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The new paper from the BIS on stress testing looks to be an important one. I have not had a chance to go over it in detail yet, but if you are in this area it is one you should read urgently. I would also add that much of this is likely to be incorporated in the next version of the Accord.

I will put together some comments on it over the next week as time allows.

Just a quick note to welcome the (sort of) full implementation of Basel II in Australia – and its full implementation in most other jurisdictions (apart from, of course, the USA).

I say sort of in Australia as a few banks are staying on Basel I for some things, not others. The usual sort of “phased implementation” (AKA foul-up) you often get with major changes like this. Anyway, welcome Basel II.

The sideline on liquidity risk is to note that the one area that has caused the recent problems has been liquidity, not a lack of capital or other problems. Liquidity is the one area that is not really covered by international standards, with all differing regulators following different mechanisms (as noted below). The next project of the BCBS really should be to establish some standards in this area, and it looks like (thanks GRR) this is underway. While not a great fan of regulation, common standards I always believe to be useful, so perhaps some principles-based standards would be a very useful thing here.

Anyway, happy new year. My wishes for this year are:

  1. May we get better risk management from our banks;
  2. Less regulation from the regulators; and
  3. More principles-based standards to follow.

I also believe porcine aviation will make great leaps this year. If you have any similar wishes, feel free to add them in.

This whole Centro thing is looking interesting. The core problem is simply stated – they have a lot of debt that is maturing now and, given current conditions, they have not yet been able to refinance on anything like reasonable (for them) terms. The firm has also been highly geared, so refinancing in this market means that they will need to raise more funding through equity.

Listed property trusts are notorious for their complex structure, with individual shopping centres frequently having differing investors with the overall management (and an equity stake) being held by the listed entity (or entities) as at Centro. This makes sorting things out when they have problems very difficult.

The problem, as simply put above, raises a few questions – not least of which is “How did they let this happen?” There are likely to be more than one investigation of this over the coming months – and a lot more if they do fail as a company (which does not look likely at the moment), so any views here must be treated as uniformed conjecture.

At the moment, it looks like an old fashioned liquidity issue – the company has simply let too much of its debt mature at once and that maturity is happening at a bad time. I have said this before and I will say it again – it is bad policy to bet the house on being able to roll any debt facility at any time. A good treasury policy (like the one on CPA Australia’s website) will cover this risk like this:

The XYZs funding requirements and funding strategy, will be reviewed annually and set out in the Treasury
Funding and Risk Management strategy paper. The funding strategy detailed in the Treasury strategy
paper will be developed consistent with the following parameters.
1. [Determine the debt maturity profile. For example provide a information on how much debt will
mature over 1, 3 and 5 years. What is the maximum level of debt that is permitted to mature in next
12 months?]
2. [Does there need to a policy on whom debt can be borrowed from; does debt raising need
diversified in terms of counterparties, types, maturity and geography and do limits need to be set?]
3. [What is policy in terms of raising debt in foreign currency and management of the associated
currency risks?]

This is not just a few things to fill in, but things to think carefully about. Getting all your funding in large blocks may be tempting, but it can be horrifically expensive – ask Centro.

Quite often, though, a liquidity issue is masking a deeper solvency issue. Banks will normally lend (if on occasionally difficult conditions) if they are satisfied they will get their capital back and interest in the interim. It looks like Centro has not been able to convince them this is a strong possibility – which is why they cannot roll the facilities.

If they have over-paid for the shopping centres in the US – a possibility since the economy there looks like it is slowing.

Another interesting point is the disclosures in the last full year report. They disclose only just less that $1.1 bn in total current liabilities (look at page 34). This figure is meant to include all debts maturing during the next 12 months – all of them, including any short term accounts, ordinary trade debts, etc. etc. as well as all major debt facilities. They are now trying to refinance $1.3bn in total facilities – so what are they doing refinancing in one hit $200m more than the total current debts of all types they had at 30 June? Something looks odd here. As I said, these entities have a convoluted structure, so it may be OK, but it does look odd.

My guess is that the audit team is currently being pulled off any other work they were on and are now starting to go back over the files. It should be an interesting period to the the auditors of Centro – and, possibly, a few other listed property trusts.

I have been out of contact over the last few days due to the fact I am moving house, so when I finally got my podcasts to listen to there were a few. I saw one from the BBC’s Today program on Northern Rock (warning – multi-megabyte MP3 file) and I thought this may be a good one, in light of my previous experience with them. I was gravely disappointed.
In what is now a continuing meta-story, the journalistic coverage of Northern Rock is showing just how little even financial journalists understand banking.

The errors in this particular piece revolve around a mis-understanding of one of the absolute basics of banking – liquidity risk. The premise of the argument in it was simple – Northern Rock was unable to meet calls on deposits meaning Northern Rock is insolvent and therefore worth nothing.

A basic understanding of banking would show this up as not a logical argument. As discussed in the post on liquidity risk linked to above, banks borrow short and lend long. This gives rise to liquidity risk, which means that if more than a certain amount of deposits are withdrawn in a short period a bank will not have enough physical cash to pay them. This can be, and must be, separated from the overall worth of a bank.

