Monthly Archives: November 2013

What has happened to our banks?

univestWhat has happened to our banks?

We have yet another scandal at the top of a bank, and another relating to the behaviour of RBS to add to a long list of problems with banks and bankers. As banks are run by people is the problem with bankers who are not qualified to run a bank, or is the problem more broadly one of abstract ideology, greed, and the celebrity culture? To what extent are the media fuelling this problem?

Some months ago I was asked by the head of a UK business school whether or not Islamic Banks had a role to play in restoring credibility to the investment banking sector. After some thought about this question, which I considered as comparing mutually exclusive doctrines, I found myself asking if the definition of an investment bank, and indeed banks in general had become so obscure that no-one really understands them any longer.

Then we have the scandals with the people at the heads of banks. Are these people imposed bankers out of nepotism, very convincing mavericks, or real Bankers? If not real Bankers is their nepotism born out of allegiance and/or celebrity status?

Over the coming days I will express my thoughts from many years of experience about the current events in the banking sector, and the unlawful abuse of their clients by both investment and corporate bankers. The stories that I have heard regarding RBS, if true, are horrific abuse of power, especially as much of it will prove unlawful. I have listened to stories that can only be absolute abuse of banking code, especially in the property sector. It is sad that many finance directors and lawyers are not aware that, other than in extreme situations, the ‘call clause’ in a financing agreement is not worth the paper it is printed on in law. I personally fought off, in 1992, an attempt to have this call clause used by a bank extending a facility to a property company and then having a change in strategy within the bank thus calling all of their property loans. Major plc’s were borrowers, but complied with the call. The property company I represented was the only property loan on their books for 2 years thereafter having realised how much it was going to cost them for me to move this financing elsewhere. The chairman of this bank actually stated to me that he was thankful that not many people had my knowledge of banking law.

So what are investment banks and why do we need them? During the mid-1980’s they evolved out of the former Merchant Banks which provided the liquidity for global trade, and structured debt solutions for major projects throughout the world. However, capital movement around the world was somewhat limited thus frustrating economic growth through lack of available capital. Deregulation of the capital markets of the world in the mid-1980’s enabled rich sources of new capital, but it required very special and creative structured finance skills to satisfy the investment terms of these new investors with the financing needs of projects. For example we saw the global expansion of international securities, the design of structured securities products aimed at providing finance more aligned with the specific needs of a project, and the attraction of major global institutions and private investors to purchase such securities thus providing liquidity to the system that banks alone could not provide. It was instilled into me in those early days that our role was to match financing need with capital availability providing the expertise to both optimally structure the risk in the funding requirement, and to demonstrate our integrity to investors that would lead to the trust to provide the funding. Investment banks do not lend money (their income essentially comes from origination fees and trading profits), but they make it possible for investors to provide capital to funding requirements, (thus the Capital Markets) and facilitate the liquidity of capital investment to optimise the flows of investment capital.

When I first entered the upper echelons of investment banking in the late 1970’s the following parameters were engrained into me:

  • Investment banking is a people business
  • Investment banks do not get involved in politics, religion, or nationality
  • Investment Bankers must leave any political and religious doctrine at home
  • Investment Bankers should not display any nationality or cultural preferences
  • Senior Investment Bankers need to understand the liability side of the Balance Sheet
  • Integrity is paramount, and is a given

The very best bankers shunned the spotlight, and would not consider themselves to be of celebrity status.

Having been part of the evolution of the then embryonic International Securities market in the mid-1970’s (loans syndication was still the major mechanism for major project financing) my work since then has involved the global expansion of international securities, the design of structured securities products aimed at providing finance more aligned with the specific needs of a project, and the attraction of major global institutions and private investors to purchase such securities thus providing liquidity to the system that banks alone could not provide.

For some years this new market worked well especially in the arena of infrastructure development which was a necessary part of global economic development. New products emerged such as asset-backed securitisation making it possible to provide ever increasing funds to satisfy mortgage demand, credit card finance, lease finance et al. However, just as the Manhattan Project produced a new science of nuclear fission which could significantly benefit the world in the development of electronics, energy production, medical treatments, etc., in the wrong hands such innovation would have devastating results.

