BNP Paribas SA and Société Générale SA first-quarter equity trading rout highlights how much their flagship derivative products expose the lenders to risk and the difficulty they have competing with U.S. investment bank giants, analysts say.

While their expertise in exotic investment products pays off in the good times, it puts them in the red in the bad. The coronavirus-induced first-quarter market slump will likely lead to a review of both banks' trading strategy, according to experts.

BNP Paribas posted a first-quarter loss of €87 million in equity trading, compared to a profit of €488 million in the same period in 2019, according to S&P Global Market Intelligence data. SocGen's equity trading income slumped to €159 million from €857 million, while smaller investment bank Natixis posted a first-quarter equity trading loss of €32 million, compared to a profit of €125 million in the first quarter of 2019.

Derivative specialists

French banks have singled themselves out as leaders in equity derivatives, such as dividend futures, and have built expertise by creating complex quantitative investment models, developed by talent from France's top engineering schools.

But when the European Central Bank recommended the continent's banks cancel dividends despite payouts having already been announced, the strategy played against them. Dividend suspensions by financial institutions surged from the end of March owing to central bank pressure. Banks usually hedge against the risk, but this time around were caught short. It cost SocGen €200 million, the bank's deputy CEO, Philippe Heim, told Deutsche Bank Global Financial Services Conference May 26.

Dividend futures are derivative contracts that allow investors to bet on future dividends. As most European banks had already announced their dividends, it should have been an easy bet.

"It was really an exceptional situation. It's very rare for companies with the scale of the large European banks to cancel a dividend," said Jérôme Legras, head of research at Axiom Alternative Investments.

The French lenders' first-quarter performance contrasts sharply with that of U.S. banks such as Morgan Stanley and JPMorgan Chase & Co., which both saw a rise in equity trading income in excess of 20% over the period, according to S&P Global Market Intelligence data. The U.S. lenders were less exposed to the ups and downs of equity trading because they have a larger global reach and are less exposed to Europe, Legras said.

French banks "have lot of difficulty in competing against U.S. banks, they find it hard to make sufficient profits, they have high costs, they regularly lose market share to them," he said.

Structured products

French banks specialize in structured derivative products, which are more profitable but more complex and riskier than other derivative products, such as flow equity derivatives, Legras said, pointing to Natixis' revenue decline in late 2018, the result of derivative transactions on volatile Asian markets amid a sharp global markets downturn.

Structured products are pre-packaged investments linked to an index or basket of securities, and their payout can depend on the performance of a stock market index. Although high risk, they offer high returns. Flow equity derivatives, which are exchange-traded futures and options as well as exchange-traded funds, are much more liquid and less subject to risks from market fluctuations.

Amrit Shahani, research director at Coalition Development, which publishes league tables on global investment banking, said in an interview that structured derivative products accounted for 39% of equities revenues for French banks, compared with 14% for U.S. banks.

Flow derivatives revenues increased by 400%, while structured equity derivatives revenues fell by 80% in the 2020 first quarter on the year, he said, estimating that French banks lost €1 billion over the period due to the slump in structured products.

Tomasz Walkowicz, vice president for European financial institutions at rating agency DBRS Morningstar, said the derivative losses do not bode well for the banks as they should be allocating profits for provisions at a time when bad loans are expected to rise due to the economic fallout from the coronavirus.

"It might not be easy to change the way this business functions on a very short-term basis," he said. "One of the things they could do is to minimize the risk to avoid any potential fluctuations in profit as a result of market movements."

Review

Natixis CEO François Riahi told analysts on a call that the bank would review products impacted by the crisis.

SocGen CEO Frédéric Oudéa told an Exane BNP Paribas European CEO conference June 9 that the bank was reviewing its range of structured products with a view to developing simpler investments. The bank's recent acquisition of Commerzbank AG's equity markets and commodities business acquisition will help the bank adapt its market range, he said.

The lender continued to feel the impact from canceled dividends in April, but had seen a “progressive recovery” in May in its equities business, with “strict constraints” on structured products, Oudéa said.

BNP Paribas CFO Lars Machenil told analysts his bank was in the process of diversifying its equities business, strengthening it through acquisitions of other businesses.

SocGen is more exposed to equities than BNP Paribas, Walkowicz said. For SocGen, equities and prime services, which includes equity derivatives, represented 10% of total 2019 group revenues, while for BNP Paribas the same business accounted for slightly less than 5% of 2019 revenues, he said.

While the business provides decent fees at a time when banks are suffering margin pressure due to low interest rates, it is challenging when faced with extreme market movements, Walkowicz said.

All the French banks were hurt by an end-2018 trading debacle, and now they face the same dilemma, he noted.

"If you want to play in these kind of products you should be a rather big institution with a very strong balance sheet and a lot of capital and good diversification to be able to absorb some of these extreme market movement losses."

"Ideally you would be someone like J.P. Morgan doing this business [with] a very small contribution to revenues and profits. You wouldn't be worried too much if one single part of the business wasn't doing very well in one single quarter," he said.