The Morality of Dishonesty

univestThe Morality of Dishonesty

The following story was relayed to me in a somewhat cruder form last week. The original author is unknown to me. However it had some interesting observations and so I have edited it into a relevant form for today’s society.

A few years ago two armed thieves robbed a bank – one of them shouted: “Don’t move! The money belongs to the bank. Your lives belong to you.”  Immediately all the people in the bank laid on the floor quietly and without panic.

This is an example of how the correct wording of a sentence can make everyone change their world view.

One woman lay on the floor in a provocative manner. The older robber approached her saying, “Madam this is a robbery not a rape. Please behave accordingly.”

This is an example of how to behave professionally, and focus on the goal.

While running from the bank the younger robber (who had a University degree) said to the older robber (who barely finished basic education): “Hey, maybe we should count how much we stole.” The older man replied: “Don’t be stupid. It’s a lot of money so let’s wait for the news channels to be told how much was taken from the bank.”

This is an example of how life experience is more important than a degree.

After the robbery, the manager of the bank said to his accountant: “Let’s call the police.” The accountant replied “Wait – before we do that let’s add to the robbery the £800,000 that we took ourselves a few months ago and claim that it was stolen in the robbery.”

This is an example of taking advantage of an opportunity.

The following day it was reported in the news that the bank was robbed of £3 million.  The robbers counted the money, but they found only £1 million, so they started to grumble. “We risked our lives for £1 million, while the bank’s management stole two million pounds without blinking? Maybe it’s better to learn how to work the system, instead of being a simple robber.”

This is an example of how knowledge can be more useful than power.

Moral:  Give a person a gun, and he can rob a bank – at great personal risk. Give a person a bank, and he can rob everyone – with little personal risk.

Work Related Stress – Do Corporates understand this problem, and do they care?

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Work Related Stress – Do Corporates understand this problem, and do they care?

Are major corporates playing lip service to EU OSHA (The European Agency for Safety & Health at Work) guidelines on work related stress and psychosocial risks? Having recently had the opportunity to review this campaign, and the proposed methodology of incorporation into a multinational corporate environment, where the primary implementation was the proposed OSHA poster campaign, and the implied consideration was not to blame management, I have my doubts that management understand the significant impact to bottom-line resulting from a stressed workforce.

What do we mean by stress and psychosocial risks? – as defined by the European Agency for Safety and Health at Work

Psychosocial risks arise from poor work design, organisation and management, as well as a poor social context of work, and they may result in negative psychological, physical and social outcomes such as work-related stress, burnout or depression. Some examples of working conditions leading to psychosocial risks are:

  • excessive workloads;
  • conflicting demands and lack of role clarity;
  • lack of involvement in making decisions that affect the worker and lack of influence over the way the job is done;
  • poorly managed organisational change, job insecurity;
  • ineffective communication, lack of support from management or colleagues;
  • psychological and sexual harassment, third party violence.

When considering the job demands, it is important not to confuse psychosocial risks such as excessive workload with conditions where, although stimulating and sometimes challenging, there is a supportive work environment in which workers are well trained and motivated to perform to the best of their ability. A good psychosocial environment enhances good performance and personal development, as well as workers’ mental and physical well-being.

Workers experience stress when the demands of their job are greater than their capacity to cope with them. In addition to mental health problems, workers suffering from prolonged stress can go on to develop serious physical health problems such as cardiovascular disease or musculoskeletal problems.

For the organisation, the negative effects include poor overall business performance, increased absenteeism, presenteeism (workers turning up for work when sick and unable to function effectively) and increased accident and injury rates. Absences tend to be longer than those arising from other causes and work-related stress may contribute to increased rates of early retirement, particularly among white-collar workers. Estimates of the cost to businesses and society are significant and run into billions of euros at a national level.

How significant is the problem?
Stress is the second most frequently reported work-related health problem in Europe.
A European opinion poll conducted by EU-OSHA found that more than a half of all workers considered work-related stress to be common in their workplace. The most common causes of work-related stress were job reorganisation or job insecurity (reported by around 7 in 10 respondents), working long hours or excessive workload and bullying or harassment at work (around 6 in 10 respondents). The same poll showed that around 4 in 10 workers think that stress is not handled well in their workplace.

In the larger Enterprise Survey on New and Emerging Risks (ESENER) around 8 in 10 European managers expressed concern about work-related stress in their workplaces; however, less than 30% admitted having implemented procedures to deal with psychosocial risks. The survey also found that almost half of employers consider psychosocial risks more difficult to manage than ‘traditional’ or more obvious occupational safety and health risks.

Having considered these definitions, and reflected on my own experience over the years creating, changing or rescuing investment banking operations I found myself compiling my top ten reasons for stress in the workplace. In no particular order they are:

  • Managers who rule by fear and/or dictate cause stress
  • Managers who do not know how to manage people cause stress
  • Managers who fear for their own position cause stress
  • Managers promoted under the Peter Principle cause stress
  • Managers who are emotional and/or insecure in the decision process cause stress
  • Managers who promote politics or other unhealthy competition amongst their staff cause stress
  • Managers who do not have an intimate knowledge of the business cause stress
  • Inexperienced people – wrong people for the job – cause stress
  • People suffering stress in their private life are prone to suffer stress in the workplace
  • Likewise people stressed in the workplace can take it home and cause stress in their private life which then reflects back into the workplace

My generic definition of a manager in this list is a strategic or tactical role, from main Board director down to line manager.

Therefore, from my own experience over many years, both as a Director of Operations and Management Consultant, my observation is that management are by far the most significant cause of stress in the workplace. This is logical if you think about it because these are the people who define the workplace.

The workplace that I speak of is probably one of the most stressful. Investment banking operations are extremely dynamic, constantly changing to meet new market demands, every transaction dealt during a trading day must be processed that day, imperfect settlement means that on a normal day some 30% of transactions fail (significant funding and hedging cost considerations), more on a volatile trading day, and little errors can result in a high cost. A typical trading day could see some USD 3 billion of turnover with an average transaction value of some USD 4 million or equivalent in other currencies. An error of just 0.25% on such volumes could result in a daily loss of some USD 7.5 million – the cost to run such operations for 1 year. So the stakes are high, and there is no room for errors.

With this background in mind it should not be too difficult to imagine the impact of any of the stress situations that I have identified above. During my career I have experienced the stress caused by poor management ranging from excessive demand on staff both in effort and time, fear, incompetence, poor leadership, breaches of human dignity, mental cruelty, demand for favour (including sexual), and physical brutality. I have experienced the human impact caused by workplace stress, whether it be mental breakdown in the workplace requiring long-term medical treatment, broken marriages, dropout, and even a premature death resulting from a mental beating from a tyrant director. In the environments in which I have worked it would be very unusual not to experience the extremes of human behaviour as it is a dynamic people business, and attracts some of the most aggressive people, many of whom have no understanding of compassion, or consideration of the impact of their decisions on others.

Examples of managers who rule by fear and/or dictate are plentiful. These people are particularly bad if they have an emotional character, and/or are very insecure. If these people are given too much power they can raise havoc in the workplace. Whether they like you or not carries more weight than merit, and total loyalty is a pre-requisite irrespective of how bad the leadership, or poor the business decisions. Very much also depends on their mood on the day resulting in erratic business decisions. Sacrificial lambs are a feature of such people as they comply with the final phases of poor management, i.e. punishment of the innocent, and decoration of the uninvolved. A manager makes a mistake; some innocent underling becomes the sacrificial lamb and loses their job.

For those not familiar with the phases of a management doomed for failure I will recount the origin of the eight original phases, which I see have now been condensed to seven or even six. In the mid-1970’s I was with Chase Manhattan Bank engaged in a project being managed by the consulting firm Arthur Anderson (no longer with us). After the first year the progress of this project was so dysfunctional that a group of us within the bank compiled the equivalent of a university Rag Mag for Christmas 1977. We identified the phases of our dysfunctional project as Confidence, Enthusiasm, Confusion, Disillusionment, Panic, Search for the Guilty, Punishment of the Innocent, and Decoration of the Uninvolved. For those who remember we also designed the tie with the motif of a picture of an anchor with a ‘W’ underneath it as presents for the associated Arthur Anderson staff, and still widely available in the City of London. This was not my first experience of poor management, and the associated profound stresses on the staff, but it was by far my most prolonged period of continual stress as a result of chronic management.

I was later asked to restructure an investment bank where the existing debt securities operations was a shambles. Operations staff were working an average 60 – 80 hours per week, there was no integration of the various functions involved, politics and finger-pointing was rife, poor transaction processing was the norm, moral was non-existent, and systems were wholly inadequate.

Having immediately realised that the executive management was located 18 floors above the operations totally removed from what was happening, and the various departmental heads were lacking the knowledge required for the business, my first task was to make it clear to the management all the way up to chairman of the bank that there would be no interference, that no-one, including the MD and Chairman, could request anything from any of my staff without coming through me first, and that my authority extended across the trading floors. I also refused to join them, preferring to have my office within the operations area (which was later mimicked by the MD). As the former head of settlements had suffered a nervous breakdown I recruited a known entity to fulfil this role, and replaced all department heads who were either not qualified, or not capable. Within 3 months anyone still on the floor at 6pm had to write down why they were still there, and put it on my desk. This is a psychological process more for them than for me as they have to read what they have written, and thus ask themselves whether or not it is credible. I needed them to go home to their families, and return fresh the next day to meet the ever present challenges of a new trading day.

After 25 weeks we had a fully integrated professional operation with new in-house systems. Politics on the floor was actively discouraged, and my door was always open to anyone on the floor for non-business related issues. At least twice each year we had informal gatherings for all staff and their families at which other halves were actively encouraged to raise any concerns they had. For every 5 people on the floor a representative was appointed, and these people were encouraged to meet together monthly to discuss any issues affecting the working environment (necessary feedback). Their output came directly to me, was taken seriously, and corrections made when necessary. We had a hard working, but happy group of people with the only workplace stress being that caused by the normal everyday imperfections in the business sectors in which we operated.

From experience I would suggest that the maxim for a stress-free workplace is to rule by consent, and lead by example.

Before restructuring this investment bank it was losing some £2 million per month through stress related errors caused directly by poor management. Therefore corporates need to understand that the overwhelming cause of stress in the workplace is poor management. Neither poster campaigns or denial will address this problem. The impact on the bottom line can be substantial if such stress is not taken seriously.