If we can accept that history has many examples of great inventiveness being used with moral integrity to the greater good of many, and by the few intent only upon greed, avarice and power, can we draw upon these flaws in human nature to describe the culture within investment banks today.

My own view is that the degradation of moral integrity within investment banks started directly after the ‘Big Bang’ in 1986. Too many banks had paid far too much to be part of their somewhat blurred vision of post-deregulation of the financial markets and thus needed an aggressive income generation policy to recoup their costs to save face with their shareholders. At that time I wondered if many institutions had lost sight of the fact that little new capital would be available, just a redistribution of existing availability providing an improved mobility of existing capital, and thus more liquidity.

In the run up to Big Bang in 1986 many uncomfortable marriages of convenience occurred in the form of major banks buying stockbrokers and stockjobbers to include equities within the investment banking environment. The culture gaps experienced created some challenging problems. Whereas technology issues were resolved during those early weeks after ‘Big Bang’ in 1986, the prima donna positioning of the various traders continued long afterwards. This change in attitude by trading staff started a trend across the community that became endemic using ‘profit’ as their argument.

What I noted at that time was that far too many Board members of banks had little idea what was happening in these operations, and relied upon the head of trading departments to manage the bank’s position. Traders saw this as an opportunity to do as they pleased – primarily for their own benefit. I was asked to explain to the heads of the banks in London comprising the Acceptance House Committee why Euroclear and CEDEL were not prepared to provide the settlement credit lines being demanded by their trading managers. This meeting concerned me in that it was clear just how out of touch these people were with this new world of investment banking.

SWAPs became trading instruments leading to synthetics, swap options, and the now notorious Credit Default Swaps. The term nature of these instruments meant that they could span years but traders tended to ensure that they were booked to take all of the presumed profits of a term transaction in the first year to maximise bonus and to hell with the possibility that over time this transaction would have costs on an annual basis, and could completely unravel if rates moved outside of the transaction limits (as per the experience of ill-advised small corporates buying interest rate swaps). Experienced support professionals who understood the degrading impact of these events were patronised, completely ignored, and, if troublesome, dispensed with. Trading managers and their allies surrounded themselves with bright young people who did not have the experience to understand the consequences of what they were asked to do. The rot was setting in. As a Board member of CEDEL at that time I met with peers from other banks so I knew of others who felt the same way. By the end of the 1990’s the mavericks controlled the investment banks, profits from ever more risk taking soared, bonus culture was out of control, the regulators were asleep; and the shareholders loved it.

There is one other facet to this cultural issue that is important before looking at ways to address this problem for the future. There are far too many examples where the investment banking trader/deal maker has evolved into a main Board Director, or even worse the CEO, but without the necessary transition in attitude or skills, especially the prudent management of risk. Would anyone expect a car salesman to become CEO of the car manufacturer? This would be rare indeed as a good salesman is very focused on the next sale/commission, not the long-term interests of the company. Thus when a trader emanates to the Boardroom the checks and balances of reasoned debate tend to be overtaken by the aggressive will of the trader who imposes unilateral control of all investment banking activities over his fellow Directors, and encourages the reckless use of depositor funds in the name of profit. A recent article in the Financial Times on the reflections of Martin Taylor, the former CEO of Barclays Bank, regarding Bob Diamond and his imposing presence on the Barclays Board provides a good example of this. Taylor indicates that Diamond wanted to increase exposure to Russia by 5-fold. The Credit Committee only accepted half of this increase. However Taylor claims that Diamond ignored the Credit Committee ruling, increased the exposure, and within months Russia had defaulted with huge losses to Barclays. Apparently Diamond used plausible deniability, fired the traders (under his control) and charmed the Board by swearing his eternal allegiance to Barclays. In any other environment Diamond would have been fired for blatant breach of the Credit Committee policy irrespective of profit or loss, but he wooed the Board into thinking he was indispensable to the fortunes of BarCap. Taylor regrets the decision not to fire Diamond, but he is not alone in getting wooed by the prospects of vast profits, a blurred understanding of the risks, and the disregard of risk lines set by Credit Committees best placed to take a more circumspect view. I would not like to count the number of times I have encountered this situation.

