Is Market Volatility the New Normal?

A recent example of market volatility - Silicon Valley Bank

One of the most prominent recent examples of market turbulence was the failure of Silicon Valley Bank (SVB) in March 2023, which had widespread implications for market participants in both the U.S. and Europe. SVB’s business model was heavily geared towards the venture capital and start-up industry. In an era of cheap money and rising valuations, many SVB clients chose to hold their cash with the bank. SVB deposits therefore grew from around $60 billion at the end of 2019 to around $190 billion at the end of 2021.¹

SVB’s lending opportunities were accordingly reduced as its customers already had sufficient access to capital. It therefore decided to invest surplus cash in long dated U.S. Treasuries. While these investments did not pose any credit risk, it created a mismatch between its assets and liabilities (i.e. between the longer term U.S. Treasuries and short term bank deposits). When interest rates started to rise, the price of the U.S. Treasuries fell sharply along with the value of SVB’s holding of these instruments. At the same time, SVB’s clients began to withdraw their funds as higher interest rates had also affected their businesses. This dynamic was exacerbated by social media posts drawing attention to SVB’s portfolio losses, which in turn led to more clients withdrawing their funds. SVB sought to raise further capital by selling off its Treasury holdings, but these had to be offloaded at a significant loss. This cycle was repeated until SVB was closed 10 March 2023, when the Federal Deposit Insurance Corporation (FDIC) was appointed as receiver in order to protect depositors. 

How did regulators react to the failure of SVB?

SVB was a mid-size U.S. regional bank, and as such was subject to fewer capital and liquidity requirements than would have been the case in the UK and Europe. European regulators have stated that a similar situation would not have happened in Europe due to higher levels of regulation, although other SVB branches such as SVB UK were also affected by the contagion.

Whatever the differences in approach, regulators on both sides of the Atlantic acted decisively to resolve the situation and calm the market. The U.S. is currently not expected to make any major changes to its regulatory structure to account for any potential shortcomings that were exposed by the failure of SVB. However the Federal Reserve is known to be actively involved and monitoring the performance of smaller U.S. banks.

For further information please see the following Engage alerts:

• Silicon Valley Bank (SVB) and Signature Bank Collapses: Your legal and regulatory FAQs answered
• Silicon Valley Bank UK Limited FAQs
• Beware the Ides of March – practical considerations if your bank is failing

What is the current state of the market?

Turning to the current state of the market, institutions and clients have reacted to the more volatile environment in the following ways:

• Clients are turning from the mid-size regional banks to larger players, reflecting a flight to safety. Banks and non-bank financial institutions are also increasingly recognising the importance of tools such as treasury functions, hedging strategies, asset and liability management and diversification during an asset or liability overhang.
• Refinancing costs have risen as central banks have withdrawn monetary support. Rising interest rates are causing pressure on the margins of corporates and banks, which has not been fully passed onto clients yet. As a result, banks are still active but have become more cautious due to the possibility of further interest rate rises which could adversely affect the performance of the underlying portfolios held on their balance sheets. 
• In the current market environment, participants are focusing on their areas of expertise. Rather than spreading themselves thinly institutions have pivoted to shorter dated and unsecured asset classes such as bridge development finance, automated lending and buy now pay later (BNPL).  Corporates are also looking to free working capital through trade receivable securitisations.
• ESG-linked opportunities in the securitisation space are becoming more common. This is reflective of the massive investments that will be required across developed economies for the green transition - Hogan Lovells recently advising on the first German domestic solar panel warehouse securitisation is a good example of this.² There is also a pipeline of similar transactions in different asset classes.
• Public ABS volumes are lower. European public market ABS issuance in Q1 2023 was down 43.9% on the same period for 2022.³ The U.S. ABS market was also down by around a third.⁴  These trends can be attributed to changes in interest rates combined with concerns about recessionary tendencies and geopolitical factors, such as the recovery from the Covid-19 pandemic and Russia’s invasion of Ukraine.
• However there is still plenty of opportunity and activity in the private space. These transactions bring greater certainty of execution for the borrower due to the direct engagement of the deal participants, and avoid some of the uncertainty that comes with public market transactions. The introduction of mezzanine tranches to the structure of some private deals in that context has been a recent trend that is expected to continue in the foreseeable future. 
• For assets originated during periods of very low interest rates, pulling across linked hedging arrangements will be key. This will be accomplished either through the transfer of the existing hedging arrangements or through a termination of those hedging arrangements to crystallize the current market value and then using that to compensate the buyer, or to put in place a new hedging arrangement.
• The market is seeing increased refinancing needs now that central banks are starting to taper. This could lead to many issuers rushing to the market at the same time, favouring the buyside. This also highlights the need for issuers to think early and strategically about techniques such as significant risk transfer. In these market conditions planning ahead is key – one example of this could be ensuring that your preliminary prospectus is updated and ready to share with investors when a window of opportunity arises. 
• Diversification has been increasingly seen over the past few years as institutions are looking at alternative exit solutions for portfolios. Rather than an ABS take out or ABS refinancing, this might take the form of a portfolio sale to a long term hold investor. Market participants will consider these opportunities, either as a long term solution or as an interim solution, while markets calm and solidify.

ESG – what is the current state of play?

Turning to broader market developments and ESG in particular, the webinar participants noted that institutions had in engaged with ESG in previous years in a more limited way, for example through the issuance of green bonds and RMBS/CMBS products with a green focus.

However it is now clear that the market has moved beyond that towards a deeper level of integration with the ESG agenda. For many institutions having some sort of sustainability strategy is now seen as essential. This, coupled with an increased emphasis on mandatory reporting, has meant that various banks, insurance companies and financial institutions are now including metrics such as the gender pay gap as a standard part of their ongoing disclosures.

