BNP Paribas and Societe Generale’s equity derivatives operations have just suffered their heaviest losses since the 2008 financial crisis. The message from executives and analysts: don’t expect a major pull-back from these complex products any time soon.
France’s two largest investment banks reported hundreds of millions of euros in losses related to structured equity derivatives positions in the first quarter after a collapse in stock markets and sweeping cancellations of company dividends.
Executives at the two banks have responded by outlining opposing strategies: SG says it is revamping its equities unit, BNPP says it has no such plans.
In reality, though, analysts say both French lenders are likely to remain prominent in an activity that they’ve built their stock-trading units around over the past two decades.
"We do not want to pull out of this product. We think demand will be even higher as more clients seek downside protection from the stock markets,” Philippe Bordenave, chief operating officer at BNPP, told IFR.
In contrast, Severin Cabannes, deputy chief executive officer at SG, told IFR the bank will "accelerate" a "rebalancing" of "the product mix on the equity side towards more vanilla products” it started a year and a half ago. Even so, it looks likely SG will still maintain a significant presence in this area.
"These are structured investment products for investors managing long-term savings. In this low interest-rate environment, there will clearly be demand for these types of investment solutions,” said Cabannes.
NOSE-DIVING PROFITS
BNPP and SG have long derived a substantial chunk of their equities trading profits from packaging and selling structured products that provide payouts to retail investors based on the performance of stock markets.
Structured equity derivatives on average accounted for 39% of equities revenues at the duo last year, according to Amrit Shahani, research director at analytics firm Coalition, compared with an average of 14% across the top 10 global investment banks.
The structured products business is highly profitable for banks when markets are benign, producing a return on equity of around 15%, analysts say. That's far higher than the returns that can be made trading simpler "flow" equity products. But these more complex structured products are also prone to blow-ups when markets nose-dive.
Equities revenues at BNPP and SG plunged 118% and 99% in the first quarter respectively when taking into account losses from companies cancelling dividends, which cost each bank in the region of €200m. Both banks also suffered losses linked to hedging the complex risks coming from structured products books.
That contrasts starkly with the results of the big five US banks, which have a lighter presence in structured products and are more prominent in trading of flow products. They reported average revenue gains in equities trading of 30%, with many singling out equity derivatives as an important driver.
"Societe Generale is historically a leader in structured products and we are smaller than our peers in flow. This is our historical business mix," said Cabannes.
"There was a huge stress of market parameters we have not seen since 2008. It’s a worst case scenario that impacted our structured products portfolio."
LOPSIDED
SG reported a 42% slump in markets revenues in the first quarter, an indication of just how lopsided its business is towards equities – and structured products in particular. Equities brought in 56% of the €4.5bn of SG’s markets revenues last year, while analysts estimate structured equity derivatives usually account for about 20% to 30% of its overall trading revenues.
David Escoffier, a former head of equities and derivatives at SG, said he resigned from his position as deputy head of global markets at the bank in 2016 after pushing to reduce costs aggressively across the global markets unit in order to maintain a sustainable business model for equities, diversified across cash, prime services, listed derivatives, flow and structured products.
In the end, SG didn't embark on a major cost-cutting drive across its investment bank until last year following a string of disappointing results.
“At the time [in 2016] global markets at SG was still very profitable and we could have done it and [kept] most of our talented teams. It was a missed opportunity – the difficulty, of course, is that such calls are much easier to make in hindsight,” said Escoffier.
He also highlighted the departure of several seasoned executives from the division during recent years of relatively benign markets.
“Those had successfully navigated multiple large crises in the past decades – learning invaluable lessons along the way. Such experienced hands on deck may prove in too short a supply currently – even more so with further market dislocations expected," said Escoffier.
A spokeswoman for SG said the bank maintained a highly experienced group of senior executives within its markets division.
COMMITTED
BNPP is arguably in a stronger position to weather the derivatives losses given the composition of its trading unit. Equities accounted for 36% of its €5.6bn in markets revenues last year, with the remainder coming from its far larger fixed-income unit.
Steep gains in fixed-income trading in the first quarter helped cushion the blow from the equities losses and the decline in its overall markets revenues was more modest at 14%.
Bordenave said the bank wants to expand other parts of its equities business that are lower risk such as prime broking, where it lends to hedge funds, after buying Deutsche Bank’s prime broking operation last year. Still, he said the bank remains committed to structured products.
“It is a profitable product in the long run even if we accept that we will have a down quarter every now and again,” said Bordenave.
SHIELDED
SG could also point to some bright spots in non-structured activities in the first quarter. It reported strong performance in flow fixed income, as well as in prime services, listed products, flow derivatives and cash equities within its stock-trading division.
Still, few expect SG to invest heavily to ramp up lower-margin flow activities at a time when it has been looking to bring down costs overall through restructuring its investment bank. Tellingly, senior management have largely shielded the structured products business so far, instead landing the majority of cuts on the fixed-income unit.
Cabannes suggested the bank would rethink its approach to structured products rather than retreat altogether. “We will develop other types of products with less complexity to manage in dislocated markets,” he said.
That tallies with a broader expectation among analysts that SG is likely to resist scything back this trademark activity in a major way.
A restructuring of SG’s equities business "would be unwelcome given that the core structured products franchise was protected from previous efforts largely focused on the [fixed income] business," said Omar Fall, a banking analyst at Barclays in a recent note.