By the end of 2006 skilled observers knew that the credit markets were out of control, but no-one was listening. The CDS and CDO money machine had far exhausted the capability of the monoline insurers, whose Balance Sheets had been stacked with more dubious assets in order to meet the demand of their fee generation activities, and the ever increasing production of irresponsible concepts such as ‘super-senior debt’ were all part of the profit frenzy of unregulated activity. Chuck Prince, the then CEO of Citigroup was recorded as saying to the Financial Times ‘As long as the music is still playing, we are still dancing – and the music is still playing’. In her book ‘Fool’s Gold’, Gillian Tett describes how, during this period, Jamie Dimon at JP Morgan Chase had refused to participate in the frenzy, but was being pressured by greedy investors to match the profit of other banks engaged in these activities. What a fall from grace he has suffered over recent months.

Even today, post the 2007/08 meltdown, we find the mavericks still essentially in control epitomised by the most recent scandal in the UK whereby corporate bankers, probably from an orchestrated script that even they did not understand, were encouraged to sell complex SWAP instruments to small corporates with devastating effect. Bonuses taken, but leaving the banks to face humiliating fines and further damage to reputation.

If it is accepted that the above defines a major, if not predominant, flaw in investment banking culture then what practices could be instituted to change this culture to a more acceptable form of banking without losing the creative skills for formulation of new and applicable products, and the liquidity environment to make such products attractive to the widest range of investors.

The typical cry from outraged politicians across the world (who for all intent know little or nothing about these markets) is for more regulation. This is nonsense as no amount of regulation will impact a short-term culture environment where traders will take whatever risks they need to make their bonus as they will be long gone to their retreat in Barbados before the devastating  (both reputation and financial) impact of their actions are felt by the banks. The only changes to regulation that will extract any effect would be the prosecution of reckless traders who profit from the damage they do albeit I see a legal minefield differentiating between rogue trader, and irresponsible trading with plausible deniable consent of management. The legal maxim actus non facit reum, nisi mens sit rea comes to mind. Furthermore the UK Financial Services Act would need to be amended to bring habeas corpus into effect for individual prosecution so that banks could limit their legal liability to the trader and thus impose some responsibility discipline into their actions without removal of the rights of the individual in Common Law. The Serious Fraud Office would need to be the prosecutor for UK based traders. Importantly any such change of this type of prosecution needs parity in each of the major financial centres to have any real deterrent value. Rendition of individuals to the USA when London is the heart of the financial World is not a reasonable solution.

Furthermore my experience of regulators is that they have little or no knowledge of the complexities of securities products, or the markets. Forensics and post-mortem after the event is a far cry from being able to evaluate the impact of new financing structures, e.g. super-senior debt, and realise the impact of such artificial concepts on the market, and thus prevent its introduction. It is also worthy of note that the independent rating agencies and monoline insurers also need to take responsibility for what they are prepared to acknowledge as worthy credit, and in the case of monoline insurers, their capacity to manage major defaults.

Asking a trading manager to operate with constraint is counterproductive as it is easier to ask forgiveness than seek permission. Equally you would not expect such a trading manager to determine credit or risk policy as this would invariably lean toward excess. The role of the trading manager is to maximise return on capital employed within pre-determined credit and risk boundaries and thus looks out into the market to seek opportunity. The trading manager, director, or whatever you wish to call him plays the role of the trading team captain ensuring that the play strategy is right, and that every player is contributing at peak performance.

Therefore a counterbalance is needed to ensure that rules and boundaries are independently derived, and then observed at all times in order to protect the Balance Sheet of the bank from inappropriate exposure, i.e. looking inwards. In conventional businesses such activities can be dealt with over days or even weeks, but in a trading environment with a turnover of some USD billions per day such attention can be minute by minute. Whereas a Credit Committee can provide overall guidelines on limits and exposure, the reality of the trading environment requires credit and risk limits such as new counterparties, trading in hybrid securities to fulfil a client requirement, etc. to be determined swiftly, and certainly within a trading day. Thus a combination of compliance, settlements, and funding act as the referee during the trading day.

