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Risk

It’s been a while since I last posted. You have enough to read. But sometimes issues are so fundamental to a debate – and get such little airing – that I must make the point. And twitter, whilst my preferred medium, isn’t sufficient. So, whilst carrying on my day job of re-plumbing some elements of the credit system, I’ll write the odd blog. More importantly, I want to engage constructively in the ongoing debate about financial regulation which will include the odd comment on other blog posts. This is partly because the debate  and our regulators have a bank bias whilst fairly ignorant of insurance regulation.

Regarding the point of this particular post, there has been some comment following suggestions last week that policymakers are actively seeking a reduction in the size of the OTC derivatives markets. I offer my thoughts in the comments section of the Streetwise Prof’s article.

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Statue of Achilles.

David Murphy (Deus Ex Macchiato)  & I exchanged some views on his helpful series on Credit Valuation Adjustments on FT Alphaville this week which is a minefield to me.However, risk transfer and corporate funding are not. So this passage caught my eye (my emphasis)

There is another area where the CVA rules produce undesirable behaviour: smaller corporates. These firms trade derivatives to hedge their own bond issuance — corporates tend to issue fixed rate bonds but prefer to pay floating, hence entering interest rate swaps – or commodity prices, but they often don’t have large pools of cash that they’re willing to tie up as collateral. Thus they generate reasonable CVAs.

However, such corporates are often not themselves liquid in the CDS market, so banks can’t buy protection to reduce their CVA capital. Thus they have to charge the corporate more on the derivatives that they want to enter into.

That wouldn’t be so bad if the corporate had a rational alternative, but they don’t. Central clearing is also expensive, and that requires that someone post collateral, either the client or their clearing member. If the client hasn’t got the money, or doesn’t want to fork it over for this purpose, then they will have to pay their bank to do it for them. The net result of these increased costs is likely to be that corporates hedge less, and keep more risk. This is viewed as enough of a bad thing by the European Parliament that their current version of the EU rules implementing Basel contains an exemption from the CVA rules for some corporates.

There are alternatives. However, they require a re-plumbing of the methodologies corporates as well as bank and non-bank funders use to manage corporate credit risk and liquidity. That point was outlined in my opening comment:-

Another very helpful explanation. What I found particularly interesting is you say corporates have “no rational alternative”. I would suggest that the passive role corporates have played in the creation of credit risk transfer structures for their funding purposes is changing.

Corporate treasury are aware they do not want to be caught again as they were in 2009 by outsourcing funding liquidity risk (and ultimately their reputation and solvency) to their liquidity providers. As the financial infrastructure reforms after the GFC, corporate liquidity risk management – an understandable concern of any funder as part of their continual “Going Concern” assessment – is unlikely to rely to the level it did on the failed credit structures created by traditional credit intermediaries.
This will mean corporate treasury teams increasingly see value in building credit impairment reserves within formal captive insurance structures rather than simply held informally on their balance sheet. These enable corporates to better manage operating cash-flow, payment obligations and credit impairment as receivables fall due. By optimizing internal liquidity, such an approach also reduces demands on external funding. If the CRT mechanism also de-risks collateralised/sold assets within an ABL/ABS transaction, the banks RWA exposure amount improves as PD & LGD reduce, eliminating the need to charge the corporate for more CDS.

Of course, this solution isn’t favoured by banks with falling revenues and lower margins. But that is not an immediate concern for Real Economy mid-Cap CFO’s receiving terms sheets offering poor advance rates on short-term assets at funding margins that do not fairly reflect risk. Many corporates must therefore become their own credit risk underwriters as they can no longer rely on their banks or rating agencies methodologies or often generic credit risk data.

It’s no silver bullet but then, life is never that simple!

David’s response (again with my emphasis)

Thank you, that is a fascinating comment, and I agree with it.

One extra riff, if I may. You talk about corporate liquidity risk management moving away from the pre-crisis models, and I would agree with that. But right now there are three sides to that. First, where to get long term funds/manage their traditional cashflow (e.g. receivables, trade finance). You cover that admirably.

The second is managing short term liquidity in a world where there are more demands (such as clearing) and fewer supplies. Part of the answer to that will be collateral swaps and such like, but part of it will also be developing non-intermediated sources of contingent liquidity from non-banks (and possibly even non-financials). That brings me to the third part; surplus cash investment. With liquidity premiums as rich as they are, there must be sensible low risk ways for corporates to monetise these. It’s not obvious that banks will be able to monopolise these flows…

Again, David raises critical questions for any treasury team. I responded

Thank you for the generous words. You raise good additional points.

My first reaction to this is to turn to Supply Chain Finance. This model has developed significantly recently and can now be applied (with some help) by corporates with surplus cash flow (for example surplus cash impairment reserves within a captive/ ICC/PCC structure) into discharging their liabilities for purchases early, thus earning yield through discount benefits. The supplier equally benefits from improved cash flow and this virtuous circle potentially dis-intermediates the banks and monetizes the significant liquidity/collateral that exists outside the formal financial system for the benefit of the Real Economy, increasing the velocity of liquidity through the broader system.

