Tag Archives: Capital market

2-weeks post-BREXIT. Where are we?

univest2-weeks post-BREXIT. Where are we?

The EU Referendum has raised a number of issues that show why this referendum was needed. During recent years politics has become too elite and detached from the people it is there to serve. A good shakeout is necessary, as is happening in the USA. BREXIT has triggered this process in Europe, and especially the EU. So where are we post-BREXIT?

Scare Story: The UK will suffer unprecedented political turmoil

This is true, but more in the EU than the UK. The reaction at the quickly convened emergency meeting of the European Parliament on the Monday following BREXIT resembled more a Third World bun fight than a rational First World debate. The exchange of insults and rebuke was extraordinary.

The UK political turmoil has shown that David Cameron lacks the qualities of a true leader. Having consented to a referendum on the basis of a reformed EU, which he did not achieve, a strategically capable leader would have returned from Brussels to announce his frustration with Brussels, and then overseen the referendum debate without expressing his own view, or that of the Government, ready to implement the decision of the people (democracy) thus providing the political leadership and continuity post-BREXIT that is currently so lacking. We have a political vacuum until we have a new leader – not good for confidence around the world.

This political vacuum has fuelled an anti-democratic minority to challenge the outcome of the EU Referendum result. It is interesting to note that these whingers obviously have the view that a democracy can only be democratic when the vote result concurs with their view. And these whingers include people like Richard Branson who, reportedly, saw some 30% wiped off his Virgin empire. The people have spoken and, with a larger turnout than your average General Election, the clear majority voted for BREXIT. In a democracy every citizen has the obligation to make themselves aware of the issue requiring a vote of the people, and to cast their vote accordingly. In this digital age there is no excuse for lack of information. The result is clear, so to the whingers – move on; we will flourish.

The positive result of this turmoil as we approach political summer recess is that the UK Civil Service has time to consider the optimal exit terms for negotiation with the EU, and a period of reflection by the EU machine. As I refine this blog I found an article in yesterday’s London Evening Standard written by Frank-Walter Steinmeier, the German Foreign Minister, in which he acknowledges that the EU elite have been indifferent to the voices of the people, causing great unrest. His solution – even faster political and economic integration. Will they ever listen?

Scare Story: The UK markets will collapse with pensions and quality of life in decline, and London will lose its status as the Global Financial Centre

Since the casino players, looking purely to make money from the volatility surrounding the referendum vote, have gone to sleep (when will the G7 address this global destabilising problem) the UK stock markets have stabilised, and indeed risen some 15% – a vote of confidence by investors, and good for pension funds. Adjustments will occur as the UK realigns itself; albeit the attack on commercial property funds is bizarre. Furthermore all talk of the capital markets moving within the EU has evaporated – the underlying covert motive by both the USA and Germany having been neutralised.

Our EU partners have not been so fortunate in that the BREXIT vote has caused much instability within the EU forcing markets down by as much as 15%. Although they have recovered some of these losses there is little evidence of full recovery any time soon. Italy is on the brink of a banking crisis, and there is much discontent within the EU. We have the USA regulators stating that both Deutsche Bank and Banco de Santander fail their stress tests and thus must increase capital if they wish to continue to trade US dollars. And of course VW are looking at considerably more substantial fines around the world. There is also reported a vote of no confidence for the EU to settle Euro transactions.

The doomsayers claim that the 10% fall in sterling against the US dollar is a major disaster for the UK. On the contrary sterling has been over-valued for some time damaging the ability of the UK to sell its goods overseas. As I write this blog sterling has recovered to 1.29. It would be better for the UK economy if this rate fell below 1.26 for a few months before the US Presidential elections will likely deflate the US dollar, pushing the value of sterling up again. I would remind the whingers that when Germany pushed for the introduction of the Euro the result for Germany was an effective significant devaluation of the Deutschemark which was much needed by the German economy to trade themselves out of the grossly underestimated cost of reunification – but at a real cost to all other Eurozone members.

