As of late September, who on Earth knew about Liability-Driven Investment (LDI) and the threat it posed to the viability and liquidity of pension funds? Clearly not the Bank of England and regulatory authorities, who had to make £65bn of emergency funding available to ward off a debt market meltdown and the wider financial contagion such an event would trigger.
As Gordon Brown has warned, the UK’s shadow banking system poses an ongoing and material risk to our financial stability, with speculation and poor practice stoked by the rock-bottom interest rates of the past 14 years. But as interest rates rise at an eye-popping pace it is likely that the next financial crisis is being incubated in the UK’s multibillion-pound corporate debt market.
There are many with a vested and – given the consequences of systemic failure – an understandable interest in keeping the ship afloat. But lax banking regulation, of the type that threatens pension funds and collapsed stock exchanges and fractured economies in 2008, is beginning to cast a long shadow across the Square Mile.
Up until a few months ago, money was cheap. Low interest rates and quantitative easing left the City of London awash with cash looking for a home. Instead of lenders being in the driving seat, borrowers held the whip hand, allowing them to strike the most favourable deals and rates.
Now there is increasing concern in some professional quarters that in the age of cheap money the pendulum swung too far, with the City at the forefront of the phenomenon commonly referred to as “sponsor-designated legal advice”.
In its simplest form, sophisticated corporate borrowers demand that, at the price of securing their business, lenders use their hand-picked legal advice. This means that a contract, which can run into billions of pounds, is drafted by a legal team in the pay of only one side of the transaction. Bluntly, low financial returns, like high returns, can persuade normally sane and clever people to do really stupid things.
[See also: How the Treasury quietly runs Britain]
Clearly, there is little or no incentive for the lawyers to protect the interests of the lender because they are in the pay of the borrower, and want to secure their client’s business when the next deal comes around. The more advantageous the contractual terms for the client paying the bill, the better the chance of being retained.
As interest rates rapidly march upwards and global pressures, such as soaring energy costs, once again fracture markets, as they did in 2008, there is a very real danger that loosely regulated and drafted debt agreements will begin to unravel. And let’s be clear: when the cost of borrowing rises from its March 2020 low of 0.1 per cent to its widely forecasted ceiling of 6 per cent, that is a 5,900 per cent increase.
With many companies’ balance sheets loaded with debt, there will inevitably be corporate failures as interest rates rise and the cost of servicing their debt goes up. It is at this point that the weaker loan documentation of poorly advised lenders will put them at greater risk of suffering unrecoverable losses. As with the subprime mortgage-backed securities contagion of 2008, when the market unravels there is a danger of systemic failure.
Will poorly drafted and weak loan documentation be the only factor in another banking crisis and taxpayer bailout? Probably not. But will it be a contributing factor when combined with a raft of corporate failures and other pressures on a stressed financial system? Almost certainly, yes.
When recently questioned about the risks attached to this glaring best advice conflict of interest, hiding in plain sight, the Treasury said that it was “not aware of any concerns that sponsor designation of legal advice poses a risk to UK debt markets, and as such has not raised this matter with the Financial Conduct Authority or the Solicitors Regulation Authority”.
The Treasury’s insouciant response has echoes of the subprime disaster that precipitated the most recent and far-reaching crisis in capitalism. The argument then, as now, is that “everyone is doing this, so what’s the problem”. It might be the case that on this occasion there will be a happy ending to the story with the greed, avarice and stupidity attached to the decade-long glut of cheap money not leading to another bout of toxic financial indigestion.
But just before we hope for the best it is worth noting that the Treasury, when issuing debt through the UK Debt Management Office, makes no provision for its legal advice to be funded by the counterparts buying that debt. In its own words, “each party selects and pays for its own legal advisers as it deems appropriate”.
It seems that what is good for the corporate goose is most certainly not good for the Treasury gander. So, instead of 11 Downing Street waving away the concerns attached to sponsor-designated legal advice, it should instead, as a matter of urgency, be auditing debt contracts to ascertain the risk they pose to an already stressed financial marketplace and the wider economy.
Recent events in the pension fund industry provide a salutary warning to regulators: everyone was doing LDI and no one saw the risks because everyone was doing it.