In November 2012, Kweku Adoboli was imprisoned for seven years for a fraud that cost UBS over $2 billion. Rival Swiss bank Credit Suisse is now in the process of placing a bond that will protect it from operational risks like this for the first time. It has been reported that Credit Suisse may struggle to reach the full $649m target for Operational Re by the deadline on May 12, but if the bank manages to place a significant proportion of the bond, it could open up new investment opportunities for investors in Insurance Linked Securities.
Credit Suisse has had a difficult year - the share price has lost close to 50% of its value and the company has earmarked 6,000 job cuts since Tidjane Thiam took over as CEO last July. Mr Thiam, previously the head of British insurer Prudential, is hoping to use Insurance Linked Securities to mitigate some of the operational risk faced by the Swiss banking group.
Credit Suisse has been developing this new type of securitisation with its insurer, Zurich. It will cover losses from events including rogue trading, cybercrime, internal fraud and employee theft for over two years. These types of risk are not typically covered by traditional insurance. Zurich is acting as a fronting carrier and taking on 10% of the overall risk, packaging and ceding the remaining 90% to the capital markets in two separate tranches of notes. At least two separate losses causing over a total of over CHF 3.5 billion are needed to impair the bonds.
Capital burden grows
In the aftermath of the financial crisis, regulators have required banks to hold substantially more capital against their operational risk. The Basel Committee on Banking Supervision recently proposed a single standardised method for calculating operational risk, which it warned could cause minimum capital requirements to increase for some banks.
This operational risk includes the potential for losses from failed internal processes, people and systems, including legal risks, and from external events. It accounts for around 15% of a typical bank's regulatory capital. If successful, the Operational Re issuance could set a precedent for other financial institutions and major corporates to offload some of their risk to the capital markets, thereby relieving them of some of this capital burden.
The regulators' concerns are well grounded. Large losses from rogue traders are relatively common and the potential for large cyber losses is well established. According to the CCP, total 'conduct costs' for the largest banks from 2010 to 2014 were GBP 206 billion ($298 billion) - though this includes regulatory fines which are often prohibited from being included in insurance policies.
Inevitably there are a number of issues to overcome with such a transaction. These include lack of transparency as well as a lack of data and modelling around operational risks, particularly cyber. And while ILS investors are attracted by the non-correlating nature of catastrophe insurance risk, the fortunes of an operational risk bond are likely to be viewed as being more closely tied to the ups and downs of the broader financial markets.
Posted: Monday, May 16th, 2016