To put it in simple terms (and turn it around a bit) – let’s say I borrow money from a bank to buy a house. I manage to service the loan for a few years, during which time the value of the house goes up by 50% per annum – making me very wealthy (in part due to the leverage effect). Unfortunately, I lose my job and, during the period where I cannot find another one I cannot meet the repayments on the loan.

Am I financially worthless? Clearly not – there is a lot of value in my home. Can I meet the bank’s demands to pay my mortgage? No.

The Today piece confuses these when the journalist and the talking heads pulled in for the piece argue (at some length) that the failure to pay the demands of depositors means that Northern Rock is worthless.

I am gradually coming to a general rule on actually reading the speeches published by the BIS – the less interesting the title is, the more likely it is that the speech is actually worth reading.

This one “Some thoughts on securitization and financial turbulences” by Jean-Pierre Landau, Deputy Governor of the Bank of France, is a good example. Fairly boring title – quite good content. His (or, more likely, his underling’s) analysis is robust, with a good idea of what happened over the last few months. He is also right that the worst is currently behind us as the real problem was always the liquidity freezing up, not the size of the actual losses.

Where I feel he is wrong, though, is in the policy prescription:

Strong capital will not guarantee liquidity in all circumstances. There can be panics and sudden increases in the demand for liquidity. That’s the job of Central Banks to help in those circumstances. But a strong capital base in the system – and in all its components – is likely to limit future liquidity shocks.

The first two sentences are perfectly correct. Capital is simply not a substitute for liquidity. The next two, though, are wrong – and they do not logically flow from any of the analysis in the rest of his “Thoughts”. Bank regulators commonly get fixated on capital as the be-all and end-all of bank risk management. The attitude commonly seems to be more risk (of any type)? More capital needed. Liquidity, though, is not improved by having more capital; in fact, it may be hurt.

The best capitalised bank in the world will not be able to pay its debts as and when they fall due without liquidity – i.e. it will be bankrupt. Liquidity management is, and always should be, considered separately from capital management.

He is right that a well capitalised bank will find it easier to get liquidity in a liquidity poor market – but Northern Rock was, by the standards of the industry, well capitalised and profitable. Having to go to the Central Bank (the Bank of England) was what destroyed them. Adequate liquidity would have meant that they had no problems and no need for the Bank of England’s help.

The message? Good capital will help – but in a liquidity crisis what you actually need is liquidity. Also, don’t always believe that a Central Banker is right.

Now that many of the banks with some losses in the US sub-prime area have reported it may be a good time to look back at what has happened and then look forward to what is likely to happen over the next 6 to 12 months.

Current Situation

Looking back, I am glad to be able to say that I have been proven substantially correct. None of the bigger international banks have had any real problems – with most not even having this problem to cause them to drop into losses for the year, even though some have reported losses (after full write-downs) for the quarter.

Northern Rock was the only bank outside the US to suffer real problems and this was a liquidity issue – not a capital one. Inside the US several smaller banking insitiutions have failed, but these have been quite small banks that were heavily involved in the lending.

In Australia, again, none of the banks or larger ADIs have had any real problems and, after a few weeks of liquidity problems, we have largely returned to business as usual.

The ones that have had problems are the non-banks that have relied on wholesale funds to keep their businesses afloat – Rams Home Loans being a perfect example. Rams, as a business, did not fail, but they have been unable to secure funding to keep it going and had to be, effectively, rescued by one of the banks (Westpac).

Really, what this “crisis” has done is what any instability should do – prune out the weaker players and allow the well-managed and run (or just the lucky) to continue. The ones that have failed were the ones with a business model that was too reliant on other players in the market and / or had poor timing on their fund raisings. When there was instability they were the ones sitting there exposed. Again – the strong survive and the weak perish. If a firm cannot go for a few weeks withoutexternal funding then, honestly, why should they be able to survive?

As banking crises go, though, this was a puppy – if a bit of a vicious puppy.

The Medium Term

As the remainder of the US sub-prime stuff reprices over the next 6 to 12 months, though, will it get worse? In short, the answer is no. The bulk of it is still to re-price, but most of the banks that have reported have written down their entire sub-prime holdings, not just the stuff that has repriced already. The reason for this is clear – it is both prudent, and required, for them to do so.

A quick look at IAS 39 and FAS 133 (the relevant accounting standards for most of the banks) says that they have to write their assets down as soon as it looks like they have lost value.  In the case of the sub-prime stuff this has already happened. There will be some adjustments to the values over the next few months, but they can be expected to be upward revaluations as the market starts to clear of this stuff. The written down values would be the current worst case – not necessarily their expected outcome.

In situations like this banks (and other listed firms) are increasingly obeying the maxim that ou get the bad news out early, and, if anything, make it look worse that it is. The reason for this is that the market hates downside surprises, but likes upside ones. Getting the bad news out early and big is better than a situation where you just gradually dribble out the bad news.