What this exchange supports is a critical factor (and I would add financial asset) missed by most commentators. There is an abundant source of potentially ‘de-riskable’ short-term assets, that are often significantly  underfunded. These assets – in many instances – are “promises to pay” that can be transparently structured and support faster Real Economy growth. However, they are a granular, dynamic, hard to track and unsexy asset. They require bank resource to manage. With Real Estate, bankers don’t have those worries. Yet trade receivables  comprise around $20 trillion of Balance Sheet value in the US alone. By “underfunded”,  for every $100 of a short-term trade receivables asset portfolio, corporates generally receive around $70 of liquidity with the remaining $30 sitting dormant as encumbered capital on each corporates balance sheet. In Europe the position is even worse given a much smaller proportion of non-bank corporate loans (EU 10-20% versus US 80-90%) and the role of the large European trade credit insurers who continue to sell a model to their clientsthat failed so spectacularly in 2007/8/9. Trade receivables are central to working capital and therefore essential to economic growth. Yet, there is almost no mention of this abundant asset in financial commentary.

Understanding how to improve the funding process requires knowledge of  both the liquidity and risk management requirements of non-financial corporates. Most banks failed in these areas themselves,  so their advise to corporate clients lacks credibility.

Banks should be acknowledging to clients that the financial world has irreversibly changed since the global financial system begun its slow collapse in 2007. Such acknowledgement, as with alcoholism or substance abuse, requires the financial system to admit that :-

  1. investors will no longer easily commit their funds to transactions or securities. They will not only want evidence high quality and granular credit risk analysis of referenced assets has taken place in a timely manner. They will also want to ensure it continues to take place on an ongoing basis.
  2. Information asymmetry creates mistrust. Traditional credit intermediation and rating methodologies must be rebuilt to eliminate it.
  3. Outsourcing financial risk management to banks has failed. Non-financial corporates are beginning to take greater control of the collation and supply of high quality, timely and granular credit risk information that is shared with key counterparties to maintain systemic confidence. This data underpins collaborative – not adversarial – funding methods and structures that funders historically offered as part of their service. Information asymmetry is no longer smart.

We are leaving a financial world where banks essentially sold more and more liquidity to customers only if  the vehicle they used were bank-sponsored. Changing liquidity providers was extremely expensive when  services and funding were bundled with one relationship bank, especially in Europe. The time it took and costs of renegotiating a new (complex) service and credit agreement were too onerous. A few years ago when liquidity was cheap  funding costs were manageable. When the economy was good bundling mattered little.  Corporates had  appreciating assets, a thriving economy and importantly credit.

Things have changed. Clients are now getting wise to the service bundling and pricing tricks banks use. Increasingly, customers are a little more critical of the value for money.  As for the price of liquidity now….well , the client receives a bundled price for all their services so it’s difficult to tell how much each service costs but they are smart enough to know one price may subsidize another.  The clients income and ROCE are reducing (more encumbered capital, lower asset value, more credit risk uncertainty in a more volatile economy &  higher liquidity costs thanks to general inflation). They’re not keen to see  their funders pass on their increased costs to them.

Given further damaging allegations in the UK that banks mis-sold swaps, corporates will  increasingly focus on protecting themselves from an imploding financial system, outsourcing less financial control to bank risk advisers and protecting their precious capital better. They can no longer accept their traditional funders shrugging their shoulders as they charge ever-increasing prices blaming “The Markets” or “increased regulation”.

It is also a fertile fallacy that corporates cannot do more to reduce funding costs. Many commentators and Financial journalist miss this point when often deferring to the financial lobby perspective. And those that are critical offer anger and vitriol rather than forensic alternatives.

Yet, for years, banks have been able to support overall corporate cash flow through their considerable influence over two of the three  sources of cash flow you’ll see on any financial report ; cash flow from financing activities and cash flow from investment activities. Any weakness in operating cash flow could be supported by priming these other two sources. This not only enabled bonus pools to benefit;  it also hid any fundamental weakness in the core business models of corporates. For well remunerated Executive Boards able to use funding & investment income to support the share price, procuring the services banks offered generated considerable benefits to financial metrics driving executive remuneration. Now the music has stopped,  protecting and optimizing operating cash flow is critical to survival.

Corporates are focusing  on the fundamentals:-

  1. Improving liquidity risk management
  2. finding new sources of contingent non-bank liquidity
  3. enhancing own credit risk management through the construction of  formal credit impairment reserve structures available to support liquidity shortfalls that threaten the corporates ability to meet obligations as they fall due; obligations a phone call to the bank would have once solved.
  4. finding effective non-speculative uses for surplus cash.

All of these potentially undermine the ability of banks to generate fees. Banks would far prefer it if corporate treasury just swept each days surplus cash into banks overnight deposit accounts. At least that could support the banks own funding liquidity  needs. And in this dilemma is the banks Achilles’ heel. Many bankers are too focused on maintaining their roles within a broken system to see what’s happening in the wider world. They fumble for soothing words and rationales to explain their recent behaviour as an errant partner would when they say “It’ll never happen again”.  However, when trust has been broken it is very difficult to restore. The banks continue to engineer methodologies that generate short-term speculative financial value using complex chains and what are likely to be ineffective or unenforceable risk mitigation techniques;  the ability to create credit with only a tenuous link to real assets that has been a feature of finance over the last twenty-five years has declined. What has emerged is a divergence between the imperative of many financial market participants and that of (most) corporates seeking to create sustainable economic and social value.