Investment Banking – The Way Forward

univestInvestment Banking – The Way Forward

Having previously looked at the history of investment banking, and where they are today, what is needed in the future to ensure the credibility of these important banks.

Even today, post the 2007/08 meltdown, we find the mavericks still essentially in control of many of the investment banks, 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 we have defined 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 Role of Regulators

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, who would have to seriously increase their skills, 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.

Regulators such as the FCA in London do not have remuneration structures at a level to attract the people skilled in such instruments. Why regulators appoint youngsters when there is a vast body of 50+ knowledge and invaluable experience who may desire a more relaxing environment than the daily frenzy within the banking environment to see out their days. It was the smart youngsters who were encouraged by the mavericks to engage in casino transactions, without knowledge of impact, thus bringing the system to its knees. If regulators are to regulate the markets against transaction types that will create havoc then they need a ‘poacher turned gamekeeper’ approach to recruitment – and reward these people properly. If this credibility existed within regulators then every new instrument proposed by investment banks should be approved for full or specific limited usage. Likewise, as a general rule, unregulated OTC markets should be seriously curtailed, if not banned, or fully regulated. Leaving a door even slightly ajar invites clever investment bankers to find a way through it.

There is no point or value in having regulators in different major financial centres who cannot exactly agree on how investment banks and products should be regulated. I believe that the decision by the SEC unilaterally allowing the US investment banks to increase their capital gearing to 40:1 was a major contributor to the financial problems through 2007/08. Not only did this encourage casino gambling by investment banks in the USA but also provided a competitive edge to US investment banks that had to be mirrored throughout the whole investment banking community to maintain a level playing field. Securities and associated derivatives are the essence of a global capital markets and, just as with Central Banks, requires one central governing body regulating capital adequacy and risk. Regulators throughout the World have to be in harmony on the essential capital and risk management of investment banks, and the products in which they can engage. This would also prevent anticompetitive meddling such as the EU Governments attempting to impose a financial transaction levy on banks throughout Europe which would clearly be more detrimental to London than anywhere else.

It might also be worth considering nomination of major financial centres in the World where every investment bank in those centres operated under identical rule sets. Indeed this idea could be expanded to contain all investment banking activities to these major financial centres and thus all investment banking would be under the same regulatory umbrella. Much of such investment banking activities occur in the recognised major financial centres today so this would not be onerous to implement.

At the beginning of the widespread use of International securities in the 1970’s every Eurobond instrument was supported by an identifiable asset, even if just a Balance Sheet. This provided a clear understanding of the risks involved with holding the Eurobond. When more complex securities such as asset-backed securitisation came into being there was still a pool of assets that could be clearly identified. With mortgage-backed securities the asset cover was usually provided by a ‘AAA’ rated monoline insurer credit wrap (without stressing the Balance Sheet of the monoline) thus the asset was the Balance Sheet of the monoline insurer backed ultimately by the underlying property assets. Today it is very difficult with many securities products to adequately identify the underlying asset in a direct way, if indeed any such asset exists. As existing securities are partially stripped and repackaged the underlying asset becomes blurred, and there is no fundamental economic benefit that can accrue from such instruments. So is it time to retreat from synthetic casino instruments of no real economic value and thus ensure that there is a clear economic reason for the issue of any securities product, including derivatives. In recent years banks have used casino instruments such as the Snowrange issues that essentially bet on stock market activity or interest rate movements to raise cheap capital. Having studied a number of these issues I am disappointed that banks need to use such nebulous mechanisms in this way when, if structured with some thought, they can provide a needed and valuable project finance collateral instrument, especially in developing economies, and which achieves the same objective for the bank, but also provides real and identifiable economic benefit. Perhaps investment banks should use their financial skills to revert to structured project finance to win back credibility. If investors are provided with a continual flow of instruments which are no more than a casino gamble then this consumes capital that could be more usefully employed in economic growth. If regulators remove casino products from investment banking then investment bankers have to apply themselves to raising capital for economic activity. This would also force mainstream banks to use depositor funds for lending purposes rather than engaging in casino gambling.

 

The Role of Compliance

It is very rare to meet a compliance officer within an investment bank with the knowledge and expertise to be accepted as a positive contributor to the business rather than the person to be avoided as a constraint to business because of the ‘if in doubt, say no’ where doubt can be interpreted as the lack of knowledge and understanding of the business.

Compliance officers are essentially the eyes and ears of the regulators. Therefore their knowledge needs to be thorough, and their role clearly defined. In my early days at Citicorp we had compliance in the form of an internal audit team the head of which reported only to the President of the bank, and with the absolute authority, without the consent of the President, to close down any operation or entity that was considered non-compliant. Internal audit consisted of a small team of inspectors that could go to any operation anywhere in the World without notice. Within each corporate entity there would be representation proportionate to the size of the entity and who reported only to the head of internal audit. They could summon the inspectors if they felt that something was wrong, and had not been corrected to their satisfaction. Believe me that this internal audit team put more fear into every aspect of the business than any compliance team I have encountered post-big bang. Bob Diamond suggested that Barclays had some 200 compliance officers yet he was still allowed to operate as he pleased. Compliance similar to the internal audit team I experienced at Citicorp but where they are paid by the bank, but ultimately report to a senior regulator, should impose much needed discipline into investment banks, especially at a senior level. However, such compliance officers need to be well trained, and worthy of the power that they wield.

One aspect of compliance which I consider unwieldly is the amount of written documentation involved in this process, much of it in a legal jargon. Is it reasonable to expect our compliance officers to be trained lawyers, or is it more important that they understand the business, the products, and the markets? The more cumbersome the role of compliance, the less likely that it will be effective. Therefore I would suggest that the whole concept of regulation be re-visited to determine the type of regulatory structure that can be reasonably and effectively implemented.

Much of who can engage in what activities can be controlled by rule tables within competent computer systems. If new products are pre-vetted by Regulators then, again, computer systems can control what transactions are admissible, and in what size, volume, etc. This was all possible in the late 1980’s and early 1990’s with the advent of AI. Technology has moved on to a more mobile capability, but the challenges presented by allowing high value transactions to be executed using such technology do require extensive risk/reward assessment where convenience is the very last consideration. I have experienced the attempts by traders to circumvent rules built into systems. For example we had a fixed income trader who wanted to step out of their allowed range of traded instruments to engage in gilt futures. A trader authorised in this product was on leave, but somehow had allowed his login details to become known to the fixed income trader who used this information to access the gilt futures markets. Unfortunately for him the computer systems knew that the gilt trader was out of office so an alert was posted to the trading floor manager, the head of settlements, the compliance officer, and the director of operations (me). Thus this potentially very expensive transgression could be swiftly dealt with.

This level of control is relatively simple when trading is contained to a trading room but, now I understand that there are traders who can use their mobile phones to trade from anywhere, and I  am also aware of trading stations at the homes of traders. This poses enormous problems for compliance. I would propose that unless every aspect of any transaction can be properly and fully recorded, including any and all voice communication, then trading should be contained to a specific trading room. Remote trading stations pose significant risks, not least from hackers. If hackers can infiltrate the most sophisticated (and budgetless) systems in the intelligence community then this is a risk too far. Furthermore remote trading opens the door to orchestrated trading, whether market manipulation or book distortion. If one analyses this problem laterally there is no excuse for remote trading out of hours as processes to overcome the global nature of trading were introduced in the 1980’s to roll active positions to a trader in the next time zone with instructions on how to react in the event of certain market conditions. If these market conditions do not arise then the position will revert untouched to the originating trader at the opening of the next business day.

Trading practices today centre around the ‘convenience’ to the trader, and the argument won on the basis of ‘profit’. A number of very expensive and publicised trader problems have occurred as a result of such practices, and I would wager from my own experience that many more have gone unreported. It is time to change the argument to one which states that if any trading practice cannot meet robust compliance requirements then such practices should not be allowed.

A Change in Culture

Although the regulatory and compliance structures outlined above would provide a more mature and robust environment for investment banking activities, the changes required to the current risk taking attitude of traders will not occur without a radical change in the way that investment banks are managed. Soccer players are a reasonable analogy to traders because their career is short-term, as is their perspective. I think it is arguably universally accepted that Sir Alex Ferguson is the most successful and respected soccer manager in the World. We know him as a strong character who can build and mould successful soccer teams using a well-honed balance of discipline and encouragement of flair with his players. The players know that Alex is the boss, and know that his words are essentially law. He instils a belonging in his players to Manchester United Football Club, the most renowned soccer club in the World, and commands loyalty and respect from his players and supporters alike. If any player thinks themselves bigger than the club, e.g. Beckham and Ronaldo, no matter how good a player, they are sold on as they have clearly forgotten from where their fortunes derive. Players such as Scholes and Giggs have been loyal to the club for the whole of their professional football career even though they were both World-class players who would be welcome at any other soccer club in the World. Players such as Cantona, who had such a bad reputation and not wanted by any club, was given an opportunity to redeem himself by Alex, and proved to be a great and loyal asset to the club for the remainder of his playing career. In a slightly different light we see that every Formula 1 driver expresses a desire to drive for Ferrari at some point in their career regardless of how Ferrari is performing. And note that these people vocally praise the support teams that make their success possible. These are success stories in an environment of high energy, high risk, short career span people who want to belong and are prepared to openly express their commitment and loyalty. How could investment banks learn and profit from a culture change that encourages long-term loyalty in a team structure that strives for success as a collective rather than individual reward.

Managing any self-respecting professional investment banker, whether deal origination/execution, support operations, or systems is a very special skill. These are not conventional people. They live on the edge of the box or totally outside of the box, and not willing to comply with boring rules of convention. This is the essential characteristic of their ability to be creative and productive in such an energetic environment where things happen in the moment with no dwell time to consider. They must have confidence and conviction supported with knowledge. If they have been through higher education, and succumbed to conventional wisdom during the process, they are unlikely to survive no matter how bright they are. Like soccer players they have individual skills and flair which needs to be positively moulded into a successful team. Teams of like-minded people create a sense of belonging and loyalty as a natural progression of working together. The management of such people needs to provide a suitable working environment which contains the necessary constraints regarding risk and excess without trying to apply any conventional management techniques that will stifle performance. Like the soccer players they are contained within the boundaries of the playing pitch, where they are encouraged to combine their individual talents to win the game within the constraints of the rules of the game. In our analogy to Alex Ferguson all team members know that the manager has a formidable knowledge of the game.

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 team captain in our soccer analogy 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 (the game).

