The UK economy dominated discussions and presentations at the Association of Corporate Treasurers (ACT) Annual Conference last week, as it seemed to be under attack on a series of fronts. Politically, there’s a real possibility that the UK general election on 6 May will result in no clear victory for any of the major political parties, and there are concerns that any form of coalition government may be too weak or divided to tackle the country’s debt and budget deficit. On the economy, the recent downgrades to the sovereign ratings of Spain and Portugal, along with the ongoing problems in Greece, have served to worry investors that the UK’s AAA sovereign rating may itself be under threat. On top of this, the regulatory fallout from the credit crisis is still in full swing, with the prospect of the big banks being split up into their constituent parts and the reeling in of hedge fund activities are both still real concerns for many of the delegates.
For the sake of balance, Matthew Hurn, deputy president of the ACT, and executive director, group treasury at Mubadala Development Company, did open the conference by announcing that, for treasurers, the future is looking better than expected, saying that there’s never a better time to be a treasurer, in terms of demonstrating the value the role adds to the business. However, in a nod to many of the other presentations at the conference, Hurn added that he wants a healthy and effective, not over-regulated, banking sector.
Has the Dust Settled and What Does it Mean for the Corporate Treasurer?
The economist and author, Professor Tim Congdon, CBE, opened the main keynote presentation by posing two questions to the audience:
- Are bankers members of the human race?
- Do they deserve to be treated as such?
Happily for many in the audience, Congdon’s answer to both questions was “yes”. But when addressing the question in the title of the presentation, he pointed out that a legacy of the crisis is the higher capital ratios in the banking sector – issues from the crisis are enduring and, no, the dust hasn’t settled.
There are two kinds of problem in banking as Congdon sees it: the need to get cash on the asset side of the balance sheet and the need for positive capital on the capital side. Above all, banks need to be both solvent and liquid.
In times of emergency, banks have lines to the central bank to get cash out. Congdon explained that central banks react to two things:
- Illiquidity. Unlimited loans (‘last resort loans’) for the required period at a high/penal rate of interest and against good collateral.
- Insolvency. Emergency ward. Possibly last resort loans but with a view to securing capital injections, or taken over by better-capitalised institutions.
Here Congdon was highly critical of how ‘officialdom’ had perceived the credit crisis, treating it as a problem of insolvency. But, he argued, in the UK at least, it’s been a problem of illiquidity. The UK banking system is not bust, but rather the closure of the international wholesale market exacerbated the situation.
Looking on the positive side, Congdon pointed out that it is highly likely that UK taxpayers will profit from the banking crisis, due to the large public ownership of many of the country’s largest banks. UK banks lost a maximum of £20bn during the crisis, which he argued is comparatively not that bad, pointing out that Ireland’s banks are bust and Iceland too, whereas this is certainly not the case in the UK.
Looking at the circumstances that were in place to precipitate the credit crisis in Autumn 2008, Congdon doesn’t expect this scenario to return. He cited that very low interest rates will be maintained and/or quantitive easing will be repeated to prevent shrinkage of banking systems and a return to recession.
So has the dust settled? Certainly some of the fallout from the credit crisis will be with us for years to come. For example, the increases in capital and liquidity ratios required of the banks will go on for 5-10 years Congdon predicted, although he added that he didn’t think the banks need this. Ending on an upbeat note, Congdon also thought that, assuming bank balance sheets don’t contract and money growth is positive, the next few years should be excellent, in cyclical terms, for the UK and global economies.
Pension Risk Management Strategies
A key issue that many UK corporates need to address is that of pension risk. A so-called ‘pensions timebomb’ is possibly in the pipeline, as longer life expectancy squeezes pension plans that didn’t prepare for that eventuality. A panel session at the conference, moderated by Danny Witter, head of UK corporate coverage at Deutsche Bank, addressed these issues and provided examples of how corporates can offset their pension risk.
Looking at the amount of risk that UK pension plans run, Stephen Dicker, senior consultant at Towers Watson, explained that they’re nowhere near as conservative as European regulators want. Value-at-risk (VaR) is approaching £100bn. There’s been a strong move to liability-driven investing (LDI), and treasurers have been leading this move. Dicker outlined the variety of methods that corporates can use to manage pension risk, which are presented in the box below.
Ways of Managing Pension Risk
- Enhanced transfer values.