With this in mind corporates of all sizes must review their funding strategies and take greater ownership of the process. On the eve of the centenary of the sinking of the Titanic, corporates can no longer rely on being passengers. Outsourcing responsibility for their corporate wellbeing as a ‘Going Concern’ to those who have not only let them down, but fail to acknowledge their mistakes, is a situation no Executive Board can afford to repeat.

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Deus Ex Macchiato provide a link to one of the finest summaries of the financial crisis I have read ; “Choosing the Road to Prosperity”  by Federal Reserve Bank of Dallas Director of Research  Harvey Rosenblum.

Preceding it is a letter from the Dallas Fed President, Richard Fisher, quoted as being “one of the more hawkish and conservative Fed Presidents”. Even this description begins to show how the old political pigeon holes really have such little meaning now.

Some of the choicest quotes:-

As a nation, we face a distinct choice. We can perpetuate too big to fail, with its inequities and dangers, or we can end it. Eliminating TBTF won’t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance.

In 2010, Congress enacted a sweeping, new regulatory framework that attempts to address TBTF. While commendable in some ways, the new law may not prevent the biggest financial institutions from taking excessive risk or growing ever bigger.

When competition declines, incentives often turn perverse, and self-interest can turn malevolent. That’s what happened in the years before the financial crisis.

The financial crisis arose from failures of the banking, regulatory and political systems. However, focusing on faceless institutions glosses over the fundamental fact that human beings, with all their flaws, frailties and foibles, were behind the tumultuous events that few saw coming and that quickly spiraled out of control.

Greed led innovative legal minds to push the boundaries of financial integrity with off-balance-sheet entities and other accounting expedients. Practices that weren’t necessarily illegal were certainly misleading—at least that’s the conclusion of many post-crisis investigations.

With size came complexity. Many big banks stretched their operations to include proprietary trading and hedge fund invest- ments. They spread their reach into dozens of countries as financial markets globalized. Complexity magnifies the opportunities
for obfuscation. Top management may not have known all of what was going on—particularly the exposure to risk. Regulators didn’t have the time, manpower and other resources to oversee the biggest banks’ vast operations and ferret out the problems that might be buried in financial footnotes or legal boilerplate.

These large, complex financial institutions aggressively pursued profits in the overheated markets for subprime mortgages and related securities. They pushed the limits of regulatory ambiguity and lax enforcement. They carried greater risk and overestimated their ability to manage it.
In some cases, top management groped around in the dark because accounting and monitoring systems didn’t keep pace with the expanding enterprises.

Complicity extended to the public sector. The Fed kept interest rates too low for too long, contributing to the speculative binge in housing and pushing investors toward higher yields in riskier markets.

Hindsight leaves us wondering what financial gurus and policymakers could have been thinking. But complicity presupposes a willful blindness—we see what we want to see or what life’s experiences condition us to see. Why spoil the party when the economy is growing and more people are employed? Imagine the political storms and public ridicule that would sweep over anyone who tried!

Easy money leads to a giddy self- delusion—it’s human nature. A contagious divorce from reality lies behind many of history’s great speculative episodes, such as the Dutch tulip mania of 1637 and the South Sea bubble of 1720.

In the financial crisis, the human traits of complacency, greed, complicity and exuberance were intertwined with concentration, the result of businesses’ natural desire to grow into a bigger, more important and dominant force in their industries. Concentration amplified the speed and breadth of the subsequent damage to the banking sector and the economy as a whole.

It concludes

The road to prosperity requires re- capitalizing the financial system as quickly as possible. The safer the individual banks, the safer the financial system. The ultimate destination—an economy relatively free from financial crises—won’t be reached until we have the fortitude to break up the giant banks.

If only other regulators and central bankers had the guts and balls to write so clearly, unequivocally and honestly without fear of their legal officers or political masters, the recovery process could have truly begun in earnest.

Here’s the link to the article in case you haven’t already got there.

Sober Look and I had an online discussion regarding his post about the hidden pitfalls of Basel III. He suggested there had been some interest in my comments and could I provide a case study. I duly did this evening (finally)  and sent him a simple version of a generic case which I have amended here to include the commercial objectives a typical corporate would be very keen to achieve in the current market conditions.

Case Study

Commercial Objectives

  • European multinational with Head Office in Eurozone“periphery”
  • More robust funding structures and to adapt their debt repayment profile to their expected cash flow generation.
  • Minimize funding liquidity risk and improve advance rate achieved for their assets.
  • Sale rather than Financing accounting treatment. (IAS 39)
  • Greater certainty of trade credit insurance cover through the economic cycle.
  • Achieve commercial outcomes without increasing administrative burden on treasury.
  • Improve credit risk management for both trade and finance purposes.

Financial background

  • Operations in Europe, Africa, Latin America & Asia.
  • 2010 turnover > €1,000m, ROCE 5%, EBITDA < €100m.
  • Total Trade Receivables portfolio €150m.
  • Working Capital needs €125m (2011) and €150m (2012).
  • Concentration risk – 22 major buyers with sales > €7m p.a.
  • Increasing counterparty credit risks within EU.