Likewise traders should not be allowed to determine their own strategies without reference and approval of a detached COO – the Alex Ferguson role. Traders who cannot properly articulate their proposed activities in a coherent manner should be refused the right of execution.

On the subject of behaviour it can readily be demonstrated why a trading director is generally not the right person to manage the discipline of traders – not least because the director of trading is one of them – they are the pack, and the trading director the pack leader. The trading director considers the loss of a good trader before the serious nature of his behaviour, and the behavioural impact on the other traders by forgiving unacceptable behaviour. I am aware of forgiveness of extremes of behaviour throughout the investment banking sector, but certainly not exclusively to it.

If we look at banks that have either failed (Barings, Lehmans), or banks that have suffered large losses under the heading of ‘rogue traders’ (SocGen, UBS), we will find a common denominator – the front-office was all powerful, and the back-office were considered irrelevant people with no voice. I know that this attitude to back-office exists in many investment banks today, yet a good operations support team is equally as valuable as the front-office in securing, realising and protecting revenues. If allowed to properly engage they provide valuable input to traders and are valuable eyes and ears of the COO who controls all of these activities. The COO provides the boundaries of the playing field, the rules of the game, and the moulding of all of the players into a team, including the Director of Trading whose natural self-preservation and ego will provide some initial hurdles. Having seen this in action turnover of staff diminished to an extraordinarily low level, and the ability to cross-cover in times of volatility was exceptional.

The Bonus Culture

How many investment banks still have the perverse attitude that traders should receive vast bonuses whilst the support function that at the very least minimises the cost to do business receive only a nominal percentage of salary. This attitude is so wrong in every respect and is an inherent facet of the corrupt culture within the investment banking sector where the top people take care of themselves, and spread a few crumbs for those that actually made their profits possible. A good support operation controls the downside risks thus more of the income is translated into profit.

Can we change the existing bonus culture in a way that it will be adopted throughout the investment banking sector, help to avoid reckless transactions, and encourage more term loyalty of investment bankers. I have listened to a number of options in this direction, especially from grandstanding politicians and media reporters. However none have grasped the nature of bonuses in the investment banking sector so their suggestions, whilst sounding good to their audience, will be rejected out of hand by the bankers.

When sales people of any product or service complete a transaction they are generally entitled to a commission within a short time frame as part of their remuneration package. This commission is their incentive to perform and is the general nature of the sales process throughout the World. Some transactions involve a term timeline to completion so commissions are scheduled according to the value received at various points along the timeline. Some sales involve a sole sale person, others require a team approach and thus a commission pool is created and the value of this pool distributed to each team member at periodic interval tied to the value received by the company. Such commissions are referred to as bonuses in the investment banks, but otherwise share all of the above characteristics of commissions. I have already discussed the origin of bonuses in a previous blog. So how can the bonus system be modified to help to properly reflect performance, as well as to encourage loyalty. It is worth noting that an investment bank can have a daily turnover equivalent to that of a major corporation over a whole year, so understanding scale is important.

Deferred bonus for completed transactions is neither popular nor equitable. The bank has the value of the transactions in its profits, and thus the bonuses should be paid. It is also counterproductive as it causes discontent, and a headhunter can readily negotiate a payment of such deferred bonus as an inducement for a good trader to move. Alternatively, for a term transaction, a bonus should not be paid until the bank has accrued real value less any required contingency for future risk until such time as the transaction completes, and is without further potential liability. This is an equitable approach regardless of sole trader or team, and the latter case will probably have the greatest impact on bonus culture.

My experience suggests that the more important issue to be addressed by investment bankers is whether or not it is more appropriate to engage in pool bonus structures to encourage team performance, and thus loyalty. I am in favour of pool systems for a number of important reasons. Firstly and foremost it does encourage team performance which significant reduces the possibility of rogue activities, and provides a natural cover for sickness and holidays. Other benefits include natural selection in that if any member of a team is not performing this becomes immediately apparent making the exit of the non-performer self-evident.

As for quantum, remember our soccer players, Formula 1 racing drivers, and their short career span. I have experienced many traders freeze or completely fold at their desks over the years. These people will never trade again, and probably not work again so I do not resent high bonus payments as it might well be their last. The only time I have exception is when these traders are so greedy that they always look for ways to trade outside of the acceptable range of activity, and will not even consider contribution to a pool for the people who support them, and without whom they would not make any bonus.

Summary

From my experience the counterbalance resource that represents our Alex Ferguson role is an executive COO with the following characteristics:

  • Highly experienced in all aspects of investment banking – but not from a deal origination background
  • Has control of all aspects of the operational business base including risk, exposure, compliance, settlements, funding, and systems including origination/execution staff discipline, but excluding business daily strategy within approved guidelines.
  • If there is an investment bank CEO then this COO should have equal status and equal responsibility to the Board. If there is a parent company then both the CEO and COO should have equal representation on this Board.
  • This COO should be the main contact of the investment bank with regulators such as the Bank of England.
  • This COO should not be obliged to accept market sensitive information without the opportunity to check such information with the source.

This resource will provide the counterbalance to the ‘Bob Diamond’s’ of this World and preserve a more stable environment without loss of business opportunity, and without loss of credibility. Under such a structure rogue traders would be confined to history as there would be no means of hiding such activity, and any activities outside of risk and credit lines (which can occur during a trading day) would be monitored in real time and corrected within that trading day.

There is no doubt that the ‘Bob Diamond’s’ of investment banking are valuable resources as deal makers but if the bank is to achieve stability and credibility such people need a tight rein to curb their natural tendencies to push the boundaries beyond reasonable limits of risk and exposure in the name of profit. However, giving such people executive power is tantamount to giving a nuclear warhead to a fanatic. The Peter Principle needs to be applied with rigour, regardless of the demands/charm for executive status ‘as a requirement to perform’. They can assume the title of ‘director’ for market purposes, but without executive portfolio.

I have no doubt that, assuming that such existing people can be persuaded back to their deal making tasks, there will be continual clashes of personality and will to regain their executive control as their deal making ego will see robust management as a constraint to profit generation. But I have already referred to the specialist management skills needed within an investment banking environment, and shareholders must support this position instead of listening to the charm of fool’s gold from reckless risks. Assuming that you can walk into a casino, put all your money on ‘00’ at the roulette table expecting to win, invariable ends in tears.

The outcry about bonus payments need to be put into perspective, albeit they need to be rationalised as previously described to encourage loyalty and fair distribution.

Robust management supported by a regulatory system which has professional competence and provides pro-active oversight with universally accepted rules of engagement throughout the World will provide the framework for investment banks to perform their specialist and fundamental role in global economic recovery, and its continued growth. This does not mean more regulation by grandstanding politicians (just look at the mess they are creating in the Eurozone debacle). It requires a unification of existing regulation, and then implementation with the required skills. Investment banking is a global business, and needs a uniform global platform of regulation.

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.

Where are the banks today?

univestWhere are the banks today?

Having explained the history associated with where the banks are today, I would now like to examine the current situation.

Ironically the banks are essentially in the same situation as they were in 1986/87. Then they had spent enormous excesses preparing themselves for the new era of investment and corporate banking, they needed more capital to expand into new business opportunities, and remuneration packages reflected the desire to attract the most prolific profit generators. Today we have the enormous losses of the banking collapse in 2008/2009, enormous sums paid to regulators in the form of fines, large claims for damages including large legal bills, demands for more capital adequacy, and remuneration packages still need to attract profit generators.

There are essentially two ways to increase capital: a) asking investors for more investment, or b) translating profits into capital. The latter is by far the easiest with no impact on existing investment returns. The former puts pressure on profit generation to maintain a good dividend yield, which then places pressures on costs to support the remuneration required by the profit generators.

But are some of these profit generators really worth the cost? How many of these profit generators produced large profits through excessive risk or even market manipulation, have been paid their bonuses and moved on, leaving the bank with credibility problems and fines exceeding the benefit of the profit generator.

Let us look at an extreme example. Interest rate swaps are a sophisticated instrument that should only be sold to qualified professionals. Yet some profit generator convinced someone in the banks that these instruments should be sold to small corporates (SME’s) that would have difficulties even qualifying for a straight-forward interest swap under normal corporate banking rules. The structure of interest rate swaps are so complex that there should be more pages of cautionary notes attached than explanation of the mechanism of the instrument. And the banks would know that base interest rates are not going anywhere fast. So do we assume any interest rate movement is geared towards the bank’s borrowing cost? If so then manipulation of these rates by the banks must also be an issue.

Last year I designed a Documentary Credit solution for a tri-party tolling deal (a raw material supplier provides materials of a given quality to a producer of goods with a third party guarantee buyer of the finished goods thus guaranteeing payment to the raw material producer, i.e. guaranteed cash flow) over three countries. The safest mechanism was a conditional tri-party letter of credit which is only a small step removed from a conventional letter of credit. Although the banker to the third party buyer was completely satisfied with the structure they were not convinced that the financial director of the third party buyer fully understood the structure, and thus would not engage. An interest rate swap is streets ahead in complexity to such an instrument, and I would be very surprised if any of the financial directors of these SME’s remotely understood what they were being sold. Even worse I would doubt that the corporate banker selling this product knew any more about these instruments than the script provided by the investment bank. As swaps are purpose designed for a specific need on a Balance Sheet, who was looking at the SME to define their need, and to ensure their understanding of what was being offered?

I think it is clear that the banks are totally focussed on income generation from wherever it thinks it can be obtained. In too many cases the mavericks are still in control. So how can they generate these much needed profits?

Firstly, and foremost, they cut operating costs. Within investment banks this is most certainly a false economy, but it suits the mavericks. A professional operations director, properly respected by the Board, is the first line of defence to protect the bank from abuse. If we look at the problems over recent years in the likes of UBS, BarCap, SocGen, Deutschebank, JP Morgan Chase, et al, none of these problems could have occurred had a solid operations base been in situ. When I ran operations for various banks there was no possibility that a trading director could override any decisions by me on credit, risk, trading volumes, trade procedure, compliance, discipline, funding, hedging, and systems. My head of settlements, who knew more about the markets than any trader, attended the morning strategy meetings with the traders. If he said that trading could not occur in certain instruments, or specific securities issues, or ticket sizes, this was not a request but an instruction. Trading was not allowed over mobile phones. No dealer could get into the dealing room before 7:30am unless by specific authorisation, and only with a settlement clerk present. Our systems had artificial intelligence monitors on all traders, positions, risk, and credit in real time, monitored by me, head of settlements, and financial controller. Traders did not have autonomous computer systems, yet we always had the most sophisticated trading systems on the street. Our counterparties knew that if they did not confirm a trade with our settlement department during the same trading day then we had the right to void it, so dealers could not hide deals. All funding, own book hedging, and bond borrowing was undertaken by settlements on a book basis to ensure that we were properly covered at minimum cost.

