Archegos shows reputational risk in picking partners

What on earth were the banks thinking? That was the collective refrain of Wall Street observers in the final week of March, when it became clear that several global banks had extended billions of dollars of leverage to Archegos Capital Management. Archegos defaulted on its margin loans when some of its highly concentrated bets went wrong, leaving both Credit Suisse and Nomura with billions of dollars in losses.

Bill Hwang, who operates Archegos, paid $44m in 2012 to settle insider trading charges brought by the US Securities and Exchange Commission. Should that penalty not have been a red flag? The $10bn fund did a lot of trading in swaps, a profitable business for banks’ trading desks. Credit Suisse and Nomura, along with other banks, appear to have concluded that this outweighed the risk posed by Hwang’s character.

The Archegos affair comes not long after private equity fund Apollo lost Leon Black, its chief executive, chair and founder, over his business dealings with the late paedophile Jeffrey Epstein. Black cited the “relentless public attention and media scrutiny” in explaining his decision to leave.

Agility is useless when you don’t know where you are going

Every company, and every executive, has always had to worry about the character of the people they do business with. But in the age of social media and of activism — both of the social and investor varieties — the speed at which a reputational crisis can emerge and spin out of control has increased.

It is often said that the digital age requires corporations to be “agile”, or quick to adapt to change. In the case of the reputational risk posed by counterparties, the opposite is true. Agility is useless when you don’t know where you are going. Financial institutions need to establish a sense of purpose and a set of values that do not change, precisely so that they have a clear sense of which partners to pick, and what to do when things go wrong.

Talk of purpose and values is easily mocked. It sounds touchy-feely. But the cases of Credit Suisse and Black show how fast intangibles become tangible.

The good news for most companies that suffer reputational harm from doing business with what turns out to be a shady partner is that such damage is repairable. Rupert Younger, director of the Oxford university Centre for Corporate Reputation, makes a distinction between reputation for competence and reputation for character. The former is slow to form and hard to lose; the latter is more volatile and changeable.

Younger uses an example from outside finance. After Toyota recalled vehicles in 2009-10 because of problems with their accelerator pedals — a competence issue — sales fell and took several years to return to pre-recall levels. Compare the Volkswagen emissions scandal of 2015, a question of character. The carmaker cleared “bad apples” out of its ranks and sales hit a record sales total the following year.

This does not mean that, after a relationship goes bad, a few firings will always resolve the matter. For financial institutions, in an important sense, character is competence. Assessing and managing counterparty risk is the job. And with each failure of character, the problem looks less idiosyncratic — a matter of bad apples — and more cultural or systematic.

Old, informal systems of due diligence are no longer sufficient to assess the worthiness of potential partners

Back to purpose and values, then. Corporate boards must be able to articulate why the company exists, above and beyond rewarding shareholders, and how they are going to accomplish the mission, above and beyond its business strategy. Who is it trying to help? And in what way will it (and will it not) go about helping them?

If the mission is simply making money, and its values extend only so far as staying within the applicable laws and regulations, of course it is going to make grave mistakes in who it does business with, and of course it will of necessity have a muddled response when things go badly. Such a company, like Shakespeare’s King Lear, “but slenderly knows itself” — and will end up raving on the heath of public opinion.

The Enacting Purpose Initiative — a corporate governance think-tank made up of a consortium of business schools and other organisations — puts it like this: “A statement of purpose should be precise, not vague or woolly. It should establish what and whose problems the organisation seeks to solve and . . . why the organisation is particularly well-suited to addressing them.”

Modern finance is global. Old, informal systems of due diligence — school networks, mutual relationships — are no longer sufficient to assess the worthiness of potential partners. At the same time, the various constituencies that companies must satisfy, from employees to activists to customers, are more demanding than ever, and often disagree.

Some business relationships will go badly wrong; some conflicts will prove impossible to reconcile. The only way boards and executives can minimise the risk of this, and manage the fallout, is by being clear why they are in business, what they care about — and who they will deal with.

That will inevitably mean passing up potentially profitable relationships. But finance has always been about making hard choices.

Robert Armstrong is US finance editor