By Ruma Dubey

When the financial crisis of 2008 broke, later on we discovered that amongst many other things, one of the fundamental reasons for the collapse was due to the mis-pricing of risk and therefore of assets.  Mark-to-market and complex derivative instruments became nightmares and we in India were probably introduced to these terminologies only then. Mark-to-market losses were so rampant and widespread that investors started shunning all companies which had hedges and derivative investments.

We have come a long way since then and since then banks have cut down on their risky assets, which are mainly categorized as Level 3 assets.  These assets are most illiquid, the banks offer some unbelievable rate of return for a very complex instrument. And profit or loss on these instruments is calculated on mark-to-myth model. The idea is that the entire product is a myth and so is the promised return as the return is a wild number, not based on any scientific measure of calculation. Typically, HNIs (who else) are the ones who invest in such level 3 assets – very high risk and very high returns.

It is like a realty price in a controlled economy, like say the UAE. There is no real demand and supply which dictates the price there – whatever the Govt sets the price of the area, that’s the price. So the price is mythical and so will the returns. These class of assets have very poor trading and that in itself means there is no reliable market for them, which in turn means that we cannot affix any accurate market value. Banks and investors use a rough pricing model and most of the times, they are not accurate. 

With Brexit happening, mark-to-myth is the terminology doing the rounds there and three main banks are in question – Credit Suisse, Barclays and Deutsche Bank. All these three banks, making London their financial hub for running all European operations and UK business, are holding piles and piles of Level 3 assets.

Level 3 or opaque assets held as at end of 2015 for Barclays stood at 36 billion pounds – 49% of its core capital cushion; Deutsche Bank at 32 billion Euros  - 96% and Credit Suisse at 31.5 billion Swiss francs – 133% of its core capital cushion. These are huge numbers. And this has made many investors calculate the market-to-myth losses. The stock price of these banks has literally collapsed, trading at very steep discounts to their book value. Many hedge funds have increased their selling in these banks.

Given the uncertainty surrounding Brexit, especially the future of these banks in Britain post exit from Europe, these banks have become high risk, more so due to the high percentage of Level 3 assets held. It will be very difficult or maybe even impossible at this juncture to sell these “mythical” and opaque assets. With no real value attached to them, these banks are currently sitting on tinder boxes.

Mark-to-market shook the very foundation on Indian companies and banks; so will these mark-to-myth leave a trial of devastation again? No. Indian banks are not linked to these banks like the way they were in 2008 thus the effect would be restricted to these three banks only.

To put it more aptly, Britain today does not mean as much as China. And that says it all.