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‘Shadow banking’ offers major opportunity to Bermuda, says top asset manager

Bermuda has a major opportunity to get involved in “shadow banking”, according to a top fixed-income asset manager.

Cliff Corso, chief executive officer of New York-based Cutwater Asset Management, which manages around $23 billion, said the shrinking banking sector opened up the possibility for the Island's insurers to use their assets to fill a growing “lending gap”.

Shadow banking — a term describing the role of non-bank financial intermediaries that provide similar services to traditional banks — carries negative connotations and is associated with high risk and a lack of regulation.

However, Mr Corso believes those fears can be overcome by transparency and appropriate regulation.

“There is a long-term trend in the banking system of delevering and derisking — which is effectively changing the banks into utilities — and that leaves a huge gap for lending, which creates an opportunity to fill that gap,” Mr Corso said in an interview.

“So insurers and pension funds, big players with a lot of assets, who do naturally gravitate toward lending, bond, fixed-income type investments, could step in to fill that gap. The challenge in my mind is that people toss around the phrase ‘shadow banking' and associate it with high risk.

“But if we believe in these structures that are filling the lending gaps, then what a great opportunity.

“And here's the opportunity for Bermuda. It's a jurisdiction that's respected for its transparency, and its legal and regulatory structure. If the market continues to find opportunity to fill that lending gap, then Bermuda's sitting in a pretty good place to capture a share of that market — and it already is to some degree.”

Mr Corso was speaking with The Royal Gazette, during a visit to Bermuda this week, when he moderated a panel at the Insurance Day Summit. Cutwater works with some Island reinsurers, helping them to navigate the fixed-income market during a challenging period of prolonged low interest rates.

“We know that shadow banking got an evil connotation in the last cycle, because it wasn't regulated and when it was off the balance sheet, there was no real oversight, skin in the game, or framework,” Mr Corso said. “But I think if there are structures that are transparent, with a regulatory framework around them, then I think it will be durable and lasting.

“I think the collateralised loan obligations (CLOs) market is a good example of that. Yes, they got swept up in the volatility during the global financial crisis, but as things calmed down, most of those structures held up very well, because they were regulated and structured well and they weren't overly engineered. That's why I think that market is beginning to grow robustly.”

He added that Cutwater had advised some life reinsurers on the Island in putting together investments of this type.

“We are working with reinsurers on the Island to put together asset-liability packages that are somewhat lending-like in nature,” Mr Corso said. “We're matching cedant liabilities with a very diverse pool of assets that are durable.”

It's a trend Mr Corso expects to grow among property and casualty players as well. He said Cutwater is receiving more interest from clients looking to get involved with reinsurance.

“I think all this is good news for Bermuda,” Mr Corso said. “As you get more asset managers, hedge funds and vehicles coming in, the challenge is keeping that balance of allowing the market to grow, but in a controlled and safe manner. That will be the challenge for the Bermuda Monetary Authority and Mr Cox [BMA CEO Jeremy Cox].”

Commenting on the fixed-income market, Mr Corso said Cutwater expected US ten-year Treasury yields to rise from their current depressed level below 2.6 percent to around three percent by year-end and then to peak at around four percent.

Most Bermuda reinsurers are heavily invested in government debt as they seek a ‘safe' place for their multi-billion dollar investment portfolios. But low interest rates are strangling investment returns. And some fear that a spike in interest rates as central banks tighten up monetary policy will leave insurers facing a hefty blow to the value of their fixed-income assets as bond prices tumble.

Mr Corso said many asset managers had adopted the same approach, leading to dangerous possibilities in what he described the most challenging fixed-income investment environment he had seen during his career.

“Everywhere you hear everyone saying, ‘I've traded duration for credit',” Mr Corso said. “So the five-year area is a very, very crowded part of the yield curve in our view. It's difficult when you're running a portfolio and you're trying to be defensive, so people are in there for logical reasons. Perversely that's the part of the yield curve that could get really shot.”

Cutwater's approach for dealing with that risk is to use a ‘barbell portfolio'. He explained: “Instead of investing in the average along the yield curve, you go very light in the middle part of the maturities and own the front end and the long end. As the curve swings up, that's a better performing structure.”

Cutwater Asset Management CEO Cliff Corso

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Published June 26, 2014 at 9:00 am (Updated June 25, 2014 at 8:36 pm)

‘Shadow banking’ offers major opportunity to Bermuda, says top asset manager

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