Features, September 2000 The bankers are coming The last few months has seen investment banks gearing up to deal weather derivatives. Mark Nicholls asks what impact their arrival will have on the growth of the market, and how their approach to weather risk differs from existing weather dealers It's not often that companies welcome more competition. But growing interest from investment banks in the weather market has been greeted with unalloyed enthusiasm from existing weather dealers. They believe that the banks will bring sorely-needed end-users to the market, and plug weather derivatives more firmly into the capital markets - developments that will make managing weather risk more efficient and cost-effective, both for dealers and the end customer. The latest bank to set out its weather stall is BNP-Paribas. At the end of June, the French bank announced the formation of a 'global risk solutions' team that is, inter alia, offering weather derivatives to corporate clients. Fellow French bank Credit Agricole Indosuez is understood to be planning to trade weather derivatives from New York, but declines to comment at this point. And, as reported in Environmental Finance (June 2000, page 6), Merrill Lynch recently became the first US investment bank to set up a weather trading desk. Japanese banks are also enthusiastically embracing the new market. To date, the International Bank of Japan, Nomura and the Bank of Tokyo Mitsubishi are all touting for weather business. And in Australia, Westpac is maintaining a watching brief on the market, having quoted a number of deals, according to the bank's head of commodities Simon Klimt. However, it's not all good news. A number of banks have been closely tracking the market's growth, but have decided not to jump in at this point, citing limited customer demand. Morgan Stanley Dean Witter (MSDW) and Salomon Smith Barney (SSB), the investment banking arm of Citigroup, both say that they would look at individual client deals, but aren't setting up dedicated weather teams. And Goldman Sachs - the bank behind the first, and, as yet, only weather-linked bond - is continuing to "look at opportunities on an individual basis - we don't have a market-making role," according to a spokesman. Investment banks have long been conspicuous by their absence from the new market. SG, the investment banking arm of another French bank, Société Générale, has, to date, been the only bank as actively involved in the market as the big US energy firms and reinsurance companies that drove its initial development. This reluctance is partly to do with risk management. Capital markets players, such as investment banks, typically try and hold largely risk-free, matched portfolios of financial instruments, by finding offsetting positions - whether by matching two clients themselves, or by hedging in secondary markets. This has proved very difficult in the still relatively illiquid weather market. And not only is the market illiquid (making it often difficult to transact trades), but most customer demand has come from companies in the energy sector. Demand therefore tends to be skewed towards products to protect against mild winters and cool summers. Hence, weather derivative dealing has been most enthusiastically adopted either by energy companies, which have underlying weather exposures themselves, or by insurers, who are happy to earn premium income from taking risks that are uncorrelated with their exisiting portfolios. This risk management conundrum is one of the reasons that SSB is holding back, says Paul Zhang, a derivatives specialist at the bank in New York. The bank is talking to some clients about hedging their weather exposures, but has yet to do any deals, he says. It would aim to place any weather risk with a third party rather than manage or absorb it in-house. Should the bank get actively involved in the market, it would try to run a balanced book. "We'd try and offset the majority of directional bets, and warehouse some of the residual risk," he says. But the lack of liquidity currently would prevent this, he says. "It's still a little early." Zhang says that the bank is not receiving sufficient client enquiry to encourage it to increase its activity. However, some banks - as part of the much-touted convergence of banking and insurance - are taking a more insurance-orientated approach to risk management. This, indeed, was the raison d'etre behind Paribas' decision to set up its risk solutions group, aiming to combine "the full range of risk transfer techniques available from both markets", according to a company statement at the time. Denis Autier, the London-based head of the seven-strong global risk solutions group, agrees that the market is too illiquid - and too one-sided - to allow the active management of risk by taking offsetting positions. "[For this approach] you ultimately need clients looking to hedge their risk. Today, most people are looking for protection against a mild winter. I don't see many people with an opposite need." His bank's approach, therefore, will be to run a diversified portfolio, taking an insurance-based approach. But it won't simply be a buy-and-hold strategy. Investment banks have the structuring expertise, he says, to repackage weather risk (by securitising it, or placing it in a fund product). They also have the distribution network to place the risk with institutional investors. For example, French fund management company Barep Asset Management has issued two funds linked to a portfolio of weather and catastrophe risk exposures to date, attracting over $80 million of investment. SG, which has been offering weather derivatives since 1998, has also take the fund approach. The bank packages catastrophe bonds and weather risk into diversified portfolios, funded partly with SG's own money, and partly by external investors. Although it sources most of its catastrophe risk from bonds arranged by other banks, SG has developed a global weather derivatives business, and originates 80% of its weather exposure from deals with its clients. Diego Wauters, global head of insurance derivatives at the bank, says that SG took two years to develop a sophisticated system to ensure that the investment vehicles are adequately diversified. He adds that all the funds have performed according to expectations, with unleveraged products offering returns of 4%-5% above Libor, the risk-free interbank borrowing rate. Securitisation has had a more chequered history thus far, with energy company Koch Industries issuing $50 million worth of weather-linked bonds in October 1999, far less than the planned $200 milion offering. Around the same time, its competitor, Enron, cancelled a similar bond. Autier is unfazed. "We expect to issue a securitised weather bond in 2001," he says. "Each situation is specific - it's a question of timing and price. Things can evolve very quickly." As in the older and more successful catastrophe bond market (where investors buy bonds linked to insurers' exposure to earthquakes or hurricanes, for example), it can be unattractive to issue bonds to capital markets investors when there is plenty of appetite from the reinsurance companies, who are the traditional buyers of catastrophe risk, he notes. He adds that, down the line, a two-way weather market will develop, where demand for hedges from the energy sector, say, is matched by companies with opposite exposures to manage. And, at that point, BNP Paribas' risk management approach will change adapt in line with it. In the absence of a balanced market, the ability of the investment banks to access capital markets investors will be crucial. Shuichi Okuda, in the derivatives and structured products division in the Bank of Tokyo-Mitsubishi in Tokyo says that his firm - which is marketing weather derivatives to clients from Tokyo, London, and New York - is targetting retailers, leisure companies and resorts in the short-term, with the expectation that utilities will enter the market in the longer-term. FOR THE FULL STORY EVERY MONTH, SUBSCRIBE TO ENVIRONMENTAL FINANCE, OR CONTACT info@environmental-finance.com FOR OUR BACK ISSUES SERVICE