Now the mavericks having taken control of, or suppressed, the operations base, what I see today horrifies me in that there is little or no real control over what many business generation platforms are doing in the name of the bank. They are treated like gods, or at least divas, and anyone who speaks out against what they are doing is destined for unemployment. The senior management have a fixation that if they do not comply with the absurd requests of these people that they will take their ‘skills’ elsewhere (and thus risk their own personal rewards). However, put a senior operations person in place in every bank, and who knows what they are about, make them more powerful than the trading director, and the mavericks have nowhere else to go. Alternatively if they are likely to leave you with a horrible mess to clean up after they depart do you want them in any event?

Having entered investment banking in the mid-1970’s with Citicorp, now CitiGroup, my first job was to find a way of providing Walter Wriston, the Global CEO, with global real-time positions of the bank in all markets. This is before the internet – indeed we created the first global corporate intranet in 1978 to achieve this requirement. With today’s technology this task is not only simple, but should be fundamental if any control is to be placed on banking activities.

What about the banks engaged in corporate business? Again horrific. Many so-called corporate bankers that I have encountered in recent years are no more than information gathers for some faceless people hidden from view in dark places. These faceless people are the arbiters of all activity with corporate clients, yet have never met any of them. Gone are the days when a corporate banker, certainly in the SME arena, can read financials better than the financial director of the company, and actively advise on how the financial position can be improved prior to bank lending. Now it is more akin to lending against security without any consideration as to the quality of the lending instrument – just the level of income that can be achieved. Surely it is in the bank’s interest to have quality people guiding their corporate clients and thus protecting their investment, not merely taking security and destroying people’s lives.

Just as an illustration of how dire the training within banks really is, I went into a large branch of Barclays bank in Holburn in London where their principal client base is likely to be corporate clients. I wanted to send a SWIFT payment in USD. I was told, by their resident corporate banker, that Barclays Bank do not send SWIFT payments. This is a sad reflection on where banking is today, and it needs to change quickly. My next blog will look at the way forward.

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..

Do the political problems in the USA over recent weeks indicate that democracy in the USA is flawed, and now, with self-sufficiency in energy, can they be trusted with the obligations of a global reserve currency?

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Do the political problems in the USA over recent weeks indicate that democracy in the USA is flawed, and now, with self-sufficiency in energy, can they be trusted with the obligations of a global reserve currency?

The brinkmanship demonstrated over recent weeks between the Executive, House of Representatives and the Senate reveals a total disregard for how a few ultra-right wing politicians can cause great concern in the international markets. I argued in my blog, EU/Eurozone – Start Again or Plod On – A New Government, that having the upper and lower houses in a democratic system both elected, especially at different times in the economic and political cycle, can result in stagnation of the governmental process.  This has to be a flaw in the democratic system, especially when just a few people can hold the World economy to ransom. The USA has shown time and time again that, in any global issue, their own interests are most certainly the top priority. Albeit that, if my calculations are correct, this stand-off stagnation has occurred 18 times during the past 30 years does this fact make the global uncertainty created any more palatable? As USA debt reaches levels that are unassailable in terms of any hope of repayment is it time to seriously look at this problem?

The debate that I think is needed is related to the introspective nature of the USA, as provider of the global reserve currency. Only some 15% of USA citizens have passports, very little is taught in their schools regarding the World at large, they are taught that America is the best place in the World, they are the biggest and the best at everything (they have a World Series in a sport that is only played in the USA), and very few can indicate on a map of the World where major countries are located, let alone cities. Indeed I took my teenage daughter to the USA some years ago where she was told that a nominal relief in Boston was the largest relief in the World, and when we walked past the CBS building in New York there was a screen proclaiming ‘America, the oldest surviving democracy in the World’. Is such a culture to be trusted with the broader obligations of the holder of the global reserve currency?

Up until recently one of the fears within the political circles of the USA was their increasing dependence of the greater World for strategic resources such as oil & gas. This did provide a more tempered approach to how they dealt with international issues. However they have now become energy self-sufficient so will this change attitude to international issues as they recede into their natural state of introspection?

The other side of the debate is what is the alternative? Forget the Euro or Renminbi replacing the USD as the global reserve currency as neither is remotely qualified to assume this role. However it was not so long ago that the USD, and thus the World economy, was linked to the Gold Standard, and this was removed overnight; driven by the UK. Can we devise an alternative that can both commands the level of confidence required by the World markets to be acceptable, and disconnected from the introspective political wrangling that artificially impacts it credibility, and thus stability.

I am reminded of structures in the past such as a basket of currencies, e.g. Special Drawing Rights (SDR’s) but these can be unduly influenced by stronger participants, albeit more dampened than the impact of the USD as a sole reserve currency.

My thoughts are that there is a lateral solution out there, and long overdue. I also suggest that recent events make a solution to this problem ever more urgent as I do not see the USA reforming its political system to prevent the stagnation we have seen over recent weeks.

‘Interest Only’ Project Finance

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‘Interest Only’ Project Finance

Insurance instruments can provide valuable credit enhancement to capital risk, especially in environments such as, but not limited to, emerging and developing economies. Having mentioned ‘Interest Only’ financing in my last blog a description of this technique can only add weight to the intelligent use of the insurance markets as a valuable aid to project finance.

One of the major problems encountered with developing/emerging economies is that long-term capital for business development would be a preferred solution under normal circumstances, but the instability risks dictate short-term exposure. For certain types of project ( typically < USD 50 million requirement) where, for instance, there is a quality Western off-take to cover debt service, there is a technique that can be applied that utilises insurance products to change the country risk profile of the project and thus permit long-term financing on an attractive risk profile. This technique involves over-lending and traditionally works on the basis that the advance to the project includes an amount that is specifically used to purchase an asset, in the form of a deep-discounted instrument, to insert into the Balance Sheet of the borrower and which is pledged to the lender, and has a guaranteed maturity value equal to the total capital lending. The deep-discounted instrument is usually a stripped-USD Treasury or zero-coupon bond thus changing the risk profile of the borrower to that of the US Government for capital purposes. The borrower pays interest (albeit at a premium rate over a comparative rated borrowing, but much lower cost of finance than a straight borrowing) on the total borrowing through a lien over the off-take proceeds. (Please do not confuse this process with so-called leased assets that cannot be pledged)

The benefit of this structure is that all debt service by the borrower (which is all interest) is normally tax deductible, thus making the effective cost of money relatively cheap. Furthermore, so long as the borrower has no beneficial interest in any excess value of the US Treasury on maturity then it is normally possible to negotiate a tax exemption with the relevant tax authorities relating to the capital gains over the lending period. In reality all that has happened is that the lender has inserted a valuable asset, that can be pledged, into the borrowers Balance Sheet that otherwise would not be capable of providing suitable security.

The advantages of a stripped Treasury solution is the fact that it provides an “AAA” rated security which is easily disposed of in the event that the lending terminates early. What is not known is the discount price at the time of such disposal, or the value of the security/collateral at any point in time throughout the term. This can be a problem with booking such a transaction. Furthermore the current 10 year yield on US Treasuries is too low for such purposes making the over-borrow costs too expensive.

Let us examine how we might improve on this situation using insurance products rather than a stripped-bond.

There are a number of insurers that offer guaranteed growth funds in various guises currently producing yields in excess of 8% p.a. Many are investment grade credits and, over a 10 year term, tend to out-perform bond yields. What is more interesting is that many of these insurers are also now owned by major banks. If the lender were to use the over-lending amount to invest in such a fund and use the policy as the Balance Sheet asset with assigned rights to the total value of the proceeds (which are generally tax-exempt) then two prime advantages exist. Firstly, the value of the policy cannot reduce in value irrespective of market conditions as the price of units cannot go down in value. The only factor that can affect the value is if surrender occurs early in the term in which case there are likely to be early surrender penalties (around 5%). Secondly, as such a fund will normally out-perform bond yields, there is likely to be a profit which can be secured as a maturity fee. Therefore, for a reduction in credit rating from “AAA” to probably “AA” we have achieved a far more stable collateral value and with a probable profit.

This type of structure only really works for financings of 10 years or more but demonstrates that the insurance market can facilitate financings that otherwise would not have been possible on very attractive terms to both borrower and lender. Some guaranteed growth funds will also provide life assurance cover as part of the fund package thereby allowing the lender to assure the lives of key borrowers at no extra cost yet provides more risk mitigation.

We have successfully executed such structures where the lending bank has used its own subsidiary insurance company investment funds to generate the capital redemption amount thus accruing all of the fund fees and charges for their own institution.

Let us extend this type of structure one step further to provide some interest cover in the event that the off-take does not generate enough cash flow to service debt financing. Most of these guaranteed growth funds have an encashment facility which can be used by the policy holder to draw regular income up to a certain percentage of the profits of the fund. A very simple calculation will determine by what ratio the initial premium needs to be leveraged in order to secure the require exit value whilst providing the capacity to draw income for both the interest cost of the leverage, and any underpayments on debt service. This would be invisible to the borrower, and would not remove the liability on the borrower to make good any short-fall. However it would prevent the need to reclassify the risk on the original loan in the event of an interest payment default.

Let us now attempt to define the benefits to such a financing through an example of a privately (socially) owned food processing factory in a emergent economy that suffers from the aftermath of a period of undemocratic control where asset values are difficult to define, and the legal framework makes any form of security charge unacceptable. The company requires to modernise its facilities in order to comply with the requirements of its major (good covenant) Western customers. The company has exported over 70% of its production to these customers with hard currency payments for a number of years, and their customers are prepared to enter into long-term off-take contracts with the company. The cost of the required modernisation is $25 million which would require a term of 10 years to service with no capital repayments in the first 2 years. Political Risk insurance is available at 2.75% p.a. but only for 2 years with renewal options at the discretion of the insurer. The off-take commitments would provide at least 2.5 times debt service cover after operating costs over the term. There is no active bourse. Corporate tax rate is 48%. Local borrowing costs, if such funds were available, would exceed 16% p.a.