Scare Story: The UK will require years to negotiate new trade deals with the Single Market and the World

There are a number of countries, including the USA and Germany, who want to be first to sign trade deals with the UK. There is much confusion being hoisted by the whingers about the single market. The UK does not need to be part of the single market for the same reasons that are frustrating the trade deal between the EU and the USA (who already trade more with the EU than does the UK). What we need is tariff-free trade deals with each of the member states who wish to engage with us. If Germany can do this then why not all other member states? The EU is fragmenting, and will need significant reform if it is to survive – including trade relationships. Regardless of the political rhetoric Germany will not risk the loss of its significant exports to the UK, and France will follow.

Scare Story: UK citizens will lose the right to freely travel, work and live in the EU countries

Today UK citizens need a passport to travel into the EU member States, and to return from them. Travelling freely within the EU countries is defined by the Schengen Agreement between member States and thus does not change anything for UK citizens. Moving to an EU member State may change, but looking at the number of EU citizens living in the UK reciprocity is the likely outcome.

Scare Story: The UK is too small and insignificant to go it alone

The UK coughed on the 23rd June, and the whole world sneezed, and is still sneezing. The UK has always punched well above its weight, and always will. London is the most important global financial centre in the world, and thanks to BREXIT, will retain this status. The EU loses one of its two permanent seats at the UN Security Council, and loses the global diplomatic reach enjoyed by the UK. As the fifth largest economy in the world the UK will find its feet over the coming months, and then flourish. The EU may not be so lucky.

 

A few days ago I listened to an interesting discussion regarding the total breakdown of the former USSR. The original discussions with Gorbachev revolved around the satellite states adjoining the eastern borders of Western Europe. However, as the Berlin Wall fell practically all members of the USSR declared their own freedom from Moscow. The view was that Moscow thought it could impose a homogeneous citizen unity across the USSR without any regard for the diverse nature and cultures of each nation state. Thus laws and regulations formulated in Moscow intended to create a homogeneous USSR caused resentment and unrest in these States – the response being typical Roman-type repression by Moscow, and ultimately downfall. Even the Romans knew better when they built their empire. What could the EU learn from this? Brussels relentlessly moves towards a United States of Europe without the consent of the people. Whether they use brute force, or financial pain they attempt to impose their will over each member State. The majority of people in the UK have said ‘NO’, and I fully expect others to follow.

A few weeks before the referendum vote I listened to an interesting debate by university students regarding the EU Referendum. They did not have guest speakers, rather relying on four students on each side of the debate to put their respective cases. The debate was surprisingly articulate. The audience was an estimated 100 students who, after the debate, overwhelmingly voted for BREXIT. This tallies with the young vote of some 25% of 18 – 24 year-olds. The triangle of knowledge for 16 – 24 year-olds (post-university) consists of students who have both the intellect and knowledge to analyse issues, students who have the knowledge but not enough intellect to fully appreciate the issues, and the remainder who prefer to go to the pub and watch football. The proportion of students who have both the intellect and knowledge average around 23%. Thus most of the 25% who voted for BREXIT are likely to have understood why. The other two sectors are likely to take the safe option to stay with what they know, or not vote. Therefore, I do not accept that the older (wiser) voters in any way let the young down. This is why the social engineering of the Blair/Brown Government sending 50% of the young to university was ridiculous, a waste of money, and did nothing for those who leave lesser universities with a degree and considerable debt but with no prospect of the suitable job that was implied was available for them.

I have also heard from the young that they wanted to remain in the EU to take advantage of the Erasmus program to study in Europe not realising that this program has little to do with the EU, but formulated as an exchange program between the universities, and includes universities in the USA. There is no possibility that this will end as a result of BREXIT, not least because of the significant number of European students who want to take advantage of the far superior red brick and CAT universities in the UK.

Just as a footnote, I chose to assess the views of the more canny Scottish voters regarding the post-BREXIT opportunist actions of Nicola Sturgeon, First Minister in Scotland, as I did before the Scottish Independence Referendum. The result then was a resounding vote to stay in the UK. A vote today between the UK and the EU would yield the same result. So Nicola, don’t waste your time as the people do not want your pathway, and I cannot imagine the EU entertaining yet another country joining on a net beneficiary basis in any event. The EU Referendum was on behalf of the whole of the UK, and the people spoke. Let it be. There is a bright tomorrow for the UK, so let us focus on the future together.

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A New Multilateralism – Realisable or Wishful Thinking?

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A New Multilateralism – Realisable or Wishful Thinking?