One important lesson of the past 20 years is that the door was open to let the mavericks take control, and they were treated as gods. They have taken their rich bonuses and so can live in luxury whilst everyone else has to burden the cost and pain of their activities. Only after a major reorganisation of investment banking, essentially from within, can we revert back to the banker’s creed ‘My Word is My Bond’ with any sincerity and integrity..

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Are we at a collision point between socialism and capitalism, and is the global energy business driving this collision?

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Are we at a collision point between socialism and capitalism, and is the global energy business driving this collision?

Two events have occurred over the past few weeks which appear to encapsulate an observation that I have been considering for some time, i.e. whether or not capitalism has moved to the extremes of greed, and socialism has no answer to counterbalance this behaviour. Politicians and the media would have you believe that banks are the ultimate in capitalist greed. Whereas I have serious reservations about the activities in certain banks, I feel that the major energy companies from oil & gas production through to energy generation consider their power above that of politicians at the highest level, and that of the major trade unions. If my observation bears credible scrutiny then who are the winners, and who are the losers.

The two events that I would like to use in this debate, because they encapsulate the major drivers in this debate, albeit not the only events of concern, are the Grangemouth Refinery & Petrochemical plant debacle in Scotland, and the UK Parliamentary Committee meeting with the major UK energy companies this past week.

Perhaps a little background on the energy footprint in the UK will assist readers not familiar with the situation here.

According to Ofgen, the energy regulator, the UK has installed capacity for electricity of some 73GW of conventional generation and 9GW of renewable with ACS peak demand expectations around 60GW. Uncertainty around government policy (UK and EU) and future prices continues to limit investment in conventional generation and no new plant is expected before 2016. In the UK it is  estimate that around 1GW of new gas plant will come online before the end of the decade and the installed capacity of wind power will possibly more than double over the same period albeit that this must surely now be in question. In any event, given the variability of wind speeds, they estimate that only 17% of this capacity can be counted as firm (i.e. always available) for security of supply purposes by 2018/19.

More than 2GW of LCPD opted-in plant have also closed or converted to biomass since October 2012, resulting in less pollutant plant but with significantly reduced capacity. Around 0.5GW of nuclear capacity is reaching the end of its technical life and is expected to close by 2014/15, though extensions now have to be considered. Around 2GW of CCGT plant should be retired by 2018/19 for the same reasons, but will this happen?

As installed capacity falls in the next few years, all else being equal, prices can be expected to rise and it is possible that this will lead plant, especially coal fired, that is currently mothballed to come back online to keep prices affordable.

According to National Grid, the expected drop in peak demand is mostly due to increased energy efficiency in the domestic sector and increased Demand-Side Response (DSR) insulation of buildings, etc. I consider this to be a convenient explanation politically where the truth may be more damning.

For completeness the interconnection capacity between the UK and mainland Europe and Ireland is currently 3.8GW. Assumptions about the likely direction and size of interconnector flows therefore have a significant impact on the calculation of the risks to the UK security of supply.

Ofgen expect that, in a situation of tight margins (please), ahead of mitigation actions being implemented, prices would rise resulting in higher interconnector flows into GB. However, GB is not the only European country expecting de-rated margins to fall in the next six winters. France, Ireland, Germany and Belgium are also facing security of supply challenges, and have very similar patterns of demand and supply availability.

As for gas, DECC reports suggest that gas consumption reached a record high in 2004 of 1,125 TWh. Since then, consumption has seen an overall decline, and in 2012 total gas consumption was 845.6 TWh, around 25% below its 2004 peak. These longer term trends are driven by commodity prices, energy efficiency and, for domestic use in particular, temperature. However domestic demand in 2012 was high, up almost 16 per cent on 2011, reflecting the colder, protracted winter, but gas demand for electricity generation fell by almost a third to 214 TWh largely as a result of coal replacing gas use due to high gas prices.