As a banker this is an attractive project, and if this was a company located in a stable Western democracy this requirement would be a reasonably trivial project finance possibly using a combination of export credits, leasing structures, equity placement, term loans, etc. Given the environment in which the company resides, and through no fault of the company, the required financing using conventional finance solutions is practically impossible, especially with the lack of term political risk (primarily business disruption) cover. Even if a two year rolling facility were negotiated the company would be restricted on what it could do knowing that there was a possibility that the facility could be called if the political risk cover were withdrawn. Furthermore the combination of high interest rate charges and insurance premiums would make the cost very unattractive in terms of cash flow and investment strategy for the borrower.

We need to change the risk profile in order to structure a financing that will provide a financial environment that can reasonably be supported by the borrower, and will be an acceptable credit to the lender. Having determined that we can achieve the tax exemption for a stripped-Treasury solution on condition that we advance 10 year term funds we establish that the deep discount price is 44¢ thus requiring $22.5 million of over-lending. Let us assume after all costs and fees the total advance is US$ 50 million. Using a real template from a suitable guaranteed growth fund using a conservative 7.5% growth (8.5% yield) our $22.5 million will grow to US$50,659,488 after 10 years after all costs. As this yield is only nominally above bond yields it would be reasonable to suggest that expectation would be for a higher return. I should mention that once the gains in any years are rolled into the capital amount the guaranteed amount by the insurance fund is the new capital amount. We have now moved most of the capital risk to a friendly domicile and enhanced our credit rating to investment grade.

We now need to structure the interest payments. As we have an investment grade covenant on the capital repayment the interest rate can be set at a level which reflects this partial credit enhancement. If we assume that an “AA” rated lending would be LIBOR+1%, the covenants from the borrower’s customers would warrant no more than LIBOR+2%, and we can achieve cover for political risk inclusive of business disruption and force majuere albeit on a renewal basis at 2.75% on exposure adding 21 bps to the cost. Therefore we calculate that LIBOR+2.5% would provide an attractive return to the lender.

Banker’s Perspective

Loan:               US$ 50,000,000

Term:              10 years, bullet repayment at maturity secured by major insurer

Interest:          3 month LIBOR+2.5%, payable quarterly in arrears

Security:          “AA” covenant on capital, Quality off-take covenants for interest,

“AAA” rated political insurance for disruption of business

Fees:                US$ 2,500,000

Bonus:             Uplift on Guaranteed Growth Fund policy proceeds

Borrowers Perspective

Loan:               US$ 25,000,000 for modernisation, US$ 22,500,000 asset purchase

Term:              10 years, interest only

Fees:                US$ 2,500,000

Assuming for simplicity of illustration that US$ LIBOR was 5% throughout the term which would result in a total repayment by the borrower over the 10 year term of US$37,500,000

Equivalent Cost of funds pre-tax;     8.6% + Insurance Premium of 21bps

Equivalent Cost of Funds post-tax:   4.5% + Insurance Premium of 10bps

As can be clearly seen the introduction of insurance products has made an otherwise difficult transaction into a very attractive proposition for both the borrower and the lender. Furthermore there is the goodwill element between the bank and borrower for future business as the emergent country stabilises. As a footnote, the fund management fees indicated by the example were US$18,383,979 thus making this financing substantially more rewarding for all financing parties than an alternative conventional lending.

There is a further level of sophistication to this solution which reduces the initial capital risk to the lender, but requires more attention to the capital risk at the ultimate exit. If it is anticipated that the instability of the country of the borrower will significantly improve over the financing period, and the insurance fund is a consistent performer, then it is possible to reduce the over-borrow amount by gearing the amount placed into the insurance fund at a much lower cost (capital and interest of the gearing amount guaranteed by the insurance fund and thus LIBOR+1% is achievable) benefiting from the yield on the growth of the gearing amount less the interest cost). We have successfully geared at 3:1 with good results but a full explanation of the dynamics of this enhancement is beyond this blog discussion.

The superior nature of Syndicated Insurance for Project Finance

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The superior nature of Syndicated Insurance for Project Finance

Syndicated Insurance for construction projects is well defined for projects throughout much of the world. However other types of project require a tailored approach depending upon the defined risks involved. But the principle of syndicated insurance for project finance is not just an insurance solution – but a global comprehensive risk management tool for qualifying projects.

 Integrating comprehensive event risks into loan/bond documentation was initiated by myself with invaluable help from Dennis Parker (from Aon in London), and Clifford Chance (law firm) both in London and New York. It took 7 months of negotiation with bankers and underwriters to achieve a wording consistent with formal offering documents such as Trust Indentures in order for acceptance, albeit that it was the important endorsement of investors that finally achieved acceptance.

 It might be helpful to define the diverse range of insurance products available to the project finance specialist to understand the problem with the conventional approach to adding event risks to a financing, whether public or private placement, syndication, or bond issue. I would also include quasi-equity products such as convertible debt structures into this group.

Types of Insurance Products Available for Project Finance

Insurance products for project finance can be conveniently discussed from two different perspectives, i.e. those that require Political Risk insurance (developing and/or politically unstable countries), and those that do not. However the crossover point can be fuzzy as the need for such political risk is not only applied to developing or emergent economies but can vary depending on the term of a transaction for so-called industrialised countries. The fortunes of countries wax and wane, both through domestic political situations, and adverse effects of global economic conditions. The normal determinant is whether or not a country has an acceptable credit rating from Standard & Poor or Moody for the term of the proposed transaction, albeit  such ratings can adversely change for any country very quickly as we have seen in the Eurozone countries.

Just by way of example of how fuzzy the parameters for determining whether or not political risk cover is required in any of its various forms we only need to look at how many major countries or cities in the world would now require civil disruption, riots, or terrorism insurance cover for certain types of project.

Add to this the general myth that a corporate within a country cannot borrow at cheaper interest rates than the Government (sovereign debt) of that country then it is easy to understand why there can be confusion. Utilising insurance-based risk mitigation, which has the effect of credit-enhancing the transaction by effectively moving the domicile and credit rating of part of the risk, can easily result in lower costs of borrowing than the project country risk would otherwise dictate.

The general classifications of insurance products used in project finance are:

  • Investment Risks – Inconvertibility, Expropriation, Creeping Expropriation, War, and other Political Violence
  • Collateral Deprivation Risks – Asset Repossession and Deprivation, Civil Disruption
  • Non-payment Risks – Commercial and Political Causes, short medium and long-term credits, leases, Documentary Credits, Promissory Notes
  • Contract Frustration Risks – Including Wrongful Calling of Guarantees, Non-Delivery
  • Transportation Risks – In-transit risks
  • Credit Enhancement – Third Party credit, asset securitisation, cash flow securitisation
  • Business Disruption – Third party commercial disruption e.g. utility and transportation disruption
  • Transfer Risks – Repatriation of Investments, Debt and Leases payments, etc.

 

Project Finance Requiring Political Insurance

This is a specialised area of insurance as, by definition, the project is in a territory that has less certainty of political stability and/or appropriate legal structure than one would like in order to secure an investment or lending position in the event of problems. Such political insurance is available to cover a whole host of possibilities such as:

  • Confiscation, Expropriation, and Nationalisation
  • Forced Abandonment
  • Transfer Risk
  • Refusal of host Government of Repossession and Disposal Rights
  • Contract Repudiation
  • War, civil war, civil unrest,  and terrorism

However there can be a number of interested parties that need cover within any one project, and there can be a number of different scenarios that require the security of a political insurance wrap in order that they are effective. This is further complicated by the fact that it is not always possible for any one insurer to assume the total insurance package thus various legal platforms for each insurable risk need to be interpreted and reconciled.

Bonding

One of the prevalent features of international commercial life is the need to issue on-demand guarantees to satisfy advance payment, performance, and warranty obligations. Bank bonding has been the traditional source of such bonding but this is another area where insurers can provide a far more reasonable and appropriate instrument.

If we consider conventional bank demand bonds it is easy to understand why they are an onerous burden on the provider, and gross overkill on the part of the receiver. The onerous burden on the provider includes the capability of the receiver to call the bond at will without declaration of default, and the burden is then upon the provider to prove whether or not there is good and reasonable cause, and if not then the burden is upon the provider to reclaim their money which is both time consuming and expensive. Banks do not generally accept any responsibility for payment under an invalid presentation of such bonds. Although such risks as invalid presentation can be covered through insurance this is yet a further unnecessary and avoidable cost.

Having studied this problem for some years it became apparent that it is frequently possible to clearly define the conditions that would reasonably justify a call on such a bond. Therefore it has been possible to negotiate with insurers the development of a demand bond that is more reasonably aligned with the purpose of its existence, and callable on demand by the receiver given a specific event of default by the provider. This bonding has a number of significant advantages over bank bonding namely:

  • The bond is an off-Balance Sheet instrument for the provider and thus no adverse gearing implications;
  • It does not consume valuable bank facilities that might otherwise be better utilised;
  • They are more flexible in that there can be a number of callable events with different levels of monetary penalty;
  • It is usually cheaper.

The practical application of such bonding is fundamentally unchanged other than the bond will be defined in a contract which will also define the events under which the bond can be called, and the associated amount. In the event of a claim by the receiver the only change is that the receiver must lodge a formal notice of specific default with the insurer to invoke the demand for payment. Such payment will be made upon presentation of such claim. In the event that the claim proves invalid then it is the insurer, not the provider, who will pursue recovery. This takes the burden from the provider and imposes a more disciplined attitude to default claims by the receiver.

There are a small number of specialised brokerage houses in London that specialise in the arrangement of such bonds.

Problem Summary

Albeit that there is a whole spectrum of insurance-based products available that can be beneficial to a project financing the problem is that we have a multitude of insurers/underwriters using different types of wording on different platforms, and even in different legal jurisdictions. This does not make lenders very comfortable as they do not know which insurer is assuming what risk, or whether there are gaps between the various wordings that potentially leave the borrower, thus lender, exposed. Furthermore many of these products are annual renewable whereas a typical project will involve 5 – 10 years of debt service. The downside for the project promoters is that they would not benefit from the potentially large discounts from consolidated premiums, nor the benefit of reduced debt pricing because of the lack of confidence in the event risk integrity.

A Practical Example Using Syndicated Insurance to Credit Enhance Capital Risk

One of the major problems encountered with developing economies is that long-term capital for business development would be a preferred solution under normal circumstances, but the political risks dictate short-term exposure. For a lender or investor to consider long-term capital the event risk cover must look like an integral part of the asset risk financing, and be of a quality that the integrity and robustness matches that of the financing terms. Thus we need, at the very least, the matching concept of a single underwriter assuming the lead in the event risk package, i.e. syndicated insurance.