I listened to the Richard Dimbleby Lecture on Monday evening with expectation of some new thinking on the way forward. The lecture was called ‘A New Multilateralism for the 21st Century’ and was presented by Christine Lagarde, incumbent MD of the IMF. My initial reaction was that it presented some interesting ideas, but I couldn’t quite put my finger on the relevance of these ideas. So, on Tuesday, I printed off the transcript of her speech from the IMF website. Having now studied this speech in some detail I find it endorses my view that the multilateral institutions of which she leads the IMF are essentially out of touch with the real problems that we face in the 21st century.

Back in the 1970’s, during the oil boom, individuals in the Middle East were accumulating vast amounts of US Dollars in cash because Western banks did not want it. Indeed I remember Swiss banks charging up to 3% p.a. to take these deposits. I actually walked into a room in a palace and saw a pile of US Dollars, and was told that this pile amounted to USD 1 billion. In an attempt to give some visual impression of this pile I am reliably informed that a standard 40ft sea container will hold USD 1 billion in fresh print USD 100 denomination bills. This money was not participating in any economic benefit whatsoever, and there was no possibility that the owner could reasonably consume these funds in their lifetime. Yet just one mile away there were ordinary working people struggling to find the money for their next meal. It occurred to me that if these funds were deposited with SAMA, and used productively producing even a nominal return, such return could be used productively to provide food for these people without any degradation to the original money. Yet the owner had no interest in such a proposition, and was content to accumulate yet more piles to look at.

Unfortunately this sorry tale has since increased in propensity, and as we saw a few weeks ago, Oxfam calculated that the 85 richest people have the same wealth as the bottom half of the World’s population. Christine Lagarde added that the richest 1% in the USA captured 95% of all income gains since 2009, yet the number of people in the USA needing food parcels to survive is now reaching pandemic proportions. She further states that in India the net worth of the billionaire community increased 12 fold in the past 15 years, enough to eliminate the poverty of that country twice over. So why has she not rationalised this into the real threat to the World Order in the 21st century?

We have seen so many billionaires created out of emerging economies such as the former Soviet Union, China, and India, sapping vast amounts of sovereign assets. The rapid nature of such wealth creation should arouse suspicion. However the point that I make is that somehow a few own wealth beyond any reasonable expectation of spending throughout their life. Many will say that they invest much of their wealth, but this only increases their existing wealth. Having met a number of these oligarchs their primary objective is to continue to increase their wealth, usually at the expense of others.

What about if each billionaire set aside USD 1 billion for investment and applied just the income to relieving poverty.

In 2013 an investment return of 15%+ was easily achievable. This would provide in excess of USD 150 million from each billion invested. The billionaire has not lost their capital, but much could be achieved with the income stream. Of course a few of these billionaires are already philanthropic and names like Bill Gates easily come to mind, and who clearly understands that he does not need such vast wealth, so uses his business judgement to make every dollar count in his selected beneficial projects.

Having brushed along with the World Bank, the IMF, and the UN for over 30 years I would suggest that they are political institutions populated by political appointees and academics who have no idea about the real world. I have witnessed a number of World Bank projects which did no more for the recipient country than to provide work for a donor country corporate, create an inappropriate monster that, within 5 years, was derelict leaving the recipient with sovereign debt but with no value to show for it. I have also seen appropriate solutions costing a fraction of the price of the expensive inappropriate concrete alternative discarded because the amount of the appropriate solution did not warrant World Bank intervention. It is interesting that Christine Lagarde acknowledges that it was the fast response of the G20 that stopped the world descending into meltdown 5 years ago rather than the institutions such as the World Bank and IMF founded to deal with such events. I think that this is a good template to use in stating that the current multilateral institutions are not good at delivering effectively solutions.

Although I am clearly in support of the outcome of Bretton Woods, we should also remember that not enough people there were visionary enough to accept all of the ideas of Keynes, and which were subsequently quickly adopted as catastrophe loomed, e.g. removal of the gold standard. Other than those wearing rose tinted spectacles no-one would suggest that the institutions that emerged remotely fulfil their ambitious mandates. I have already mentioned the lack of effectiveness of the World Bank and the IMF, and the UN is little more than a toothless talking shop today – Bosnia being a classic failure.

Christine Legrande suggests that the multilateral outcome of Bretton Woods produced ‘unprecedented economic and financial stability …. Disease eradication, conflict diminished, child mortality reduced, life expectancy increased, and hundreds of millions lifted out of poverty’.

