Risk management begins with common sense

By Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Andrew Bailey of the Bank of England and designated deputy of the new UK Prudential Regulation Authority, which will supervise banks, has made some scathing comments in the Herald newspaper [1] about how RBS and HBOS were managed in the years leading up to their massive government rescues that required tens of billions of pounds of taxpayer funds.

His comments are extensive but summed up by his comment:  “… people who ran those two institutions just lost sight of what I would call sound principles of banking.”

I was working in the investment banking sphere in the City of London in the early 2000’s and observed RBS in the wake of its acquisition of NatWest in early 2000.  At the time, the acquisition and integration was arguably the best executed and most successful of any large bank merger worldwide.  However, the bank then appeared to aggressively pursue a strategy of buying market share.  I saw it commit large amounts to many syndicated leveraged transactions for inadequate remuneration in terms of the risk.  Some borderline loans led by other banks only succeeded because of this.

Fred Goodwin, the aggressive head of RBS, seemed to want to make his institution the largest bank in the world and he almost succeeded before the pile of cards came crashing down.  From 2001 to 2007, RBS’s assets doubled, mainly through a string of acquisitions.  This culminated in the disastrous acquisition of ABN Amro, a complete basket case at the time.  Shortly thereafter, RBS required a government rescue.

In my time in the City, I wondered what RBS’s balance sheet would look like if there were a recession.  Many people attributed RBS’s downfall to the ABN acquisition.  This may have been the straw that broke the camel’s back, but it seems that RBS’s balance sheet had been weakening significantly beforehand.  It seems that Andrew Bailey agrees.  He said, talking about the pre-ABN era:  “I think there was very rapid expansion of the investment bank.  I think the controls around the expansion of that investment banking activity were clearly not adequate.”

At the same time, Andy Hornby was running HBOS – at least he was supposed to be.  He had been a great success at ASDA (Wal Mart’s UK subsidiary) in running the clothing retail business.  He seemed to take the large volume, low margin mentality into the property lending business at HBOS with disastrous consequences.  (HBOS was easily Britain’s largest mortgage lender and also had very large exposures to property developers.)  Many people blame Peter Cummings, the head of the corporate bank, as being the main culprit for the debacle but it is questionable whether or not his boss had any ability to exercise any sort of oversight on his activities. 

At HBOS in 2005, Paul Moore, HBOS’s Head of Regulatory Risk, warned that the bank was becoming too risky.  Shortly after that he was forced out of the bank and was replaced by someone he claims had a sales background.

In the cases of both RBS and HBOS, effective and prudent risk management seemed to go by the wayside in the interests of growth and, perhaps, feeding giant egos.  In fact, never mind sophisticated risk management set ups, simple common sense seemed to be absent.  (The applicability of the term common sense to the Financial Services Authority at this time is another topic.)

Interestingly, Andy Hornby has returned to his retail roots as Chief Executive of Alliance Boots, Britain’s largest drug store chain.

 

Note:  This blog first appeared on 16 January 2011

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[1] See http://www.heraldscotland.com/business/corporate-sme/damning-verdict-delivered-on-former-rbs-and-hbos-chiefs-1.1079137

Martian Foreign Exchange Risk

By Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Even though I lived in the USA for several years, I still do not understand U.S. politics and politicians.  I don’t think most Americans do either.  They just seem to be born either Democrat or Republican and harbour a life-long hatred of the other that borders on vindictiveness at times.  Like many non-Americans, I just observe with amazement and never cease to be astonished about what goes on.  However for better or worse, what goes on in America profoundly affects not only Americans, but also the rest of the world.

Now that we know that the U.S. president wasn’t born on Mars (subject to forensic examination of documentation), will U.S. politicians turn their attention to making a serious attack on the deficit?  And what about the debt mountain?

 

Inflation fears are causing pressure for interest rate rises in a number of countries.  It does not appear that the Fed is yet ready to raise rates but things can change rapidly.

 

The U.S. dollar has been weak while commodity prices have been rising.  However some commentators are now opining that such process have overshot and are predicting falling commodity prices. 

 

What will happen to the Euro if the PIG bale outs become PIGS bale outs?  Or even PIGSI bale outs?  (Portugal, Ireland, Greece, Spain and Italy.)

 

And so on and so on …..

 

The bottom line is that we are facing a very uncertain situation of possible currency volatility.  Does your company have a thorough understanding of its foreign currency exposures in terms of identification, quantification and sensitivity to exchange rate fluctuations?  Do you have well-developed strategies and policies for dealing with these?  Are your hedges really effective and are you sure that they do not create additional exposures you are unaware of?

 

And if you answered yes to these questions, are you absolutely certain?  Are you sure that a yes 12 months ago is still a yes today?