Existing Funding

  • Funding via Bonds, Revolving Credit and Asset Backed Commercial Paper.
  • €120m ABCP program funded by UK bank through Jersey-based SPV.
  • Advance rate 79% on €150m driven by Rating Agency Criteria (unrated buyers, country limits, loss history, stress)
  • The daily information feed from client sales ledger to the Bank Funder however failed to:-
  1. offer granular detail or “static pool data.”
  2. offer detailed ageing profiles.
  3. Effectively track concentrations/customer aggregation, credit notes, dilution and disputes.
  4. Help reduce reporting requirements/costs for treasury resource.
  5. Enhance confidence in data flows and consistency.
  6. Support holistic Credit Risk Management
  • €27m “allowance for doubtful debt” (creating “Going Concern” issues)
  • Credit insurance purchased separately in each territory. No benefit to external funding cost.

Solution

  • Improved risk analytics (points 1-6 above) benefits Company and Funder.
  • Committed facility of €150m (additional headroom) & reduced all-in funding costs by 25 Basis Points.
  • Advance rate on total trade receivables portfolio lifted from 79% to 95%. Increased cash available for investment and growth plans by €15m p.a. (additional €45m over a 3 year term).
  • Reduced Bank Funder Risk Weighted Assets for transaction by approx. 50%.
  • Sale treatment achieved for transaction under IAS 39.
  • Cell captive established to build cash allowance for doubtful debts and support funding.
  • ROCE improved by 110 Basis Points.
  • Improved Enterprise Risk Management and Internal Controls supporting Corporate Governance.

Example Structure

Structure diagram

 

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I was a catastrophe underwriter for  over 20 years. I therefore find the starting point of this Telegraph article on health and Safety typical of the journalistic and (sometimes understandable) broad public view on the issue. It is representative of a willful blindness that has created the  corporate culture we have today; a blindness that actively encouraged through weak risk mgmt, incentive misalignment, outsourcing and Free Market Globalisation, the kind of  catastrophic life-ending and economic and social  damage inducing events such as  Aberfan, Piper Alpha, Bhopal and the Gulf of Mexico oil spill (to name a few though plenty more here) .

Wobbly ladders are really not the underlying point being made  here. In fact, it is quite laughable that £133/hr be used here as the representative cost here particularly when compared to the cost of an average lawyer. They will charge more for drafting a “my client” response to a safety rule infringement that a company’s own half decent internal controls would have  picked up. And let’s not compare that with the cost of a 100 page legal opinion from a  law firm regarding a legally marginal activity. Some lawyers have essentially become no more than glorified corporate bodyguards.

The critical point is that we’re moving into an era where the States willingness to ‘turn a blind eye’ to their assumption of Business Risks and the taxpayers ability to assume it it are increasingly conflicted. Poor employee protection and inadequate provisioning for pensions or accidents at work are a social cost. These costs of private wealth creation or entrepreneurial risk taking are a wealth transfer society is questioning harder. Companies doing things roughly right should have little to fear.  Yet executives set risk management processes and internal controls cognizant they are within the law or rules if not its spirit. This for many is the language of the “red-tape-benefit-sponging world that holds back wealth creation” . For others, it is simply language manipulation. When the risk/reward proposition benefits the risk seller  (see banks apology to the FSA) at the expense of those unconsciously assuming them, executives can no longer avoid the cost. Health & Safety is a subset of this bigger issue.
It is wholly  understandable businesses should be burdened by compliance costs. Equally, governments  must ensure there is a legislative framework that encourages growth and entrepreneurialism without ‘turning a blind eye’ to safety inadequacies and wealth transfers that cost lives as the mining tragedy in Wales suggests last year. This is an issue both main political parties must address as part of the ‘responsible capitalism’ agenda.

However, as a pragmatist, accidents do happen. There is also significant red tape. Government departments or agencies can be inflexible, rule-driven, under-staffed and distant. This creates challenges.  As a  voter and taxpayer, I expect governments of all colours to ensure those responsible for weak internal controls so obvious in industrial and financial accidents (let’s not forget the financial crisis) are accountable financially, policed by the equivalent of a vice around their (usually) male genitalia. Whilst talk of “dead wood” and “incompetence” fills the soundbites of the coalition’s ongoing review of the public sector, there is plenty of dead wood in executive suites up and down the country. Unfortunately for the vast majority of those in the public sector, they don’t necessarily have the education, connections or manners of those in executive suites that enable luck to be passed off as skill.

As an underwriter I met  many executives of Mining and Energy companies who would claim they had “zero tolerance” for loss of life and safety infringements. I have no doubt they believed what they said. Daniel Kahneman has taught us much about over-confidence. However, few pay the price for foreseeable accidents where causation can be attributed to budgetary considerations, weak project oversight or lack of executive accountability. We now know that financial – not safety-  metrics dominated executive key performance indicators for compensation (see Harvard Business Review’s : The Incentive Bubble) . This is one reason shareholders will focus on risk-adjusted returns in an era of lower credit.

Truth is, the Real Economy will only grow faster and more fairly when those asked to pull hardest know those asking them to pull harder will pay a price if the rope breaks.

 

In banking, sophistication and innovation are not necessarily synonyms for 'effective'.