- Pension increase surrenders.
- Other liability management options, e.g. encourage early retirement, cash commutation, etc.
- Review policy on discretions, e.g. discretionary pension increases.
- Review future benefit design.
- Capping pensionable pay.
- Choose the right equity/bond allocation.
- Choose the right bond duration.
- Diversify of return seeking assets to improve return per unit risk.
- Buy-out/buy-in (full or partial).
- Staged or risk-sharing buy-outs.
- Capital market solutions.
- Longevity hedges.
Dicker explained to the delegates that it is possible to hedge longevity risk. Buy in/buy out no longer looks affordable in the short-term, but there is still a desire to de-risk – this was the prevailing view among corporates that he had worked with.
Dynamic investment de-risking is necessary, but Dicker explained how corporates could get diverted at times – for example, the company could be nearly ready to sell the pension business to an insurer, when suddenly the returns they get are generating business profits. In such a circumstance, a “why sell?” argument can emerge at board level. In this situation, Dicker argued that treasurers need to advise the board strongly of the reasons to sell, backing long-term security over short-term profit.
Robert West, partner at Baker & McKenzie, then spoke about controlling defined benefit (DB) pension liabilities, how to go about terminating accrual and using de-risking schemes in pension risk management. Using a case study, West highlighted the points to look out for when going through this process. The example he used was of an employer that has a typical DB scheme and wants to terminate accrual to the scheme. The legal issues that the corporate has to be aware of in such a case are:
Pension law – the plan and its trustees
It is possible that the employer cannot afford to wind up scheme due to ‘Section 75 debt’. Arising from Section 75 of the Pensions Act 1995, this legislation provides that, when a pension scheme winds up, the scheme’s employers are liable to fully fund the scheme so that all members’ benefits can be bought out in full with an insurance company (the annuity buyout basis). This also applies to multi-employer schemes if any of the scheme’s sponsoring employers cease to participate in the scheme. In such a case, the exiting employer will be liable for its share of the scheme’s deficit on the annuity buyout basis – hence the term Section 75 debt. In addition to this concern, can the scheme rules be amended to terminate accrual? The corporate will also need to fully understand the powers that the trustees have, and to ascertain if the trustees will co-operate with the process.
Employment law – changing terms and conditions
The employer also needs to establish if their employees’ contracts allow them to change future pension benefits. If they don’t, of course, alternative strategies will be required. In addition, 60 days’ consultation is required for any changes to contract law of this type. Finally, the employer will need to fully investigate whether the employee will have any potential for claims if such a change is made.
After terminating accrual, should the corporate de-risk its pension plan through buy-in or buy-out? West said that the company in this situation has to weigh up what its objectives are, as well as what’s actually on offer. There are different legal consequences and alternative vehicles involved in both buy-in and buy-out. Additionally, corporates need to assess who will pay for it, and how secure the process is.
Finally, West highlighted the other interests involved in the process that the employer should be aware of: the trustees, the pensions regulator, and of course the members themselves. The sheer number of issues involved in terminating pension scheme accrual and de-risking pension schemes mean that any corporates embarking on such a project will need thorough legal advice.
Turning to longevity risk management, Martin Bird, head of longevity and risk transfer solutions for Hewitt Associates, explored the different options for predicting life expectancy, as planning for this has a major effect on pension schemes.
There are four main possible trends when it comes to predicting life expectancy:
- Trend accelerates: medical science discovers major cures, for example a cure for cancer.
- Current levels: current pace of medical advances is maintained.
- Falls away to zero: for example, it is found that cancer just can’t be cured.
- Trends reverse to negative: new epidemics occur, maybe the bird flu pandemic becomes much more serious, etc.
To factor life expectancy into pension risk management, Bird explained that there are two main types of longevity swaps corporates can use:
Scheme-specific longevity swaps cover named lives within the scheme. They protect the scheme against idiosyncratic, basis, and trend risks. Generally they are easy to understand, value and monitor. However, they are only really available for pensioner members, and have a minimum transaction size of around £200m.
Index-based longevity swaps are a derivative whose value is derived from observed mortality experience for a given population. This type of scheme still exposed to idiosyncratic and basis risk, but it is potentially cheaper than the scheme specific model. It is possible to cover younger members with an index-based longevity swap, but this is difficult to do. Index-based swaps also require periodic rebalancing, and there’s a question over whether they will be tradable in the future.