UK gas production peaked in 2000 and has since been declining. With declining production the UK has become increasingly reliant on gas imports to meet demand. Since 2000 net imports have steadily increased year on year, with the exception of 2011 which saw a 3 per cent decrease on the previous year’s level. The recent fall in imports can be attributed to the reduced gas demand from electricity generators, being replaced by coal.

Imports of Liquefied Natural Gas (LNG) through the two terminals at Milford Haven remain substantial, but their shares of total imports have dropped from 46% in 2011 to 27% in 2012. Demand for LNG on the global market remains strong but the UK has a diverse pipeline infrastructure (from Norway, the Netherland and Belgium) and the proportion delivered through each route will depend on global market conditions.

It is probably also worth noting that Europe, as a whole, has over capacity in crude oil refineries. The UK has 7 refineries. According to HIS Purvin & Getz Research Group the UK imports 47% of its diesel fuel, and 50% of its aviation fuel. However the UK has a 20% surplus of petrol which it exports.

Now let us look at the politics. In March 2007, the European Council agreed to a common strategy for energy security and tackling climate change. An element of this was establishing a target of 20% of the EU’s energy to come from renewable sources. In 2009 a new Renewable Energy Directive was implemented on this basis and resulted in agreement of country “shares” of this target. For the UK, by 2020, 15% of final energy consumption – calculated on a net calorific basis, and with a cap on fuel used for air transport – should be accounted for by energy from renewable sources. There was much grandstanding by the politicians at the time, especially directed towards the USA, indicating that Europe was a good citizen of the world, and would be a leader in the climate change revolution, setting targets that many reasonably minded people thought optimistic. However there followed much uncertainty surrounding the implementation of this and and other market reforms thus having as much impact on plant investment and retirement decisions as the expectations of the impact of evolving energy prices. This uncertainty means energy companies suffer much frustration of their long-term strategy through muddled energy policy, or indeed the lack of any definitive energy policy by various governments.

On the other hand the USA refused to sign up to Kyoto and, other than a little dancing at the edges, ignored the grandstanding of Europe and other countries and allowed the market to determine the future. The USA gets many things wrong, especially much of its foreign policy, but when it comes to protecting its own market it invariably gets it right. Developing new technologies and techniques such as fracking, the USA is now energy independent, energy prices are around 20% less than Europe, and they can export enough cheap fuel to disturb the markets in Europe.

In the UK the previous Labour government blindly signed up to all of the EU energy initiatives, could not fund these initiatives through already excessive taxation, so the current leader of the Labour Party, then Energy Secretary, came up with stealth taxes in the form of environmental and social levies to be collected by the energy companies from the domestic consumer, currently £117 per household, to fund these initiatives making a number of people in the renewable energy market very rich without delivering any tangible value today, or tomorrow. We now have a coalition government where the predominant Conservative Party want to repeal these stealth taxes and no longer subsidise renewable initiatives from public money but find themselves frustrated by the minority Liberal Democratic Party who see some value (to them) of continuing to wave the environmental flag. In addition the Labour Party, who created these woes for the consumer now wants to go to the dark ages of socialism and freeze energy prices. Maybe a good soundbite for the uninformed, but ridiculous in the world of global energy markets.

So let us review the Grangemouth debacle. As I said refining capacity in Europe exceed demand. Furthermore cheaper energy supplies are being imported from the USA. The management of Grangemouth, owned by INEOS, (the refinery can process some 210,000 barrels of oil per day) claimed that they are losing some USD 8 million per month fuelled partly by US imports where USA refineries pay some USD 15 per barrel less than UK refineries. The management, knowing that they need to invest some £300 million in the plant, decided that they could no longer afford to run the plant with the then operating costs. They put a package of pay and pension reforms to the 800 or so workers. In essence the UNITE union, one of the largest remaining trade unions in the UK (Margaret Thatcher saw off most of the trade union power in the 1980’s) applied its usual socialist dinosaur approach threatening strike action. The refinery management refused to accept revised terms from, or to spend 3 months negotiating with UNITE (giving the Government 3 months to find an alternative buyer) so INEOS, who had already safely closed the plant facing the threat of a strike then announced that they were going to close it. Both the UK Prime Minister, David Cameron, and First Minister of Scotland, Alex Salmon, quickly came into play to rescue this situation. We can only speculate on what happened behind closed doors but the UNITE union completely caved in and announced that they would recommend acceptance of the INEOS terms for its members, and it was clear that INEOS had been offered some government deal towards the required investment in the plant.