“Regulators have to recognise that the rules of the game failed to keep up with the progressive fusion of banking, capital markets and insurance.” Bank of England Deputy-Governor Paul Tucker

Forgive the title. However, given my nom de plume and the bank named below, it was hard to resist. It’s inspiration was a recent article in the Financial Times (£) one of an increasing number of stories about “new funding models”. This one just happens to have been adopted by Credit Agricole.

The justification for the new approach – for which it is reasonable to assume Credit Agricole Corporate and Investment Bank CEO Jean-Yves Hocher and his team will earn better than execrable fees on relatively large transactions (doing little for smaller french exporters then?) – was described thus:-

his model – which should be in place by the end of the year – will be different from the heavily criticised US version, since he is creating a new organisation within the investment bank in charge of both originating and distributing. The bank will also remain an interested party in the loans by keeping 20 per cent of them.

It may be a step in the right direction (assuming a 20% quota-share retention through the life of the transaction by the bank). But let’s be frank; one step is a short-distance in a marathon.

The methodology is unlikely to improve ‘all-in’ funding costs significantly for the vast majority of corporate customers. ‘Better than bad’ is not exactly a winning line. And it is hardly news that banks are seeking to shift assets off their balance sheets to reduce Risk Weighted Asset exposure amounts. Nor is ‘risk sharing’ through syndication or risk participation agreements a new or innovative methodology.

In reality, we are currently at an economic point where it almost doesn’t matter what funding methodology is proposed by sophisticated [sic] market participants to non-financial corporates seeking to access liquidity. Methods suggested could be bank or non-bank funding; secured (highly likely)  or unsecured (highly unlikely) debt, recourse or non-recourse, ABS or ABL, Revolving Credit Facilities, Bond Issuance, Invoice Discounting, overdraft, credit card, private placement or ABCP just for starters. The underlying problems that caused the global financial crisis remain. Credit flow has been slowed by a loss of trust in the quality of existing funding processes and the motivations of credit intermediaries and the uncertainty that Principal will be returned.

This is why it is vital that credit intermediaries begin to address some of the problems that precipitated the collapse in confidence. This means they will need to make more effort to prove how they add value to the funding process rather than extract value from it. It also means they should improve the quality of disclosure to investors (bank and institutional) that moves some way towards establishing that :-

  1. the gross and net financial interests of transaction participants are – and are likely to remain – reasonably and fairly aligned for the transaction term.
  2. transaction risks can be monitored and operationally controlled in a timely manner by all transaction participants.
  3. the Marked value of granular assets – rather than a  portfolio of often ineligible assets (aka “a sack of shit“) – used to collateralise funding can be crystallised wherever located (assuming that information is known) on the occurrence of a default event (assuming that has been clearly and legally defined) or the loan successfully repaid if unsecured which may ultimately rely on
  4. truly effective credit risk mitigation. (see Greece CDS & BIS paper)
  5. Credit Risk and counter-party data that is high quality, reliable, available to all transaction participants and that supports regulatory oversight of systemic risk. It also enables national supervisors to look inside the ‘black-box’ used to calculate Risk Weighted Asset exposure amounts, funding margins calculated and credit risk monitored on an ongoing basis.

This extract from a BusinessWeek  article written by the noted economist Hernando de Soto explains why these issues are so important:-

When then-Treasury Secretary Henry Paulson initiated his Troubled Asset Relief Program (TARP) in September 2008, I assumed the objective was to restore trust in the market by identifying and weeding out the “troubled assets” held by the world’s financial institutions. Three weeks later, when I asked American friends why Paulson had switched strategies and was injecting hundreds of billions of dollars into struggling financial institutions, I was told that there were so many idiosyncratic types of paper scattered around the world that no one had any clear idea of how many there were, where they were, how to value them, or who was holding the risk. These securities had slipped outside the recorded memory systems and were no longer easy to connect to the assets from which they had originally been derived. Oh, and their notional value was somewhere between $600 trillion and $700 trillion dollars, 10 times the annual production of the entire world.

Without addressing these currently unresolved issues, many of the so-called new funding methodologies won’t support the funding pace necessary for Real Economic recovery. The cost of capital will rise as trust in bank-modeled reality slips further.
Without banks fixing the causes of increasing risk premia, the restoration of market confidence will lack resilience.

Whether banks use money-market funds, repo markets, Central bank discount windows, Central Bank artificial respirators, qualifying institutional buyers, other financial institutions, pension funds, insurance companies or retail depositors to provide the necessary liquidity required for transactions to the Real Economy, investors will demand greater returns to replace diminishing certainty.

The challenge for banks is to prove to investors that there is value in investing in bank equity or debt supporting sustainable business models that serve the Real Economy. If there is the faintest whiff that the greater purpose of direct investment in a bank is to create “innovative” solutions that fund bonus pools without offering real social value, commercial banking will simply become value-destroying conduits.

The financial sector must address the clarity and effectiveness of the financial infrastructure they build to connect investors and borrowers. Without doing so, much of their innovation will be seen as sophistry which much of it has been. To survive, winning banks will drop their epistemic arrogance and reliance on structuring complexity and look beyond their own skill-sets for solutions. As Paul Tucker suggests, the financial sector is fusing.