Rather than consider how to build a syndicated insurance product for a generic project I would like to demonstrate how this product was derived for the very first complete application of syndicated insurance. I had already used a subset of this idea for previous projects in Eastern Europe, and successfully applied it for an Interest Only financing that I devised and structured for a capital financing in the former Czechoslovakia written by Deutsche Bank, Frankfurt (look out for ‘Interest Only financing’ as a future blog).

The project presented to me was a requirement of USD 100 million for an oil & gas development and production project in Western Siberia, Russia and in which Deutsche Morgan Grenville was already an equity investor for the exploration phase, and a solution would have a co-lead of HSBC and Deutsche Bank. It was in the Yeltsin era in Russia and no-one wanted to invest or lend for Russian projects. The company was a joint venture between a USA company (provider of finance and drilling expertise) and a Russian company (owner of a valuable Exploration, Development, and Production Sharing Agreement (EDPSA) negotiated by the USA company). Even though the assets (oil & gas) were proven and considerable they were in the wrong place at the wrong time and thus conventional funding did not arouse any interest. At that time no public bond offerings had been successful.

An overview of the primary criteria that needed to be considered:

  • The terms of the EDPSA stated, as a condition, the need for evidence of the availability of all of funding needed to develop the field. Funds were needed for 3 years with repayment within 5 years.
  • The joint venture company was Russian (this was not safe then, and recent problems encountered by BP in Russia confirm that not much has changed). If USD 100 million was injected into the joint venture company it could easily disappear.
  • All oil had to pass into the state-owned Transneft pipeline as Urals blend and could be diverted to Russian refineries (payment issues & business disruption if otherwise sold)
  • Western Siberia is a frozen wasteland in the winter, and a swamp in the summer thus sand pads with interconnections would be required (transportation issues)
  • There was only one power station in the region – very old, and the workers had not been paid in over 3 months (business disruption risk as surface equipment such as separators and compressors need energy supplies)
  • Third party transportation risk of piping crude oil to Novorossiysk on the Black Sea.

In spite of the considerable proven oil reserves even the hardened oil & gas investors had no appetite for this financing unless the risk profile could be dramatically improved. It was obvious from the outset that merely attaching a number of insurance products to the investment would still not attract interest. The conventional source of a political wrap for this financing, MIGA (the insurance arm of the World Bank), wanted a 3 – 6 month review period and a large amount of money in fees with no commitment to provide anything.

Thus a different approach was needed if we were to credit enhance this offering to make it attractive. It was clear that we needed, at least, to tap into just about every insurance product in our tool chest, and which ordinarily would provide a complex mix of wordings, platforms, and jurisdictions.

Some of the primary considerations were:

  • This financing could not be a conditional debt structure as this would not satisfy the terms of the EDPSA.
  • Asking investors to provide equity (conventional financing for oil & gas for pre-production activity) would not work. Thus a convertible debt structure would be needed through a public offering to capture the largest market of investors available, and providing an element of liquidity to investors.
  • The USD 100 million could not be placed into the Balance Sheet of the Russian j-v company. A trustee arrangement would be needed where a credible third party acceptable to all parties, and especially the Russian partners, could provide confirmation of available funds, but only release funds against confirmation of agreed deliverables. This trust arrangement would also have to provide unconditional comfort to the investors that their money was safe from unauthorised call by anyone, including a Russian court.
  • In order to achieve the comprehensive range of event risk protection needed we would need to convince the underwriters that every risk that could be mitigated through good corporate governance has been identified and addressed, e.g. placement of a generator on the field to satisfy the energy requirements of the array of separators and compressors needed to keep the oil flowing to the pipeline.
  • A secure off-take of the oil from Novorossiysk by a trusted Western company well placed in that arena.
  •  All oil payment receipts would need to be directed to the trustee with the full co-operation of the Russian j-v partner, and the Russian authorities (payment of their share of the oil revenues plus any taxation due from the j-v company)
  • Managing cash flow to keep the fields producing in the event of any third party business disruption

Having agreed these requirements in principle with all relevant parties, Dennis Parker and myself prepared a single event risks policy inclusive of all political risks and bonding requirements (irrecoverable political disruption, i.e. forced abandonment, would trigger a full refund to all investors). Insurance risks had never previously been included in the main body of a Trust Indenture but I knew that if we could achieve inclusion for this issue the financing would be significantly more attractive to investors. Clifford Chance provided oversight to this process to ensure that the drafting was consistent with Trust Indenture requirements. This process was complicated by the fact that the chosen trustee was Bank of New York who wanted their obligations written under US law, and specifically New York State law, whereas the main body was under English Law with Norwegian Arbitration.

Whereas I was concerned that we would not find a suitable single lead underwriter for such a comprehensive package I have the competence of Dennis Parker to thank for a relatively easy task.

Both HSBC and Deutsche Bank agreed to put the package to the appropriate authorities for consent to launch the issue. The road show would be the litmus test. We organised presentations to investors in 14 cities in just 28 days. We were oversubscribed after the eleventh city, Toronto – we had a product that satisfied the most hardened of investors.

This project financing demonstrated that event risks and asset risks can rank pari passu with each other providing integrity into project finance that fits the requirement in difficult environments, and at an affordable price. The credit enhancement meant that we could set a coupon yield at 10% against sovereign debt of 14.75% for Russia at that time, and with a total insurance premium of just 1.75% per annum of actual exposure for the term of the issue. This is the power of syndicated insurance for project finance.

The superior nature of Syndicated Insurance for Construction Projects

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The superior nature of Syndicated Insurance for Construction Projects

Syndicated Insurance is not so much an insurance solution – more a global comprehensive risk management tool for qualifying construction professionals. The application to major construction projects was developed by myself and John Curran, an expert in construction risks insurance, to provide banks with a quality event risk package in order to facilitate rapid financing at a lower cost to developers. It took 2 years of negotiation, cajoling and proving in whole or part with construction professionals.

It would also be reasonable to acknowledge David Barnes, Executive Director of Construction Risks at Willis in London who championed this product within Willis.

Having been asked to explain Syndicated Insurance I would suggest that this blog is for the spectrum of construction finance professionals as I must assume a reader knowledge of the conventional process of construction finance and construction risks insurance. Thus this blog will outline the features, scope, comprehensive nature, and benefits of Syndicated Insurance for construction projects.

The objective of this approach was to provide a totally comprehensive, all-inclusive insurance package that would include, and commit the lead underwriter to provide all requirements throughout the debt service period regardless of when, in the project timeline, certain requirements need to be activated. This provides security to a lender that all event risk requirements are guaranteed throughout the debt service period. 

Features

The ultimate global comprehensive and integrated insurance solution, designed with project finance specialists to address principal and bank requirements with unparalleled service and risk management delivery

Specifically designed to incorporate all development risk mitigation requirements for the larger contractor, property developer, and construction professional 

Flexible in its application – select what is required in the most applicable form – with consistency in delivery and cover 

Aligned with concepts such as long-term finance initiatives to offer long-term indemnity up to 30 years to satisfy bank finance requirements, and maintain a consistent bank risk profile, even during delays and disputes 

Comprehensive inter-laced cover with a single, major underwriter to emulate the way that bank’s syndicate the debt financing component thus simplifying risk assessment, cover, claims and disputes

A comprehensive solution for the construction professional throughout the world with valuable new features not currently available with any other product

Non-collateralised bonding facilities available to limit unnecessary use of working capital – the financial and security benefits are immediate and considerable 

Many of the difficulties encountered in construction litigation are avoided, significantly reducing the possibility of lengthy disputes, or project delays 

Added value benefits include 3 or 5 year fixed pricing with a share of insurers profit, loss control and evaluation services provided without charge, 24-hour helpline World-wide including collateral warranty advice and claims services. 

Cover Synopsis

Contractors “All Risks”Includes full cover for works, temporary works, materials & plant, whether owned or hired whilst at the contract site, in transit to or from the site, or temporarily stored away from site

Financial Risks – Takes the pressure off the Balance Sheet by avoiding the unnecessary use of working capital and bank bonding – Annual bonding facilities for Performance, Bid/Payment, Maintenance/Retention, Highways Act and other commercial guarantees

Advance ProfitsEmployer and contractor indemnified against consequential losses following contract delay – Exceptionally wide cove including interest on loans and loss of rent

Building DefectsUp to an initial 12 years’ cover with options to roll – initial technical audit uniquely leads to an automatic option to purchase for all projects – electrical and mechanical services can be included – enhanced value to completed construction sites – immediate compliance with requirements such as the Latham report objectives and anticipated EU directives – includes post-development efficacy of new technologies

Professional IndemnityLiability arising from architectural surveying and other agreed professional activities – High premium discount for modest voluntary excess – wide subrogation waiver agreement

Public and Products LiabilityIncludes contractual liability and indemnity to principal – World-wide coverage – optional excess levels

JCT Clause 21.2.1Automatic annual facility – No individual Surveys – No specific contract underwriting

Directors’ and Officers’ LiabilityComprehensive cover for the obligations of Directors and Officers to meet existing legislation, company and employee reimbursement – World-wide coverage – no excess option

Employers’ LiabilityIncludes cover for labour-only sub-contractors, hired or borrowed persons, all other self-employed persons, and authorised work experience schemes. World-wide coverage

Property DamageA wide range of financial protection opportunities for completed off-site properties occupied by you or leased to other parties – consequential loss – contents and other assets

Fidelity GuaranteeNo mandatory system of check – generous discount for voluntary excess options – automatically includes money and goods for first and third party fraud

Motor FleetIncludes courtesy vehicles – third party claims management – automatic repair authorisation – no excess option

Terrorism & Civil CommotionIncludes Terrorism, Riots, Strikes, Civil Commotion and Malicious Damage including fire

Brown FieldIncludes latent defects arising from assuming certified brown field sites for development including asbestos and heavy metals

Environment ImpactIncludes environmental pollution as a direct result of development works

Political RisksFor International projects where the political environment dictates the need for comprehensive cover against Expropriation, War & Terrorism, and Force Majeure

CONTRACTORS ‘ALL RISKS’

Cover

Responds to obligations arising from all standard conditions of contract including:

  • JCT – Joint Contract Works Tribunal
  • ICE – Institute of Civil Engineers
  • GC/Works/1 – General Conditions of Government Contracts
  • Other International contract conditions

Cover is provided in the joint names of the Contractor and/or Principal for unforeseen events causing damage to the works, temporary works and materials, whilst:

  • In transit to, or from, the contract site and while temporarily stored off-site
  • Own plant and hired plant
  • Site huts, Employee’s Tools and Equipment

Extensions

  • Removal of debris following loss or damage to the contract works
  • Professional fees in connection with reinstatement of the contract works
  • Cover for completed buildings pending sale, including show houses and their contents
  • Cover for loss of or damage to temporary works and other equipment during any maintenance period
  • The cost of recovering immobilised construction plant from any site
  • Cover in respect of the liability to meet loss of income claims made by a plant owner following damage to any plant hire

The Policy will automatically reinstate the sum insured following a loss.