A shift in emphasis from climate to nature?

To date, much of the focus around the “environmental” aspects of ESG has been focused on climate, and specifically the importance of mitigating emissions. We are now seeing the expansion of the “environmental” category to focus on the importance of nature as well as climate. Drivers for this expansion include initiatives such as the UN Conference on the Protection of Biodiversity (COP15), which in December 2022 agreed a new set of goals to guide global action through to 2030 to halt and reverse nature loss.⁵

Another key driver is the Taskforce on Nature-related Financial Disclosures (TNFD).⁶ This follows on from, and is structured somewhat like, the Task Force on Climate-Related Financial Disclosures (TCFD), its precursor on climate-related activities disclosure. In contrast to the TCFD, the goal of the TNFD is to promote a risk management and disclosure framework for organisations to report on evolving nature-related risks, specifically focusing on how organisations and people depend on and impact natural capital, rather than focusing solely on climate and emissions. Initiatives like this will help businesses to assess risk around natural resource and biodiversity decline. The TNFD focuses on four “realms”: Land, Ocean, Freshwater and Atmosphere, building on the disclosure framework that has already been put forward by the TCFD.

The final TNFD recommendations are due to be published in September 2023. The recommendations will be initially be voluntary, although increased market adoption could mean that these disclosures over time become mandatory for some in scope companies. This will encourage institutions to begin to focus on how they are affected by nature-related risk, leading to increased financing opportunities as institutions seek to mitigate and adapt to these risks.

The rise of social investing

There has also been a strong and rising demand for investment in social projects connected to education, infrastructure, health care, affordable housing and poverty alleviation. Figures show that social bond issuance raised $147.7 billion in 2020.⁷ Other examples of recent social bond issuances include the following:

• Hogan Lovells advised digital consumer lending platform auxmoney on the issue of its third public ABS transaction with a size of €350 million.⁸
• Hogan Lovells advised ABN AMRO Bank N.V., Bayerische Landesbank, Commerzbank Aktiengesellschaft, Crédit Agricole Corporate and Investmentbank, Norddeutsche Landesbank – Girozentrale – and UniCredit Bank AG on the placement of a €500 million Social Housing Bond by Deutsche Kreditbank AG.⁹
• Hogan Lovells advised EDF in its inaugural €1.25 billion perpetual hybrid social bond.¹⁰

ESG-related risk

Whilst the market has moved decisively to adopt ESG themes, the need to manage ESG-related risk has also become a key feature of today’s landscape.

The risk of greenwashing is just one example in a heightened disputes landscape where class action, stakeholder and shareholder type challenges are becoming more and more common. Climate and environment risk can also cause declines in asset portfolio valuation which will feed through to impact on capital requirements. For example, the need to improve real estate portfolios for green credentials and increased marketability is a challenge that that has been widely noted by the market.¹¹

Another consequence of this environment is the increased availability of insurance for these types of liabilities and the provision of services and technology for gathering, tracking and reporting ESG data, the collating of which is likely to become more and more onerous as extra levels of governance and disclosure become the norm.  

The growth of ESG standard setting

As noted above, in parallel to the growth of ESG products, there has also been an accompanying expansion in guidelines, legislation and market standards which aim to formalise the ESG disclosure process. These include:

• The ICMA principles. ICMA’s Green, Social, Sustainability and Sustainability-Linked Bond Principles are a voluntary global standard for the sustainable bond market, and were recently updated.¹²
• The LMA principles. The LMA has made available the Green Loan Principles, the Social Loan Principles and the Sustainability-Linked Loan Principles in order to facilitate  the documentation of ESG transactions in the loan markets.
• EUGBs. The proposed EuGB Regulation establishes a voluntary standard for European green bonds and aims to increase market efficiency through harmonised rules and standards by requiring the proceeds of EuGBs to be invested in economic activities that are aligned with requirements under Regulation (EU) 2020/852 (the Taxonomy Regulation). Please see this Engage alert for further details.
• ESG Ratings. The proposal for a regulation on the transparency and integrity of ESG rating activities would bring new regulation to a previously unregulated market in Europe, and require EU and third country market participants providing ESG ratings commercially to become authorised and supervised by ESMA. Please see this Engage alert for further details.
• CSDDD. The proposed Directive on Corporate Sustainability Due Diligence aims to introduce harmonised human rights due diligence requirements for large companies operating in the EU. Please see this Engage alert for further details.

More and more stringency is now being attached to ESG products as governments and other standard setters seek to introduce consistency and combat risks such as greenwashing. This evolution is likely to continue for the foreseeable future. Connected to these developments is inevitability of further regulatory divergence as jurisdictions such as the EU and UK advance differing interpretations of ESG regulation. Financial institutions with footprints in multiple different jurisdictions will therefore need to monitor this area closely.

Final thoughts

The first half of 2023 has seen the market having to adapt to the “new normal” of resurgent inflation, higher interest rates and sustained geopolitical uncertainty. Central banks, regulators and governments have generally acted decisively in this context and will likely be vigilant for any further warning signs of market turbulence. ESG themes continue to play an important role in today’s market, and financial institutions are likely to become increasingly subject to ESG-linked reporting standards and regulatory change in the rest of 2023 and beyond.

This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact one of the contacts listed here if you require assistance or advice in connection with any of the above.

Authored by Sharon Lewis, Julian Craughan, Bryony Widdup, and Patrick Evans at Hogan Lovells

Stefan Rolf, Joanne McEnteggart, and Sandeep Rai at IQ-EQ

References