Last October, Barclays boss CS Venkatakrishnan found himself in the crosshairs of financial analysts eager to grasp the bank’s exposure to the opaque world of shadow banking.
Just weeks earlier, the British bank had suffered a £110m loss on loans made to a little-known American car lender Tricolor, which had collapsed amid fraud allegations.
Now, with the analysts scrambling to understand Barclays’ exposure to other ventures, the 60-year-old banker was forced on the back foot to defend the bank’s private credit push.
“Credit is credit,” he shot back, after being grilled on the bank’s risk controls. “We’ve got strong risk management practices. We’re comfortable and confident with that.”
Yet now those words are under greater scrutiny after Barclays once again found itself on the losing end of another private credit foray.
Last week, Market Financial Solutions (MFS), a British-based shadow bank specialising in property finance, went under amid allegations of fraud.
Again, Barclays found itself on the hook for the collapse, with a reported exposure of between £500m and £600m. The Bank of England has been grilling Barclays and other lenders to MFS about the due diligence and risk assessments conducted before lending to the failed shadow bank.
The two blow-ups, as well as the banks’ intrinsic ties to private credit investors, have raised questions about Barclays’ foray into the risky, unregulated world of shadow banking – and whether it is giving it an unwanted headache.
In total, the British bank has a reported exposure of roughly £20bn to the private credit sector.
Venkatakrishnan, whose pay topped £15m last year, recently said that this was “relatively small” in contrast to the £346bn of loans currently issued to consumers and business customers across the bank.
The bank’s decision to move into shadow banking to juice returns is not surprising. Shadow banking, a loose term to describe private credit and non-bank lending, has mushroomed into a $2tn (£1.5tn) industry in recent years.
Since the last financial crisis, private equity firms have morphed into the world’s largest shadow banks, including Ares Management, Blackstone, Apollo Global Management and The Carlyle Group.
These companies step in to lend to companies when banks are unable to. Since the financial crisis, punishing capital rules mean banks like Barclays must set aside some of their money in a “buffer” for loans they make in case things go wrong.
Shadow banks are free from these constraints and can therefore make riskier – and ultimately more profitable – loans.
Yet for many traditional banks, including Barclays, the lure of doing business with this lucrative world has become too hard to resist.
Many of the links between mainstream banks and private credit providers have become fiendishly complex, an alphabet soup of products including credit default swaps (CDS) and Net Asset Value (NAV) loans.
And Barclays has also become a major player in one of the more niche corners of this opaque world: synthetic risk transfers (SRTs).
These are esoteric transactions banks use to offload risk from their books, and Barclays is among the biggest players in Europe.
2802 Barclays is the biggest British SRT beneficiary
Since the financial crisis, banks have been hemmed in by rules requiring them to hold more capital to offset the risk of the loans they issue. SRTs were designed as something of a way around these rules.
In a typical SRT, a bank takes the riskiest slice of a pool of mortgages or company loans and offloads it to a shadow bank, which assumes the risk that the loans might default and is paid a hefty fee by the bank for doing so.
In exchange, the bank is allowed to hold less capital against the loans, since, in theory, the default risk has fallen.
Intended to free up cash for banks, Barclays has sold vast swathes of its loan book to the shadow banks over the past 10 years since it founded Project Colonnade, the bank’s programme for managing its growing appetite for SRTs.
Barclays has a total exposure to SRTs of an astonishing £50bn and has used these transactions to offload risk on about 45pc of its corporate loan book, according to Autonomous Research.
2802 Nearly half of Barclays' corporate loans are protected by SRT
However, there is growing unease amongst regulators, with fears that these exotic trades resemble the sort of financial alchemy that precipitated the financial crisis.
Watchdogs have weighed in on the practice, from Britain’s Prudential Regulation Authority (PRA) to the International Monetary Fund.
In the UK, each transaction must be approved by the PRA individually to qualify for lower capital treatment. Earlier this year, the European Central Bank even introduced a “fast-track” approval process for standardised SRTs.
“Like many other banks, we use risk transfers to help manage credit risk responsibly and make efficient use of capital, while complying with all regulatory requirements,” a Barclays spokesman said. “We disclose details on this activity transparently each quarter, along with our published results.”
However, watchdogs are worried about how exactly these alternative investors are raising the money to buy the slices of risky loans in the first place.
In some cases, private credit funds borrow from other banks to finance purchases. Some regulators fear that, by doing this, banks can hold less capital, while the risks associated with these loans never leave the banking system.
Instead, it boomerangs between banks, while shadowy private credit providers sit in the middle of the transaction, obscuring who exactly owes what.
“The risk hasn’t disappeared from the system; it has just moved from highly regulated, transparent banks to lightly regulated, opaque private credit funds,” said Prof Raghavendra Rau, from Cambridge Judge Business School.
“How much exposure the regulated banks have to lightly regulated non-bank financial institutions is opaque. And worse, because private credit lacks public market discipline, the losses can be magnified, meaning unexpected shocks could cascade through the financial system rapidly before regulators even see them coming.”
Steven Hall, from KPMG, said: “It’s worth noting that we’re talking about risk transfer here rather than risk removal. So when we say we’ve transferred the risk from the bank’s balance sheet, it hasn’t just disappeared, it’s gone somewhere,”
Amid scrutiny, some banks have shied away from providing funding to shadow banks for this purpose – known as financing SRTs.
Deutsche Bank stepped away from the market at the start of last year. Barclays, which was never a significant player in the space, allowed its operations to wind down completely.
While financing SRTs has been the focus of regulatory intrigue, that doesn’t mean the banks on the other side of these transactions, like Barclays, that offloaded the risk in the first place, are completely out of the woods.
“The key risk here is that if markets crash when an SRT matures, banks won’t be able to renew their protection,” said Rau. “This loan may be protected (it depends on the insurer) – but they will not be able to renew.
“That means that their capital requirements will suddenly spike, forcing them to freeze lending when the economy needs it most.”
Last month, as Barclays again braved questions from curious analysts, SRTs and shadow banks were again top of mind for financiers keen to understand the British bank.
“We do really think about SRTs as a risk management tool,” said Daniel Fairclough, Barclays’ group treasurer. “It’s about the areas where we’re growing, where we think the risk is higher, and we want to manage that.”
With customers, City analysts and regulators prying into Barclays’ links to the shadow banks, Venkatakrishnan will be hoping there are no more blow-ups to come.
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