Greensill implosion exposes shadow banking risks

Relief tempered by residual nervousness will be the likely reaction of central bankers and financial regulators to the sudden implosion of Greensill Capital, a major shadow bank.

The fate of this global supply chain finance player does not appear to pose a systemic threat or need for a central bank bailout. Yet its rapid shift from pride to arch enemy raises worrying questions about the evolution of the global financial system and the ability of regulators to keep abreast.

Greensill bore many classic signs of impending financial crash, starting with a flamboyant founding entrepreneur, Lex Greensill. The company’s website trumpets his trajectory “from humble beginnings to revolutionary thought,” explaining that he saw the devastating impact that inefficient financial supply chains can have on a business as he grew up on the sugarcane and melon farm of his parents in Australia.

Revolutions in finance have a bad way of ending badly, especially when they happen at breakneck speed. Greensill Capital started from scratch in 2011, when Lex Greensill abandoned a career at a major bank, doing global supply chain finance at Morgan Stanley and Citibank, to go it alone.

By 2019, this non-bank reached said it had provided $ 143 billion in financing to more than 10 million customers and suppliers in 175 countries. Its founder also made powerful contacts in government and hired former British Prime Minister David Cameron as an adviser.

In the banking sector, this rate of expansion tends to indicate excessive risk-taking and a poor loan portfolio. And the Australian parent certainly felt pressure on his balance sheet. In 2016 and 2017, his liabilities exceeded his assets, according to a report by the Scope rating agency. Yet Lex Greensill pulled off an astonishing blow by persuading the leading private equity group General Atlantic to put inside $ 250 million in new capital, then Japanese entrepreneur Masayoshi Son’s SoftBank Vision Fund to accumulate another $ 1.5 billion.

It is therefore not surprising that the latest accounts filed by the British subsidiary at the end of 2019 show a very solvent balance sheet with a large capital cushion of $ 155 million backed by total assets of $ 682 million. Yet in supply chain finance, the face of the balance sheet says little about the nature of the risks involved.

Supply chain finance is just a modern and sophisticated name for the age-old factoring practice, whereby suppliers sell debts their customers owe them at a discount to a financier who recovers the full amount. on time. Lex Greensill’s breakthrough innovation was realizing that these debts could be pooled into investment funds, much like the big investment banks turned subprime mortgages into securities before the 2008 financial crisis. .

The investors, who were mainly clients of Credit Suisse Asset Management and the fund manager GAM, asked Greensill to take out credit insurance to cover the debts. But – unlike subprime mortgage lenders – Greensill continued to have his skin in the game as he was exposed to early losses under an uninsured portion of the fund.

This insurance was an important guarantee for investors, in particular because the portfolio was highly concentrated. For example, the Scope rating agency estimated in 2019 that two-thirds of the German subsidiary’s loans came from a single group of related private companies. These were almost certainly part of the empire of the metal tycoon Sanjeev Gupta. And things like that concentrated exposure was one of the many concerns of German watchdog BaFin, who this month ordered the German operation will be closed for business.

The big risk that Greensill’s balance sheet couldn’t reveal was that insurers would stop providing coverage. This is precisely what happened. Greensill Capital’s main insurer, Tokio Marine, has draw a line and Greensill’s lawsuit in Australia to force him to reinstate coverage failed.

Both Credit Suisse and GAM have decided to freeze their funds.

This revealed a flaw in Greensill’s business model just as devastating, say, as Northern Rock or GE Capital’s over-reliance in the financial crisis on short-term wholesale funding while funding longer-term illiquid assets. . Without insurance, a low-risk loan portfolio would potentially be
replaced by a high-risk, over-concentrated portfolio, beset by all the
dangers of the worst recession in living memory – clearly a
non-starter for investors.

A striking feature of this saga is that Greensill Capital, like the failed payment group Wirecard, owned a regulated German bank when much of its operations fell outside of traditional banking regulation. The ability of shadow banking to provoke more dangerous systemic shocks should not be underestimated.

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