Sadly, the opinions of many of those at the wheel of the school-bus when it crashed are still sought by policymakers. The lack of understanding about the broader role of financial markets (which includes the role of regulated insurance in providing economic safety nets and social value for hundreds of years)  is limiting the effectiveness of policymakers responses. As a result, progress through the sludge of reducing global economic activity will remain slow. Moreover, the medicine the banks prescribe which is  “more-of-the-same-but-repackaged-and-more-expensive” remains the drug of choice for policymakers and opinion formers but may end up killing the patient.

 

 

 

 

How to make a simple task complex

“Our capital markets and much of the ‘plumbing’ of the financial system … rely on confidence in the integrity of the assets being traded,  in the robustness of counterparties, in the reliability of infrastructure. Crises nearly always involve that confidence sliding away.”

Paul Tucker, Deputy Governor for Financial Stability Bank of England April 2011

The New Year offers an opportunity to provide you not with another forecast of what may happen during 2012  but to outline what can be done now to protect  against further growth degradation and make credit easier to access. I read a great deal of opinion but little provides real and actionable advice that can help Real Economic activity. I’ll go through some background, what’s gone wrong and how credit is being eased. Links provide further background and reading to the major points.

The financial infrastructure connecting creditors and debtors is broken. Many of the methods, tools, assets and instruments used to intermediate liquidity to borrowers in the Real Economy have lost the trust of investors. Growing doubts about the ability and willingness of Private Non-Financial Corporations (PNFC’s), Financial Institutions and Sovereigns to meet their future payment obligations has turned a systemic liquidity crisis into one of general solvency and confidence, depressing growth in advanced economies. There are now signs of emerging market contagion.  The background to the crisis is well summarized here:-

This is indeed a credit crisis, in two senses. First, its most urgent symptom is banks’ inability to continue their social function of providing credit to society: there is a liquidity crisis. But underlying this symptom, there also is a credit cause for the crisis. This is the neglect of the basic accounting fact that every credit is accompanied by a debt. In that sense, the credit crisis really is a debt crisis. Society has neglected to ensure that credit would be directed towards self-amortizing investment, with real returns that would allow the paying off of debts. Instead, credit flows have led to the accumulation of debt, balanced for a time by rising asset values. Their plunge left the banking sector with a large net debt, ruined balance sheets and incapacitated to serve the economy well.

Over the last 30 years, consumption, investment and growth became increasingly dependent on credit. Following the introduction of the 1988 Basel Accord, Credit Intermediaries (CI’s), mainly banks at that time, were required to hold minimum levels of regulatory capital. The commercial banking model built around accepting deposits  and extending loans became increasingly costly as loans were essentially assets retained on the balance sheet.

Fortunately for Financial Institutions, growth in structured finance (and shadow banking) enabled assets (or synthetically contrived derivatives of underlying asset pools)  to be packaged into credit instruments. These comprised tranches with different seniority of claims on the cash-flows of the assets referenced by the instruments. Each tranche had a risk profile that enabled sophisticated market participants to match a yield with their growing risk appetite. These methodologies enabled banks to “de-risk” their balance sheets with both legal and audit approval and provided an additional and valuable source of fee income; intra-financial credit. However, the de-risking was make-believe. When liquidity dried up in 2008, contingent liquidity support from sponsoring funders was called upon by “orphan” vehicles engaged in ‘off balance sheet’ (IAS 39 under IFRS and FIN 46R, FAS140 under US GAAP) transactions where crystallizing losses on triggered credit events would have fallen on the balance sheets of sponsoring funders.

However, the gap between the cost of credit and price of debt  grew. Asset price growth was increasingly driven by complex debt issuance rather than underlying performance. This complexity meant that modest imprecision in evaluating the underlying risks and their exposure to systemic risks caused fragile ratings to implode and the financial infrastructure to collapse in 2008.

Complexity and personal incentives for CI’s and market participants created risk myopia to modeled reality. This reality was based on information generated by the CI’s themselves using Advanced Internal Ratings-Based credit models (or national supervisors under Standardized and Foundation- IRB models) and the credit rating agencies paid by the Security issuer.

The failure of the system to adequately price credit and therefore debt has resulted in speculative and productive credit ‘sliding away’. The priority of governments is to fix the latter; the former comprises considerable financial sophistry of questionable merit to Real Economic activity. This can be highlighted by the fact that in the US alone, from 1952-1990, $1 of debt created around 70¢ of GDP growth. During the 1990‘s this fell to 33¢ and then 22¢ by 2007. The financial sector grew from being the same size as the US Real Economy in 1952 to nearly five times GDP by 2007. Real Economy credit, on the other hand, has supported self-amortizing production and consumption of goods and services, and left no net debt growth beyond the nominal growth rate of the US economy.

However, there is now a dangerous dependence on Central Banks to ease bank solvency concerns. Easing credit therefore cannot solely be the responsibility of funders, politicians or regulators. PNFC’s must prepare for further economic turbulence by creating robust funding structures supporting trade and growth that:-

  1. Improve Capital allocation and returns: Shareholders and capital market investors demand higher risk premia and granularity in securities in return for liquidity.
  2. Reduce Credit risk: both real and perceived affect confidence. Improving the timeliness of data is essential.

