most popular investments. The Plan already offered the choice of being linked either only to Investec Bank plc or linked to a portfolio of five Financial institutions.

The new additional option is fully collateralised with UK Gilts offering perhaps more cautious clients a slightly more secure proposition in return of course for a slightly reduced pay-off profile. As the Credit Default Swap (CDS) premium continues to 'normalise' post the financial crisis, for many clients the extra premium offered for taking the credit risk linked to certain financial institutions may not be sufficient compensation therefore a Gilt backed option may offer a suitable alternative.

The financial crisis has changed the way that many advisers and their clients make investment decisions with credit risk becoming more prevalent. Much more time is spent on assessing counterparty risk, and in carrying out due diligence on issuers of Structured Investments so as to feel confident that they are recommending the most appropriate structured products for their clients in addition to satisfying the regulator on their responsibilities around the advice and client suitability requirements. There are no excuses for taking shortcuts and making decisions without an informed assessment. Advisers should consider the full range of tools available to them when assessing counterparty risk, and push product providers to share their counterparty analysis to help them make decisions.

Gary Dale is head of intermediary sales at Investec Structured Products. Connect with him here.

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