Bird said that the index-based longevity swap can prove difficult in finding out the goodness of a hedge, but it is a little more liquid than the scheme specific option.
In February 2010, Deutsche Bank took on the longevity risk of around £3bn pensions liabilities from BMW, a move that nearly doubled the size of the market for this activity. With the advantages this form of longevity risk management offers corporates, and the willingness of banks to enter into this market, it looks set to continue expanding throughout 2010.
Funding Options – Navigating the New Financial Landscape
Chief executive (CEO) of SVG Capital Lynn Fordham’s presentation focused on her experience overseeing the restructuring of the company’s balance sheet. Before 2008, SVG had a long history of strong performance. It had an ongoing relationship with Permira (a general partner). SVG had commitments to successive Permira funds, most recently the Permira IV Fund.
However, the credit crisis proved to have a huge impact on SVG. The downturn resulted in potential funding shortfall and increased potential funding requirements dramatically:
- Recycling had historically allowed over-commitment.
- Expectation that recycling would be dramatically reduced.
- Distributions slowed down/stopped.
- Calls were expected to be maintained.
At the same time, funding available from financing arrangements decreased. SVG’s loan facility became constrained by loan-to-value (LTV) covenants. In addition, falling valuations increased LTVs and so decreased SVG’s ability to access the facility.
Faced with this combination of negative factors, Fordham explained that SVG then took the following proactive steps to accommodate the effects of the crisis:
- SVG relaxed its debt covenants and reduced its debt facility/notes.
- The company raised equity via a rights issue and private placement.
- Uncalled commitments were reduced (to Permira IV fund).
Following on from these immediate response measures, SVG continued striving to strengthen its balance sheet in 2009 through ongoing measures to deleverage – the company placed a restriction on new commitments and committed to a reduction and reshaping of its debt. In addition to these measures, SVG also saw its investment performance stabilise, with modest growth in the valuation of its investment portfolio, significant de-leveraging of its underlying portfolio and also general improvements in market comparables.
When it came to singling out the main cause of the problems that SVG faced, Fordham agreed with Professor Congdon earlier in the day and and explained that the company faced a serious liquidity issue. The example Fordham said that, in November 2008, SVG’s credit had improved, but the company still found itself being charged between 50 to 100 basis points more than usual for its liquidity needs. When faced with the extra liquidity charges, Fordham described her attitude as being “grumpy, but living with it”, This is a sentiment that many corporate treasurers can empathise with, as banks have become more selective as to whom they lend to. Fordham’s main tip to the treasurers in the audience is to try to get into the bond market if possible, describing it as being “on fire”.
A New Outlook for Market Risk
With foreign exchange (FX) swings and market volatility top of mind for many of the delegates at the conference, David Bloom, global head of FX Research at HSBC, gave a frank assessment of the current market environment and the risks that corporates face.
With the UK general election coming up on 6 May, Bloom began by highlighting that the political business cycle is back with a vengeance. When an administration of any political persuasion is elected, it initially adopts a contractionary policy to reduce inflation and gain a reputation for economic competence. The ruling party might keep these measures up for three years or more, but then, in the year or so running up to the next election, this same party will then adopt an expansive economic policy, in a naked attempt to appeal to voters.
One worry some commentators have in the UK is that if the result of the election is a hung parliament, where no party wins an outright majority of parliamentary seats and a coalition government is formed, that implementation of a stricter economic policy may be slowed down by inter-party bickering. In turn, could this lead to a sterling crisis? The hung parliament dilemma isn’t a concern that Bloom shares: “If they can do it in Scotland, they can do it in England”, was his pragmatic take on the situation. And addressing the potential sterling crisis, Bloom made it very clear that he sees this as a non-issue – and he made the point to the delegates that there’s already been a sterling crisis, there won’t be another one.
One of the key themes of Bloom’s address is the relative swing in power between the western economies and those of the emerging markets. He outlined how the emerging markets are set for a decade-long expansion. Post-credit crisis, political and economic risks in the more developed nations have increased, whereas risk is now much lower in emerging markets than in previous times. If anything, Bloom suggested that the smart move to hedge against market risks today is to sell sterling, euro and US dollar against the currencies of the emerging markets.