A single, big, poor number is much better than a few smaller ones.

Banks will take a good look at their counterparties and see if they need to re-visit their lending policies, but the worst of this one can now be expected to be over.

On to the next “crisis”. A Chinese revolution anyone?

Following on from the discussion in the previous post on whether bank1 deposits are money the question arises as to what happens when bank depositors try to convert their bank deposits into money – make a withdrawal, write out a cheque, pay a bill or uses any of the other methods to get at the funds. Will the bank be able to meet the demand for cold, hard, cash?

In short, how do banks manage liquidity?

The Problem

For banks, the problem is actually a fairly simple one to state. Long term, banks typically make money by borrowing short and lending long. As yield curves are typically upward sloping this works well – borrowing borrowing from people who want to deposit short and are prepared to receive between 0 and 4 or 5% to do so and then lending this to people who want to borrow to build homes and pay from 6 to 10%, run credit card balances at around 12% (or more) is a good business. With modern banking practice this even is profitable at a net interest margin of less than 2%.

Given that bank makes the most money by transforming short-dated liabilities into long dated loans the way to make the most money in the long term is to lend it all out and for as long as possible. Great strategy – with only one flaw. Some depositors are inconsiderate enough to want to be able to actually ask the bank to do what the bank has promised to do – pay their deposit at call.

The trick to making the most money, then, is to make sure that you only have enough liquid assets on hand to meet all your depositors calls on the funds and as little as possible more. This is because liquid assets pay little interest, with the most liquid, cash, paying none at all.

Getting this right is the responsibility of the ALM (Asset / Liability Management) function, usually headed by the (gloriously named) ALCO (Asset Liability Committee).

Get it wrong and, no matter how solvent your bank, if it cannot pay depositors calls you will very shortly not be a functioning institution. Read the rest of this entry »

After spending last week on a training course I am back in the saddle with an update on the situation at Northern Rock.

It has certainly been an interesting time for them and it now looks like a deal will be done with another institution to buy them out. I feel that the Northern Rock brand has now been diminished to the point where the brand itself is worth nothing (or less than nothing) and the only thing keeping investors in there is the full government guarantee.

One announcement was interesting, though – Northern Rock originally decided (a decision since rescinded) to pay the interim dividend due on 26 October. Given their evident problems this seemed odd. The announcement of the rescission did not say that it was a consequence of the problems (except indirectly) they said it was withdrawn pending “…a full announcement regarding the outcome of discussions with other parties and the development of the business model…”.

To me this is a good illustration of the differences between a capital and a liquidity event. As commentators (at least those who know what they are talking about) have said throughout, this problem was not one relating to the solvency of the bank. At all stages it has had enough assets to pay its depositors and all other creditors at all times. The problem has been liquidity. The assets were not in a form that they could readily convert to what the depositors wanted – cash.

Northern Rock was still trading profitably, so there was no real need to cancel the dividend from a legal point of view. The difficulty here is two-fold. The dividend would have to have been paid in cash, in this case GBP120m, reducing the liquid funds available. The other problem was the appearance. Handing out what looks like 120m of government money (given that was the source of the liquid funds) to shareholders simply looked wrong.

Unfortunately it again looks like the management of Northern Rock have not handled the appearances well, even if the business itself stacks up. Another reminder, if one was needed, to bank management to have a good, clear plan for handling the appearances of your business as well as the actuals.

[Correction – the dividend was to be only GBP59m. Shows I should not rely on US data sources.]

The current situation with Northern Rock shows just how important customer confidence is when you are (as are virtually all banks) profiting from the borrow short / lend long play. Without deposit insurance (which, I should add I oppose) panics can develop without logical foundation

As their most recent balance sheet makes plain they are entirely solvent – but cannot realise their mortgages fast enough to meet highly abnormal demands for repayment of deposits. This will may mean that the B of E will have to arrange a sale to the highest bidder – and the rumours I have heard is that a few institutions are looking at it, including the National Australia Bank, which has been looking around for further acquisitions in the UK.

The NAB would be a good purchaser, with, in contrast to the Rock, a good deposit base and no real reliance on wholesale funds – the reliance that triggered all this off for Northern Rock.

The lesson here? Watch that name risk and make sure that any announcement of problems is phrased correctly. Having the Bank of England make an announcement that it was moving in as lender of last resort, as Northern Rock did, probably does not set the right tone.

Have your plan up to date and ready to go at all times – take it off the top shelf, blow off the dust and review it now. You never know when you are going to need it.

I am just winding up a job looking at the impact of regulated cashflows on a corporate treasury. In this case the corporate is regulated in such that the cashflows are give a fixed real return and a compensation for inflation – with the CPI compensator initially being forecast and then corrected in arrears.

As the market for inflation indexed debt in Australia is limited we have had to suggest other ways of compensating for this type of exposure through the use of shortened duration debt structuring – essentially getting the debt/interest rate duration to match the reset period.

Is anyone else out there aware of other approaches?

Usefull links

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