Better Financial Market collaboration

The regulated insurance sector can play a far bigger role in funding the Real Economy. They have risk absorbing balance sheets and have to date avoided financial contagion with one notable exception. However, the sector faces it’s Basel III moment with the rollout of Solvency II regulation in Europe.

Financial Institutions willing to remove themselves from life-support must use more precious capital to tailor better offerings that fit clients needs whilst meeting their own commercial interests. This does not mean “lending less” as so many bankers have suggested. Proven solutions are currently in use that can help PNFC’s bring forward future investment and reduce the likelihood of credit events affecting solvency helping to restore trust between borrowers and funders. These solutions necessarily blend insurance and banking techniques as routes to capital markets continue to converge for sophisticated financial market participants. Bankers not au fait with Solvency II are unlikely to propose solutions that use insurance techniques at the expense of existing  relationships within the non-insurance financial sector.

PNFC’s are reducing costs in order to maintain or  increase operating margins. Optimising operating cash flow value is critical to survival. However, as macro-economic conditions deteriorate across Europe, and the banking system relies on the ECB, financial covenants for some sectors will undoubtedly come under increasing strain through 2012.

There are real concerns about systemic banking stability and the lack of credit. Very simply,  PNFC’s must optimize internal funding costs if they are to minimize external funding requirements and costs. The traditional funding structures, vehicles and mechanisms used by PNFC’s must evolve.

Abundant secured and unsecured bank debt  contributed positively to global trade, social well-being and GDP growth following WWII. However, as debt becomes harder to access, funding structures must adapt. They should rely less on illiquid, deflating assets. They should, ideally, support Real Economy growth by focusing on addressing the following key areas:-

  1.  Non-bank credit (PNFC – to – PNFC): Approximately twice the value of bank and non-bank debt owed by PNFC’s. Outstanding invoices account for ~60% of working capital needs & are a $18 trillion asset value in US alone or ~$70 trillion worldwide.
  2.  Better allocate  capital for all transaction parties.
  3.  Forecasting and valuation models which proved less than robust prior to ’08, should rely on timely and verifiable data.
  4.  Clearer Financial reporting, supporting independent audit and internal control procedures.
  5.  Redefinition of financial claims upon the Real Economy which reduces potential for a future crisis.

Trade receivables are a PNFC’s contractual promise to pay a fixed amount at a future date. Again, from here:-

“All money is credit. Money is the expression of an accounting relation of liability and asset, created as one agent extends credit to another, who assumes a debt. (Therefore the study of money and credit is au fond a study in accounting.) Such IOU’s are monetized and made into a tradeable instrument typically backed by the state’s authority; in other words, money is ‘transferable debt’.”

Trade invoices are a real asset second only to property and their portfolios are significantly under-valued by as much as 20% in funding transactions. Funders treat them extremely cautiously as they are highly granular and change daily, making the tracking of credit risk (systemic and individual) very hard. This is reflected in inflated risk premia in funding margins charged by funders and in also in conservatively over-collateralized advance rates.

Trade invoices are a corollary of productive credit and economic growth; a financial asset that can support far greater diversified non-bank funding in the US & EU, already used widely by US PNFC’s. Updating existing financial infrastructure and methodologies reduces risk premia and increases the quantity of credit extendable. Tailoring better financial transactions for PNFC’s unlocks economic capital, removes significant valuation uncertainty and mitigates funder credit risk more effectively than existing methods (invoice discounting, factoring, trade receivables securitisation, ABCP programs,  Revolving Credit Facilities and orthodox ABS & ABL) at lower all-in cost. This is achieved by addressing credit opacity; a central cause of the financial crisis. Uncertainty about a PNFC’s exposure to their debtors or its location are one part of the problem associated with tracking systemic credit risk as Lehman proved. The other is monitoring any portfolio with granularity that changes daily. These problems reflect in unrepresentative Probability of Default and Loss Given Default calculations used to price credit. The credit study linked to earlier suggests:-

“Credit is, of course, vital to any economy, enabling households and firms to make choices about whether to spend now or delay for a future time.  There are conditions in which it would play no active role, passively reflecting cyclical fluctuations in output, employment and inflation. In a world of more or less complete transparency between borrowers and lenders, very low transaction costs, and very low risk aversion, access to credit would not be rationed; and ex ante yields on financial assets, including loans and bonds, would not embody risk premium.  So if households and firms wanted to bring forward spending in the face of shocks to the economy, they would be able to do so restricted only by their need to remain solvent.”

Increased visibility of granular credit risk exposures enhances decision-making under uncertainty for PNFC’s and financial counterparties, reducing risk premia and transaction costs, enabling credit to be eased.  National banking supervisors will
show sensitivity
to banks attempting to meet increased capital requirements whilst maintaining lending, particularly in Europe. New funding methodologies that increase transparency reduce complexity and opacity. To suggest opacity is good for economic development is to miss the contractual heart of the relationship between debtors and creditors that has been broken; a promise. What is more, most of these ‘promises’ were made between ‘sophisticated’ financial professionals in a culture that didn’t question  epistemic arrogance; a culture led by a few confident -but risk myopic- executives loosely controlled by passive investors; Main Street played little active part. However, we should avoid the ‘blame game’; our role in asset inflation was passive. We allowed our savings to be invested by a system of professional investors without sufficient checks and balances in the Principal/Agent relationship. We are paying for it now.