Overall, Bloom’s message to the mainly UK-based audience was not to panic in these fiscally charged times. On a cyclical basis, he argued that the UK’s prospects, in the short-term at least, looked positive. He added that he didn’t think the UK will find it’s AAA sovereign rating being downgraded in a similar way to Portugal and Spain, as any new government, coalition or otherwise, will implement the tax rises necessary to manage the national debt.
The Great Re-regulation
Turning to regulation, Jane Fuller, co-director, the Centre for the Study of Financial Innovation (CSFI), provided an overview of the key trends in financial regulation occurring around the world. Using the motto “we’re all bankers now,” Fuller went through the variety of regulations in the pipeline from various national and international bodies. The UK has variety of regulatory requirements from the Financial Services Authority (FSA), the Bank of England, and the Treasury. However, the structure of the regulators themselves is under intense scrutiny following the credit crisis, and could be set for wholesale change after the parliamentary elections. The European Union regulatory initiatives are two-fold: the capital requirements for financial institutions (something that is also a strong focus of the Basel group) and the Alternative Investment Fund Manager Directive (AIFMD) to reign in the perceived recklessness of certain hedge funds. Some in the UK see AIFMD as a threat, whereas certain other nations see it as a way of kerbing the perceived recklessness of funds based in the City of London. In the US, the focus is on the Volker rule, which is designed to prevent banks from proprietary trading that isn’t requested by its clients, and from owning or investing in a hedge fund or private equity fund.
Add to these national/regional regulations the international efforts the work being done by the Basel committee, the International Accounting Standards Board (IASB), and the International Organization of Securities Commissions (IOSCO), and it is clear that financial institutions have serious change coming their way. But despite all this, international co-ordination has so far been patchy. And this is not the only big test faced in the new world of regulation – Fuller explained that the challenges to the traditional banking model through up other questions: is it actually worth keeping a financial conglomerate together in this environment? Will investors accept a lower return on investment (ROI) in return for less volatility? And how will financial institutions manage to cut costs and raise fees to maintain a healthy balance sheet? It’s clear that, while regulators have made some considerable strides to address the perceived weaknesses pre-credit crisis, they are now in the precarious position of having to try to unify the various approaches to create workable global standards, while at the same time making sure not to over-regulate and risk strangling the nascent global economic recovery.
Shaping the Future
Richard Lambert, director general for the Confederation of British Industry (CBI), provided the delegates with the business perspective on the UK’s economic hopes in the times ahead. Perhaps unsurprisingly, the topic of the general election was high on the agenda here also. Lambert started by explaining that the huge range of possible outcomes in a hung parliament has got the business community feeling really uneasy. However, while the appetite for risk in global markets is really low (mostly thanks to the Greece crisis), Lambert said that the prospect of a hung parliament had not spooked investors. Not yet, at any rate. This is good news, and a sign perhaps that the business community is smart enough not to take on face value every scare story that it reads in the media.
Lambert explained to the delegates that there are two main outcomes that the business community wants to see if the UK does indeed end up with a hung parliament – first, that there has to be a working arrangement from the parliament as soon as possible, and second, that there’s a timely outcome to all the political ‘horse trading’ deals that will be needed to set up the coalition government. Once that is set up, the first thing Lambert said the business community wants to see, from whoever is in charge, is the plan on how to restore the public finances in the UK. Whoever the next prime minister is, he’ll have to sort this out quickly if he wants to retain the job, cautioned Lambert.
Lambert spoke passionately about the value that banks and the finance industry as a whole bring to the UK economy, arguing that there can’t be a healthy economy without healthy banks. He drew the delegates attention to the point that there’s no consensus on bank policy between the major three parties, with one exception – the fact that they are all very happy to use the banks as political footballs so close to an election, citing the Labour government’s bankers bonus tax as an example.
After nearly two years of reactionary debate around the credit crisis, treasurers and finance professionals are in a period of transition. The level of risk has been raised in many areas, as a result of the shifting global economy, political uncertainty, and the impending regulatory changes. These major risks are felt throughout the treasury function, affecting corporate cash management strategies, investment and funding plans, and corporate banking relationships. Managing risk is now a major part of the treasurer’s remit and, while the risks faced are great and numerous, strategic risk management from treasurers can negate these and actually set the organisation on course for a stable and successful growth.
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