Bill Gross: investment manager, billionaire, neg on US government debt

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Rightly or wrongly, I believe that entrepreneurial billionaires didn’t become so merely by pure luck but rather they have been able to correctly assess their market more often than not. If we assume this, it is rather revealing that Bill Gross, founder of PIMCO and manager of the world’s largest bond fund ($236 USD billion) has not only reduced his US government debt to zero but has now begun to short government debt. For those unfamiliar with this concept, going short is when you sell something today in the belief that the price will fall so that you will be able to buy back that good in the future at a lower price; the difference being your profit. For Mr. Gross to make money he needs the price of US debt to fall, in other words he needs interest rates to rise. Interest rates can rise because of inflation or a lack of faith in the debt issuer (see other RSD blogs on government debt).

In combination with going short, Mr. Gross is currently holding almost 31% cash in the bond fund, further proof of his belief in future rising interest rates. 

As numerous others have stated the days of cheap capital will inevitably draw to a close.  When is uncertain, but hedging of interest rate exposure should definitely be moving towards top of mind for risk managers.  The contagion of European debt is not complete and as forecasted by some it could conceivably cross “the pond” later this year.  Stay tuned.

 

For more on this click on the link to Tyler Durden’s blog at Zero Hedge:

http://tinyurl.com/5uh838b

 

You aint seen nothin’ yet ….

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

So the U.S. government didn’t shut down thanks to an agreement to cut an extra $38 billion of spending (compared with deficit of around $1.4 trillion).  We’ve been here before and life has always gone on.  However, perhaps a more frightening situation is coming up.  The U.S. is about to hit its legal debt ceiling of $14.3 trillion which is getting on towards 100% of GDP.  These numbers just beggar belief.  The U.S. is now the only major economy with such debt and deficit problems that has not introduced some sort of realistic austerity program so the situation keeps getting worse.  Other stats can be quoted that compound the grief – or determination to act – that perhaps should be felt. 

Of course, we’re constantly told that the U.S. is different.  The economy has unequalled potential, it always grows, foreign investors hold so much U.S. debt that if they didn’t keep buying it, their investment would lose value, etc., etc. 

Nobody expects a U.S. debt default but more and more people mention the possibility before coming up with the aforementioned reasons why it will not happen.  But, surely the party cannot go on forever.  Something has to give and with the American form of dysfunctional government, it may take some external event or shock to cause the very painful action required. 

This of course would affect, not only the U.S. dollar but many, if not all other currencies in terms of volatility.  I will leave open the question of: what should companies be doing?  As a partial answer, companies should be thinking very seriously about various scenarios.  They should know and understand their currency and interest rate exposures in a far more detailed, scientific and meaningful way than the traditional “have a handle in my head” of the CFO’s and treasures of many businesses. 

I will expand on this in coming blogs but it would be interesting to have some discussion of how big an issue others see this as being.

Asia’s next export: Inflation. G20 response: Increase interest rates

by Michael Arbow MBA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com 

 

Here in the rich western world, consumers are witnessing an interesting disconnect; namely the difference between what we see at the gas pump and grocery store and what we hear when our government’s announce inflation rates.  The disconnect stems from the definition of core verse headline inflation rates. The core rate strips out the so-called "volatile energy and food prices". Luckily, for many in the West the rising cost of food and energy is an annoyance and living with the core rate of inflation – from which the countries’ central banks base their interest rates on, is grudgingly accepted. 

On the other hand however, in the emerging economies where household incomes are lower and food and energy consumes a substantial portion of household income; national governments consider these elements as part of core inflation. Thus you are finding increased pressure for the central banks of emerging economies to raise interest rates to tame inflation and protect their currencies. The local trickle down effect of this will be for consumers to seek higher wages.  Higher wages, when combined with higher (commodity) input cost will translate into higher prices charged on manufactured products.  Once exported Asia’s pivotal role as deflation exporter will change; for their manufactured exports help constitute core inflation in the developed economies. 

As core inflation rises, so to will interest rates. If your firm is highly leveraged and thus sensitive to interest rates what steps are you taking today to reduce this future financial risk?  For the consumer, perhaps locking in longer terms rates is starting to look more attractive. 

 

For more on this follow the link to Pimco’s Mihir P. Worah’s viewpoint:

 http://tinyurl.com/4jcjnqd

 

Low interest rates. Going, going, gone.

by Michael Arbow MBA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com

 

As a follower of our blogs you know our views on rising energy and commodity prices and how this will impact those firms that depend on them in the creation of their firm’s products.  We also know that this rising tide of wholesales prices will eventually push up consumer prices leading to increases in consumer price indexes (inflation) which in turn will cause interest rates to rise.  You could say that this is (money) supply side induced inflation caused by several of the Western world banks introducing quantitative easing. 

In an excellent article in McKinsey Quarterly (link below) their analysts also look at another catalyst for higher interest rates – namely the lack of savings which will be structural in nature.  It is argued that with the Western world’s aging demographic spending (on health) will increase as will the amount of money put aside for food and energy.  All of this will reduce the amount of money available to be saved and thus force borrowers to increase interest rates to incent what few savings are out there. 

With a strong case that interest rates will be going up, how is your firm’s financial risk management preparing for this and how do they plan to push back the day of reckoning? 

For a link to “The era of cheap capital draws to a close” click:

http://tinyurl.com/6ca78gd