FINANCIAL RISKS

Cover

Increasingly developers, banks, investors, local government and private sector employers are demanding the provision of guarantees, which will ensure that, in the event of insolvency, the costs they incur completing a development will be met.

 Bonds

  • The Performance Bond makes available to the employer a sum of money, normally 10% of the contract value in many parts of the World rising to 100% in countries such as the USA, which will facilitate completion of the contract should contractor insolvency occur.
  • Deed or Tender Bond – against withdrawing from a contract and that a Performance Bond is available.
  • Advance Payment Bond – against non-completion of a contract, including repayment of monies advanced by the employer.
  • Retention Bond – replaces the retention fund.
  • Maintenance/Retention Bond – against non-performance of maintenance responsibilities thereby releasing the retention fund.
  • Highways Act Bond – to local authorities against non-completion, to their satisfaction, of roads and sewers within developments.

These bonds can be provided through insurance companies. The advantage over banks, who also issue bonds, is that insurance company bonds are generally unsecured, whereas banks require collateral. Furthermore, bank-bonding facilities form part of a general overdraft facility, which could cause excessive borrowing requirements.

Insurance bonding facilities are off-balance sheet with consequential beneficial impact on statutory accounts.

ADVANCE PROFITS

Cover

Contractor and Principals’ loss of:

  • Rent Receivable
  • Interest Receivable on net proceeds of project
  • Interest Payable on project loans
  • Increased Cost of Works

all as a consequence of a delay emanating from an indemnifiable loss under Contractors ‘All Risks’.

 Definitions:

Loss of Rent – Rental income which, but for the damage, would have been received during the Indemnity Period.

Interest Receivable – The Interest Payable for outstanding loans in relation to the Project which have to be extended or re-negotiated and/or additional loans which may have to be raised to finance other projects which would have otherwise been funded from the net income of the sale of the Project.

Increased Cost of Working – The additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing loss of Rent Receivable and/or Loss of Interest Payable and/or Loss of Interest Receivable which, but for that expenditure, would have taken place during the Indemnity Period in consequence of the damage but not exceeding the loss of Rent Receivable and/or loss of Interest Payable and/or loss of Interest Receivable thereby avoided.

Indemnity Period – The period of delay in the letting (or sale) of the Development in consequence of the damage beginning on the date upon which, but for the damage, rent would have commenced to be earned (or the sale of the Development would have been completed).

 

BUILDING DEFECTS

Cover

Physical loss, destruction of or damage to the property insured. This includes the collapse of the building caused by a fault defect, error or omission in design, materials, components or construction of the building, which remain undiscovered on the day of practical completion.

  • First Party cover. Insurers assume responsibility for immediate rectification thereby avoiding the need to rely for compensation upon litigation against a Third Party.
  • Policy fully assignable for the benefit of future owners, tenants and occupiers.
  • Twelve-year period to comply with legislation such as the Latent Damages Act 1986, automatically extendable for up to 30 years to provide cover throughout various national financing initiatives and bank financing requirements.
  • Technical Auditing carried out by Insurers and included in premium thereby avoiding high cost of appointing independent consulting engineers which has previously made cost of cover prohibitive.
  • Initial Technical Audit leads to a facility for all projects, which avoids the need to audit each project, thereby reducing the cost and greatly simplifying arrangement of cover.

Extensions

  • Roof, Cladding, waterproof membrane, and underground services.
  • Electrical and mechanical services
  • Loss of rent, loss of profit and the costs of alternative accommodation.
  • Sum Insured includes demolition costs, Professional Fees, Regulatory Compliance and Inflation Provision.
  • Efficacy of new technologies post-completion
  • Premium Instalments

PROFESSIONAL INDEMNITY

Cover

In respect of the Insured’s legal liability for negligence in the conduct and execution of their professional activities and duties involving design or specification, supervision of construction, feasibility study, technical information calculation, always under the direction and control of a qualified architect, engineer or surveyor.

In addition to meeting costs and expenses in respect of damages and defense of a claim or potential claim, the cover may also be extended to meet those expenses which you may incur as a result of any action you take to reduce the cost of a claim or potential claim.

Extensions

  • Libel and slander
  • Loss of documents
  • Dishonesty of employees

 PUBLIC AND PRODUCTS’ LIABILITY

Cover

Liability to third parties following accidental bodily injury, loss of or damage to material property or accidental loss of amenities, trespass, and nuisance arising out of your normal business and site operations.

Extensions

  • Liabilities arising from defective design, specification or workmanship in respect of any structural materials or goods that you supply erect or repair.
  • Liability arising out of the use of mechanically propelled contractors’ plant on site.
  • Contingent liability arising out of employees using their own motor vehicles on company business.
  • Liability for loss or damage to premises which are leased or rented.
  • The Financial Loss Public Liability cover provides for financial losses but only arising out of loss of, or damage to, property. This Extension provides cover for liability in respect of accidental financial losses suffered by third parties where damage to property has not occurred.
  • Automatic Indemnity to Principals
  • Cross liabilities

 JCT CLAUSE 21.2.1 (OR EQUIVALENT)

Cover

Loss resulting from damage to property caused by collapse, subsidence, heave, vibration, weakening or removal of support, or lowering of ground water arising out of, and in the course of, carrying out the works.

 As there are various contractual clauses necessitating this cover, it requires each to be considered on an individual basis. This would not stop work on site commencing but it may mean after a risk assessment, that the final terms and conditions will be finalised subsequently.

The period of insurance cover will equate to the contract term.

 DIRECTORS’ AND OFFICERS’ LIABILITY

Cover

Protecting Directors and Officers of the Company, and the Company itself, in respect of claims made against them for any wrongful act in their capacity as Director or Officer.

A “Wrongful Act” is defined as breach of contract, breach of duty, act, neglect, error, omission, mis-statement, misleading statement or breach of warranty of authority.

Extensions

  • Shadow directorship
  • Costs of representation at official investigations into the affairs of the Company or its subsidiaries
  • Outside directorship
  • 12 month discovery period
  • Spouses of the Directors and Officers
  • Pollution defence costs

EMPLOYER’S LIABILITY

Cover

Provides against the cost of claims for bodily injury or disease, sustained by employees during the course of their employment, for which there is legal liability. Cover includes the actual damages awarded plus the cost and expenses incurred in defending a claim.

 An important feature of the Policy is that “employee” is widely defined and includes:

  • Labour only sub-contractors
  • Any other self-employed person
  • Employees hired or borrowed from another employer
  • Anyone participating in authorised work experience

 Extensions

  • Liability to employees and the public
  • Contractual liabilities and indemnity to Principal
  • Additional liabilities in respect of bodily injury or loss of or damage to property you assume under contract
  • Health and Safety at Work Act (1974), or national equivalent
  • Kidnap and Ransom

 PROPERTY DAMAGE

Cover

Comprehensive cover for all buildings upon Practical Completion. Cover is available for a single building or any number of buildings, with emphasis on flexibility to accommodate a diverse range of properties, resulting in tailoring cover to meet specific requirements. To obtain the optimum level of protection, a number of invaluable extensions are included as standard, removing unnecessary complication and outlay involved in purchasing additional policies, resulting in overlapping or duplication. Conversely, gaps in cover, which may only come to light at the time of a claim, are avoided.

  • Consequential loss – advance rental
  • Property owners & employers’ liability
  • General interests
  • Denial of access
  • Automatic reinstatement
  • Trace and access
  • Capital additions
  • Internal maintenance contracts
  • Loss of metered services
  • Loss of keys
  • Unauthorised use of services
  • Landscaped gardens

 FIDELITY GUARANTEE

Cover

Loss of money or goods caused directly by an act of first or Third Party fraud, theft or dishonesty by an employee provided the loss is discovered within two years of the termination of the Policy or the period during which it occurred.

An “employee” is widely defined and includes:

  • A person under a Contract of Service or apprenticeship with the Insured
  • Trainee under work experience schemes
  • Directors under a Contract of Service who have a shareholding in the Company
  • Temporary employees provided by staff agencies excluding computer staff, warehouse staff, drivers and others where special consideration is required
  • Staff retired on a pension still working on a consultancy basis

Extensions

  • Auditors’ fees in substantiating the amount of claim, or amending or re-writing computer programs or security codes following fraudulent use.
  • No compulsory requirement to prosecute defaulting employees.
  • Defaulting employee not required to be identified if proven loss was caused by an employee.
  • Cover provided on each and every basis not restricted to an aggregate.

MOTOR FLEET

Cover

All types of vehicles ranging from private cars, commercial vehicles, special type vehicles or motor cycles or hauliers.

This cover can be diverse to include:

  • Normal Commercial Fleets
  • Industrial Fleets
  • High Performance Cars
  • High Net Worth – Collection of valuable vehicles
  • Plant equipment licensed for road use

Extensions

  • Unlimited third party property damage
  • Unlimited manslaughter defence costs
  • Full cover for trailers whilst attached to vehicle
  • Courtesy vehicles
  • Automatic repair authorisation
  • No Excess Option

TERRORISM

Cover

Indemnifies the Insured for the Ascertained Net Loss sustained as a result of direct physical damage to or physical destruction of Insured Assets arising directly out of Terrorism, Riots, Strikes, Civil Commotions or Malicious Damage including fire damage and loss by looting. For the purpose of this cover, an act of terrorism means an act, including the use of force or violence, of any person or group(s) of persons, whether acting alone or on behalf of or in connection with any organisation(s), committed for political, religious or ideological purposes including the intention to influence any government and/or to put the public in fear for such purposes.

BROWN FIELD

Cover

Provides full indemnity against any latent problems associated with certified brown field sites including asbestos and heavy metals

ENVIRONMENTAL IMPACT

Cover

Provides for cover against environmental impact of accidental spillage or other non-negligent events that cause environmental problems

 

POLITICAL RISKS

This is a truly International product and thus, for countries for which such cover is required,  provides a comprehensive Political Risks section that covers the full spectrum of risks such as Expropriation, War & Terrorism, and Force Majeure.