Do we not count Korea, Vietnam, Congo, Sudan, Yugoslavia, Israel, Egypt, Lebanon, Iraq, Afghanistan, Syria …….etc as conflicts? All consumed the lives of many thousands of people including Western soldiers, left chaos and destruction in their wake, and they are still very much in our minds today. When was the last time that the USA was conclusively successful in any serious military conflict? Therefore Europe and the USA may have seen peace and prosperity since Bretton Woods but how many thousands of American and European soldiers and civilians have died in the name of preserving this peace?

To suggest that Europe has been conflict free is also short-sighted. In the past 6 years Europe has been involved in an economic war. Not too many people killed with bullets and bombs, but many have become disenfranchised, lost everything, displaced, and descended into poverty. Is this not symptomatic of a conventional war? When the vision of a European Union was first put to the people the rhetoric promised peace and prosperity for all citizens. I accept that the banking crisis made a bad situation worse, but how many European politicians in France, Greece, Spain, Italy, Ireland and the UK breathed a sigh of relief that they could hide their failure to create a credible EU behind the banking crisis?

Let us examine the two reference dates that she used, i.e. 1914 and 1944. She suggests that prior to 1914 the birth of the modern industrial society brought about massive dislocation between protectionist nations, and inequality between the ‘haves’ and ‘have-nots’. Take away the country boundaries, essentially the impact of the digital age, and what is different today?

So where do I see the powder kegs of the 21st Century? Perhaps controversially I do not see the North-South Conflict as a major threat. An implosion within the Islamic community is more likely with primarily Sunni against Shi’a. If you think about it, most of the current conflicts involve the Islamic nations, and are driven by extreme religious division. The intervention by the West in some of these conflicts in the name of protecting the West has no logical outcome. These people have no regard for Western democratic values, or of secular tolerance.

At one end of the spectrum we have the blatant inequality of the distribution of wealth. We are experiencing 2 critical phenomena, both of which are counterproductive to a peaceful, all inclusive world. We have individuals and corporates accumulating vast wealth to the point where the resulting power exceeds that of some major nations. Albeit a few of these have taken a philanthropic stance we should note that such philanthropists are mostly from Western countries. Many of the new billionaires are from emerging or developing economies where democracy does not really mean very much, and a market society is the norm, i.e. everything has a price, even social and civic values. All we need is a charismatic megalomaniac, as depicted by the Carver character in the James Bond movie, ‘Tomorrow Never Dies’, to cause chaos and suffering for many throughout the world. Unfortunately Western civilisation has degraded over the past couple of decades towards a market society thus adding a significant sting to the ever increasing differential between the ‘haves’ and ‘have nots’. For example diminish the rights of the ‘have nots’ to education, justice, political influence, and healthcare because they have no money and you have a significant pool of would-be terrorists for our megalomaniac to exploit because they have nothing else, and nothing to lose.

Then we have corporate greed. So what can the people see? During the past 6 years the people have become very aware that their corporate executives have suppressed the salaries of the workers (the value drivers) to below inflation levels whilst increasing their own already attractive remuneration by some 40% average, and which has been allowed by investors because dividends have been maintained to these investors. So the people at the top have handsomely profited whilst real income to the workers has diminished. So much for sharing the pain. In addition these executives are immune to any accountability should they fail. Have any of the avaricious people who profited from the banking crisis been prosecuted, or had their ill-gotten gains repossessed? The banks themselves are being penalised by regulators who should have been more alert to the problems in the first place, and some of these funds do go to Government coffers. But these large fines diminish the capital of the banks, and thus inhibit their capability to finance the very enterprise we need to re-energise the employment market, i.e. they inadvertently stifle recovery, increasing disenfranchised young entrepreneurs.

At a micro scale we can look at the fate of RBS under Fred Goodwin. He was a megalomaniac trying to build the biggest bank in the world. Everyone I spoke to in the City of London at the time leading up to the acquisition of ABN Amro agreed that the terms of that deal, at twice the price that anyone else was prepared to consider, was insane. Yet no-one stepped in to stop him. How much pain, and destroyed lives has RBS caused to many thousands of people. But Fred Goodwin is made for life financially; so well in fact that sticks and stones may break his bones, but he will not lose a night’s sleep over the names that he is called.