Information asymmetry cannot be eliminated from finance. However, egregious systemic failures can be designed out with with more progressive regulation. Those holding important public or private roles should operate within decision-making frameworks defining clear risk authorities contractually bound by employment and remuneration contracts. A fair system ‘incentivizes’ through bonuses and maluses, particularly when the costs of these risk failures fall on society disproportionately.

As an ex-catastrophe underwriter I discussed corporate governance and risk management with Energy company CFO’s. Some would say, and I am sure believed, that their company had a ‘zero tolerance’ policy for loss of life. However, as so many man-made disasters prove, few executives were subject to Hammurabi’s code.

It is unsurprising social cohesion has become strained since 2008 in many economies. The banking crisis has exploited an obvious fault-line. Rewards for taking risks with positive economic outcomes were paid to individuals. Yet when risks crystallized into losses with high economic and social cost, they were borne by society. This situation is not unique to banking.

Blending Insurance and Funding processes to ease credit
The funding process begins by creating timely risk information, adding external finance functionality and updating it daily. The PNFC (entities with a turnover of £5m+) then assesses it’s own credit risk appetite and tolerance. A transaction is structured that achieves the desired accounting treatment and outcomes for the PNFC and funder. Credit risk intelligence supports a transparent funding process for investors/funders. The structures and instruments achieve far stronger and more visible protection of principal/capital at yields that reflect more timely and granular risk transparency and improved PNFC corporate governance and risk management.

Risk management and corporate governance therefore become a source of competitive advantage. This flies in the face of the popular narrative that it is “risk-takers” who create wealth. Those who take it with their own money, yes, that is true. But there are fewer of those than the popular narrative suggests. Return on Capital is not the same as Risk-adjusted Return on Capital.

Insurers already support Risk-Weighted Asset optimisation through the provision of eligible (N.B. not traditional trade credit insurance) Credit Risk Mitigants to funders.
In exchange, an insurer assumes the buyer credit risk (with conditionality written to the funder) for 100% of monies advanced against eligible invoices. Increased risk transparency enables advances to increase and/or expected funding margins to be reduced by more than 1%.

Bank Internal Rating Based Models are currently unable to sufficiently optimize Risk-Weighted Asset exposure amounts for Real Economy assets. Improving banks credit risk monitoring and expected loss forecasting methods with better risk transfer structures improves PD, EAD and LGD verification and asset valuation methodologies. These funding methods are adaptable for large PNFC’s or to attract private funds for SME PNFC’s funding facilities as insurance risk can be effectively transformed into capital markets risk. Swiss Re’s Crystal transaction is one such example. Each Credit Instrument is underpinned by a credit tool that uniquely improves credit risk underwriting for banks, insurers and investors.

Conclusion
Financial infrastructure must evolve and track debt and credit values at a granular asset level if skeptical investors are to be assuaged. Mitigating credit risk effectively is vital, as traditional CRM tools are scrutinized for regulatory arbitrage.

Clearer documentation and funding structures can reduce complexity if underpinned by a highly visible and shared credit risk monitoring platform. Each transaction participants capital more effectively reflects their explicit credit risk appetite with the credit platform helping set initial transaction parameters. Legal Entity Identifier risks  reduce and the transaction is supported by daily credit risk monitoring, reporting and valuation at granular, entity and portfolio level. Participants share a single view of trade credit risk presented in a timely manner. This addresses a serious fault line of the financial crisis, information asymmetry.

Benefits

  1. Reduce “all-in” funding costs and Improve Returns on Equity/Capital.
  2. Improve credit access by allocating transaction capital based on clear risk appetite.
  3. Reduce reputation, liquidity & systemic risk.
  4. Improve cash-flow forecasting, financial reporting & Internal Controls.
  5. Enhance Enterprise-wide Risk Management.
  6. Diversify funding and create a more sustainable approach to funding.
  7. Expands funding capacity for clients exporting to overseas customers.
  8. ‘Joined up’ approach to the internal and external management of credit risk for funding tailored to PNFC’s with greater resilience to external funding shocks.
  9. Create new, transparent asset pools that can be structured to attract private sector investment and bank funding that, in Eurozone, can act as collateral for ECB funding.

In 2001, the Bank of England studied risk transfer between banks and insurers. However, little developed given abundant availability of bank credit to the Real Economy before 2008. Basel III and Solvency II now enable insurers and funders to materially improve funding outcomes for PNFC’s with turnovers of £5m+.

The balance sheets of PNFC’s, insurers and reinsurers can collaborate better and more transparently to reduce funding liquidity risk and increase liquidity and credit.
Risk-Weighted Assets are the denominator for regulatory capital calculations. Their impenetrable complexity can be simplified. Evidence of better risk intelligence compared with existing bank portfolio credit assessment methodologies, helps differentiate effective bank and transaction risk management to prospective bank investors.  These solutions reduce the regulatory capital charge of a funding transaction for a non-investment grade PNFC by 50%+ subject to individual credit underwriting judgement. However, central to each underwriting judgement is higher quality initial and ongoing risk information supporting higher quality PNFC risk management, financial reporting, audit and corporate governance structures. Society wins.