Cover

Expropriation – indemnifies the Insured for the Ascertained Net Loss sustained as a direct result of the Insured Events of Expropriation, Selective Discrimination, Forced Abandonment, Forced Divestiture, Cancellation of Concession Agreement, Cancellation of Export Licences or Imposition of Export Embargo

War & Terrorism – indemnifies the Insured for the Ascertained Net Loss sustained as a result of direct physical damage to or physical destruction of Insured Assets arising directly out of the following Insured Events: Political Violence, Civil War, Revolution, Rebellion, Insurrection or any Hostile Act by a Belligerent Power or Terrorism, Riots, Strikes, Civil Commotions or Malicious Damage including fire damage and loss by looting during the occurrence of or following an Insured Event, provided that such physical loss or damage occurs during the Policy Period at the location(s) of the Foreign Enterprise

Force Majeure – indemnifies the Insured for its provable and ascertainable Net Loss resulting from, due to, or in consequence of any cause beyond the reasonable control of the Insured including Business Interruption as a result of emergency partial or total closure of any road or railway line or port of navigable waterway or airport by or under the lawful order of the police, local or national authority or government, or the electricity, water or gas supply authority, and Third Party Blockade (or Quarantine) which means the politically motivated use of military force, or the direct threat thereof, of one or more third party sovereign nations.

FAQ’s

 What are the real benefits to a developer of this package?

  1. A single policy, segmented into chapters relating to the various categories of risk, on one common legal platform with one major rated underwriter, and from which qualifying construction professionals can select their requirements safe in the knowledge that there is no expensive crossover cover, nor unforeseen gaps.
  2. Known cover for all aspects of the development (regardless of the date of required cover activation) from the beginning of the project at a known cost, and not subject to any detrimental market changes throughout the development period.
  3. Latent Defect and Advance Profit features not currently available under any known construction development insurance.
  4. Developers can dispense with the need to negotiate lengthy warranties, and to scrutinise the terms of professional appointments.
  5. As the insurance package is not on a “claims made” basis but is, rather, for a fixed duration and level of cover from the outset, there is no need for the developer to concern themselves with the maintenance of insurance cover by professionals and the contractor nor with the continuity of the professional team in existence into the future.
  6. Many of the difficulties inherent in construction litigation (particularly as the apportionment and extent of liability) can be avoided. This substantially reduces the possibility of lengthy disputes.
  7. The sales process is substantially simplified and the need for additional documents and negotiations is kept to a minimum.
  8. Development financing becomes simpler and quicker as the lender does not have the concern of ensuring that all required risks are adequately covered and on what terms as this package provides a fully uniform and inter-laced insurance platform with only one substantial underwriter, and in a language suitable for bank professionals. This makes financing substantially simpler.
  9. The latent defect aspects of this policy provide for a far wider scope than currently available, and cover is available for up to 30 years before new inspections are required making this a significant sales aid.
  10. All of the above and more at a probable lesser cost than could be achieved using conventional insurance with less cover.

How will this insurance package affect the bid process?

Traditionally, as part of the procurement process, each contractor would factor into their bid the cost of obtaining insurance and obtaining any necessary bonding for their obligations. Contractors with fewer claims and who are more reliable would have access to cheaper insurance which, in theory should give them a competitive advantage. Under this policy the developer would be advised of the insurance cost differentials associated with each bidder and the developer would then use this information in assessing any bid. In this way the developer has total control on insurance costs.

What is different about the latent defect cover under this policy?

In its simplest form the latent defect cover addresses what should be available to purchasers, i.e. full rectification of any and all defects for a period up to 30 years without inspection and subject only to a satisfactory claims history. This cover is flexible in that the developer can provide say, 12 years, as part of the purchase contract with the purchaser having the automatic right to continue such cover on an agreed basis thereafter.

Can the insurance premium be broken down into its component parts for allocation purposes?

Apportionment of premium is essentially a mute point to the developer as it is a project cost, whoever initially bears it. The mechanism of this insurance product reduces the overall cost of insurance, and thus project cost. However each risk component can be separately costed for apportionment purposes.

VALUE ADDED SERVICES

This sophisticated product can only be realistically negotiated, placed with underwriters, and administered by the likes of Willis, Aon, and Marsh. For example Willis, with 300 offices in 74 countries and 14,500 associates serving clients in some 180 countries, have the capacity to provide the following added value services to ensure a quality service to construction professionals:

  • A specialist construction division with staff throughout the World from surveying and/or construction loss adjusting background.
  • Specialist construction claims staff enables a pro-active stance on contentious or complex claims. Integrated computerised systems enables instant access to claims information;
  • Contract conditions – advice on all insurance implications and assistance with negotiating the most effective and beneficial wording for each specific project;
  • Risk Management – advice in compliance with local legislation such as CDM – Health and Safety at Work Act (1974) and general loss control;
  • Production of a service plan which would obligate Willis to implement all elements of service from pre-renewal meetings to site surveys on a specific time scale by way of a detailed bar chart;
  • 24 hour helpline throughout the World including collateral warranty advice and claims services;
  • Dedicated legal services from your usual supplier.

Small Print

  • The very nature of this product means that it is available to qualifying professionals prepared to engage in a technical audit for qualification purposes. This audit is for a developer or main contractor and should only need to be conducted once, irrespective of the number of construction projects.
  • A first time developer is unlikely to qualify if using standard JCT or equivalent contracts. However a non-qualifying developer employing a qualifying main contractor on a full Design and Build basis is likely to qualify.
  • The construction project needs to be agreed by a lender to be commercially viable.

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Aon and Willis provide syndicated insurance – at last!

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Aon and Willis provide syndicated insurance – at last!

Last week Willis announced their initiative to provide syndicated insurance, referred to by the FT as ‘passive’ underwriting. Earlier this year Aon announced the same syndicated insurance methodology. I have seen criticism of this scheme but structured project finance specialists such as myself have been screaming for this methodology since the mid 1990’s.

The reports that I have read attempting to describe this offering do not fully appreciate why this is so necessary in the corporate sector, so a little background might be useful. Banks are in the business of asset risk, whereas insurance companies are in the business of event risk. When a prospective borrower presents a project to a bank, that bank will take the responsibility to evaluate the project and the financing requirement, including the associated inherent direct and indirect risks. The bank will then decide whether or not to fund the project. Little does the borrower know that the bank is likely to syndicate this funding with a number of other banks each taking a percentage of the financing based on the good judgement of the borrower’s bank. If funded through a private placement then this syndication will be invisible to the borrower.

The bank is likely to identify certain event risks, e.g. business disruption, for which it will need insurance cover. Using traditional methodology the borrower will then have an insurance broker approach the insurance underwriters to arrange cover for the various event risks identified. What comes back is a number of policies using different wording platforms, and even different legal jurisdictions. This does not instil confidence into the bank’s risk profile, and why banks generally do not give credence to what these various policies purport to provide. In the event of a potential claim which underwriter does the bank approach?

I would like to introduce 2 extracts from a MBA text book on structured project finance that I co-authored in 1999. Both are from one of the chapters called ‘The Role of Insurance in Project Finance’.

“Our own experience suggests that both insurers and bankers generally state that they are flexible and adaptable, but in practise usually confine themselves to tried and tested solutions. For example it took two years of negotiation, cajoling, and debate convincing insurers that the structure of our “One-Stop” Construction Risks product was a radical and valuable improvement in the provision of a reliable solution for the support of major construction project financing. If I had to identify the major factor in the reluctance to adapt to the inherent changing role of the insurer with such a product it was the degree of change in approach of providing a packaged integrated risk mitigation solution which is flexible, but contained to one major lead underwriter on one legal platform. In essence we did no more than to use tested principles of bank syndication and adapted it to the insurance market. The initial reaction of the bankers was “too good to be true”. The lawyers view was that it would remove at least 80% of construction litigation as many of the difficulties inherent in construction litigation and particularly as to the apportionment and extent of liability could be avoided, but they were not sure that bankers, or even developers, are ready for such a radical shift in thinking.

On the other hand we have produced an integrated insurance solution [with Aon] for a wide range of project risk mitigation including investor risk, cash flow risk, business disruption, all within a political risk envelope, for a Euro-convertible bond offering for a complex project in Eastern Europe which was only acknowledged by the bankers for what the insurance brought to the deal when the issue was very well received and became oversubscribed, whereas prior to the integrated insurance component there was no interest. In this offering the insurance component was an integral part of the Trust Indenture Agreement [a ‘first’ in an international securities offering] which made for a robust structure to which investors could relate and feel secure.

Our resultant observation is that both parties need to be brought together in a spirit of mutual understanding and co-operation if the bankers are to enjoy the value and benefits available through effective risk mitigation insurance tools, and insurers need to adapt to a more flexible approach to ever changing risk profiles. Furthermore there is a language barrier between these two sectors that needs to be overcome by both parties as misunderstanding plays a large part in the lack of integrated solutions.”

Aon and myself wrote the policy wording that we needed, and Hiscox took the lead underwriter role of the event risk requirements for the eurosecurities issue even though there were aspects of this package that they, themselves did not underwrite. They acted as a lead underwriter and placed all the risk within their underwriter community – invisible to us, just like a bank syndication – and only one underwriter for the bank to engage with.

“Project Finance Requiring Political Insurance

This is a very specialised area of insurance as, by definition, the project is in a territory that has less certainty of political stability and/or appropriate legal structure than one would like in order to secure an investment or lending position in the event of problems. Such political insurance is available to cover a whole host of possibilities such as:

 

  • Confiscation, Expropriation, and Nationalisation
  • Forced Abandonment
  • Transfer Risk
  • Refusal of host Government of Repossession and Disposal Rights
  • Contract Repudiation
  • War, civil war, civil unrest,  and terrorism

 

However there can be a number of interested parties that need cover within any one project, and there can be a number of different scenarios that require the security of a political insurance wrap in order that they are effective. This is further complicated by the fact that it is not always possible for any one insurer to assume the total insurance package thus various legal platforms for each insurable risk need to be interpreted and reconciled. It is our firm belief that the current practise with insurers will radically change over time such that one major insurer will assume a lead manager role, much along the lines of a bank lead manager, providing a single source of full insurance cover on one platform.”

It has taken some 13 years for this concept to mature, and I applaud Aon and Willis for their belief and understanding of the need for this approach. I hope that the banks welcome this approach with open arms.