At the other end of the spectrum we have the demographic issue. We have already seen a growing view amongst the young generation of workers that their taxes should not be funding the pensions and healthcare of the graying generation. The younger generation see that they have to pay taxes to support the pensions of an ever increasing graying population, and being told that they also have to contribute a significant proportion of their disposable income to their own pension provisions as State pensions will slowly but surely phase out by the time they retire. All of this at a time when real incomes are diminishing in real purchase power terms. Rightly the graying population state that they have paid their taxes, in the form of a special National Insurance tax specifically for the right to a State pension and healthcare, throughout their working lives and thus their State pension is rightfully theirs. The problem is that successive Governments have not ring-fenced these contributions over the years, preferring to spend it in the hope that future generations with continue to fund the requirement; a little like a Ponzi scheme. Add to this the migration of young labour where they have no historic interest in the local graying population, and expect to be able to send money home to support their own aging family, and we have potential serious discourse and unrest. Bring both of the above phenomena together and we have a powder keg just looking for a fuse.

So from where can our fuse emerge? Our fuse already exists in the form of the global internet, social networking, and twitter. Christine Lagarde is right in that the Arab Spring was fuelled by the galvanising of the people through media such as Twitter and social media. But likewise these facilities can also be used to fuel discontent and confusion. Great philosophers such as Aristotle, Kent and Hume have all commented on the importance of gossip to the masses, and our lesser quality media thrives on this obsession. So the touch paper is a disenfranchised charismatic individual or group exploiting the power of gossip through Twitter and social networks. We have seen the impact of disenfranchised ‘have nots’ in riots in many cities over recent years. It is when all of these groups can be galvanised together that we need to be concerned.

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.

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..

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.

Bank Trader Bonuses – should they be paid if the bank makes a loss?

Bank Trader Bonuses – should they be paid if the bank makes a loss?

I have been cornered at a number of dinner parties and other discussions in recent years to be grilled on the controversial and sometimes hostile subject about whether or not the traders, and indeed deal originators, within investment banks should be paid substantial bonuses if the bank itself makes a loss. Having signed-off on such bonuses in the past I know what it feels like when you see the size of the number, sometimes staggeringly large, staring at you on the page, (but then most would gulp at our daily turnover of around US$ 3 billion) so I have tried to rationalise the argument ‘for’ or ‘against’.

In the early days of such traders, (latter part of the 1970’s and first half of the 1980’s), it was commonplace that the bank provided the desk, the capital, the prestige name of the bank, and the support operations. Traders were only paid a nominal salary to live on but would be entitled to a flat-rate bonus calculated at up to 10% of the net profits they generated for the bank. These traders were never considered part of the ‘family’ within the bank, and were remote to the culture of the bank. They were commonly referred to as ‘intrapreneurs’. This was a reasonable strategy for the bank in that they did not have the exposure of substantial salaries to people who might not perform, and the modest salary incentivised the trader to make profits. Many types of companies today adopt this attitude, and it is certainly a better business model than the soccer players I refer to below.

A significantly exaggerated example of this, and well recorded in books such as ‘Liars Poker’ by Michael Lewis, was the trading environment of the then Solomon Brothers investment house which was a ruthless production line of traders who performed to required levels of profit, or were discarded and replaced at will.

An analogy could be a comparison with soccer players who have a limited period of productivity (typically 5 – 10 years) who are paid substantial remuneration whilst valuable, but are readily discarded once their star no longer shines. Headhunters in banking play the role of the soccer player’s personal manager in both initiating transfer of traders between banks, and negotiating any settlement required to be paid to the former bank to overcome notice periods, garden leave, poaching costs, etc. Traders do not have a career as such, they have a window of opportunity to make large amounts of money before they burn out, and their general philosophy revolves around this short-term opportunism.

To add to this unitary approach it should also be stressed that there are a number of separate product areas within an investment bank, and they have separate profit centres which become the accumulated profit or loss of the bank. In general there is no interlinking of these profit centres within the bank, nor interdependency on performance. Therefore I suggest that a trader who performs well is entitled to their bonus, irrespective of its size, as it only reflects the quality of the person as a realised income contributor. I must emphasise that the profit against which the bonus is calculated should be fully realised without any future exposure. Accrued profits, e.g. on transactions that still have future potential exposure, is a contentious subject, and needs to be agreed on a transaction-by-transaction basis. If a trader makes losses not only do they not receive a bonus, but usually they lose their trading seat – and possibly their future as a trader.

