Question: With Structured Products, how is the credit quality of the issuer measured and managed?
Are the Products considered too be the issuing financial institutions’ liabilities?
Gary Dale - Investec
Credit quality has undoubtedly been the main issue to come out of the Lehmans default over the last year. It has been obvious that credit ratings alone are not a sufficient measure of quality given the high profile defaults of highly rated institutions we have witnessed over the years. Providers are expected to include measures such as CDS levels when assessing appropriate counterparties in addition to any ratings information combined with the usual due diligence.
The FSA would also now expect that counterparty risk should be fully explained to the investor and also covered in detail in the suitability report. The adviser should also have conducted more robust due diligence on the counterparty(ies) covering a number of factors and more broadly than simply referring to a credit rating. Many institutions' ratings have benefited from uplifts where the institution is seen as systemic to the UK banking system, however the FSA's inference going forward is that no institution will be "too big to fail".
A more pragmatic approach is now needed and full consideration should be given to relative financial strength, the bank's appetite for risk, credit default spreads (where available), credit outlook and financial reporting. Reference has also been made to counterparties' "fundamentals" as shown on their balance sheet, i.e. capital, liquidity and leverage ratios. A bank's share price may also be used to assess credit quality. That said, no IFA is expected to become a banking analyst and so, as ever common sense is one of the best tools available.
Whenever the issuing institution enters into a contract that requires them to meet some known or potential liability at some future date, that liability must be accounted for. Therefore, the obligations the issuer has under the terms of the plan are indeed future liabilities and are managed by the institution as part of their investment banking activities.
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