What we saw during the Grangemouth debacle is an example of how commercial reality surpasses political and trade union power. It was suggested that the loss of this facility would have been devastating for the Scottish economy, and they complain about banks being too big to fail.

Then we look at the Parliamentary Select Committee interrogation of the ‘big 6’ energy companies bosses, having raised energy tariffs by some 10% average to domestic consumers against wholesale price increases of just some 1.8%. The only reasonable summary of this session is too much grandstanding by the political panel, and total indifference by the energy bosses suggesting that the high price of energy was down to the stealth taxes mentioned above. I understand that the UK domestic consumers pay the highest energy costs in the European Union. One interesting analysis on a news broadcast was that British Gas had increased their profit from £45 per customer just 5 years ago to £95 per customer today. Apparently they need these profits to satisfy investment returns for their shareholders.

So who are the winners, and who are the losers.

Winners

  • The capitalist (foreign) owners of Grangemouth
  • The capitalist owners of the major energy companies
  • The capitalist owners of the renewable energy companies who will be long gone with their accumulated wealth before the reality of this folly is known
  • It will be interesting to know who claims the victory of Grangemouth, especially with the up-coming Scottish Independence vote: David Cameron claiming a victory for a United Kingdom, or Alex Salmon who wants Scottish Independence.
  • The environmental lobby thanks to the short-sighted view of the Liberal Democrat coalition leader

Losers

  • The domestic consumer who has to bear the cost of the bailout of Grangemouth because of a dinosaur socialist union leader.
  • The domestic consumer who has to pay the cost of the increased energy tariffs, which could be indirectly attributed to the lack of energy policy by governments
  • The domestic consumer who has to bear the socialist imposed stealth taxes for renewable energy policies that are far too optimistic, expensive, and will prove to be a waste of resources. It should be noted that the socialist principal of payment according to what you earn was ignored thus betraying their core socialist vote.
  • The domestic consumer who has to pay for price increases to corporate energy users as they will pass their increases on to the consumer in the price of their goods/services.
  • The domestic consumer who will have to bear the cost of frantic, last minute efforts to maintain supply because of the lack of any firm energy policy.
  • It is claimed that reduction in demand is mostly due to the energy efficiency in the domestic consumer market. To some extent new technology and insulation will have an impact, but I fear that cost means that many domestic consumers cannot afford to heat their homes, and thus go cold. Thus the losers, again, are low income and pensioner domestic consumers – a direct reflection of capitalist greed.

I think that it was Socrates who observed that intelligent people discussed ideas, moderately intelligent people discussed events, and the vast majority, the uninformed, share gossip. Our largest selling newspapers, and to a degree some news channels, and political hype thrive on sensationalised gossip including important issues of energy policy – apocalyptic climate change gossip spread by brainwashed environmental campaigners sell more copies and buy more uninformed votes than mundane realities. There is a flaw in democracy if the noisy uninformed minority can unreasonably influence the uninformed, the impact of which is a substantial negative impact to the silent majority. It is an unquestionable fact that people united can make change happen. Therefore the people need to be properly and honestly informed.

Ironically all of this dithering means that the future is a return to non-other than the fuel which started the industrial revolution –Coal – because it is plentiful, and it is cheap, – look at Germany’s preferred fuel.

I would be very interested to hear how the above events in the UK would have played out in other countries, not least Germany and France.

References:

Ofgen Electricity Capacity Assessment Report 2013

Various DECC reports

HIS Purvin & Getz Research Group

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