At a simple level would you expect a car salesperson to forego the commissions due on their sales if the car manufacturer makes a loss? Scale this up to a salesperson who sells a $40 million commercial airliner on which I am led to understand they can earn a commission up to 7% of sales value. And both of these sales people will probably have a far longer career than a trader.

At the end of the day the primary difference between other corporates and investment banks is the scale of the commissions/bonuses. To put this into context an investment bank can easily turnover as much in a few days as a major corporate turns over in a year.

Please note that this blog relates to business income generators, not the fat-cats who sit at the top and mostly still receive bonuses when the bank makes a loss – this is a completely different story.

Investment Banks – do the media yet understand them?

Investment Banks – do the media yet understand them?

I read a somewhat cynical comment in the FT on 15th July that I cannot get out of my mind. It related to an Analysis article about Goldman Sachs and boldly states ‘they’re [Goldman Sachs] playing by the rules but they are very good at navigating as close to the regulatory wind as possible’. What do the journalists expect them to do?

Investment bankers have taken some serious knocks over the past few years. I am not saying that some of them did not deserve the widespread denunciation of their activities, but the media (reporters, journalists, their so-called experts, etc.) understood so little about investment banks that they delivered a grave injustice to all other investment bankers, by generally creating a feeding frenzy amongst the public, and a convenient escape route for politicians who had much to do with the economic demise of the UK economy. Can anyone remember a Labour government since WWII that did not leave us economically paralysed, and even in the hands of the IMF? I have been a banker long enough to remember serious bailouts of Governments – even when the general public had little or no knowledge of the economic dangers. And let’s not forget the then economic woes of the Eurozone struggling with the outcomes of political over economic sensibilities in an altruistic attempt to create a federal Europe.

One glowing example of this lack of understanding of investment banks was the reporting by Robert Peston during 2007/08, and whom we labelled ‘the Pest’ or with his partner-in-crime, Vince Cable MP, the ‘Ministry of Mis-information’. There is a saying in the English language about someone with a little knowledge, and Peston was certainly going to use his little knowledge to make his name no matter how incompetent the reporting. Indeed it became apparent after a while that the banks had found a way to feed him with what they wanted him to report, even if yet again the information was not credible – he would not know, and thus challenge his reporting credibility amongst those who do understand. The damage caused throughout the population by such uninformed reporting, both socially and economically, must be colossal. Knowing exactly what had happened within the investment banks, I found his reporting frustratingly depressing.

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.

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. 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 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.

For some years this new market worked very well especially in the arena of infrastructure and global business 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, etc. 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, then we can draw upon these flaws in human nature to describe the culture that emerged within investment banks over some 15 years.

For investment bankers pushing the boundaries is a way of life, to find ever more innovative ways to ensure the maximum availability of capital to service the ever growing capital demands of the world. Indeed Goldman Sachs is the most aggressive of the major investment banks, and their creativity is legend. Thus you could conclude that the missing ingredient was moral integrity. But where were the financial regulators in the early 1990’s when the few were screaming into the abyss that control of risk was being sacrificed in the name of profit – and the stakeholders in the banks poured praise onto the generators of these great profits. I find it somewhat disingenuous that financial regulators, who should have been proactive in maintaining moral integrity throughout those 15 years or so, are now reaping the rewards of large fines from the banks whilst normal households are struggling to make ends meet, partly as a result of their failure. And thus my concern at the comment in the FT.

Last year I was asked by a group of senior bankers and economists to produce a report describing the evolution of the problems within the investment banks, and suggestions of how their credibility (moral integrity) can be restored as there is no doubt that they are fundamental to maintaining global capital liquidity. Whereas this report was distributed around major banks it was considered too long for publishing. If there is enough interest in knowing what really happened then I will find a way to make it available electronically. As this is likely to cost me money there may be a nominal charge which I guess will be processed by the likes of PayPal (who will also charge me). However, the feedback from the intended audience, and a business school who studied a copy, suggest that this paper is required reading for those interested about the failure of investment banks from the inside.