We Know Zero

RM = QE?

21. October 2013 · Write a comment · Categories: Economics, Regulation

A couple of days ago I received my statement from Royal Mail plc, confirming my allocation of 227 shares at the offer price of £3.30 each, therefore costing me £749.10. At the time of writing the share price is at £5.14 (although it was at £5.31 a few hours ago), equivalent to a value for my 227 shares of £1,166.78.

So I am sitting on a paper profit of over £400, and the Government is under fire for undervaluing Royal Mail, from everyone from the trades’ unions, to the Labour Party, to the Commons Business Select Committee to even some stockbrokers and to 51% of the general public. In response, Vince Cable, the Business Secretary, has suggested that everyone calms down a bit and waits to see what the price is in a couple of months.

But what if the issue was not mis-priced at all? What if the short-term profits were intended all along?
Remember that this is a Government still in the business of quantitative easing (QE). A process described by the Bank of England thus:

…the asset purchase programme is not about giving money to banks. Rather, the policy is designed to circumvent the banking system. The Bank of England electronically creates new money and uses it to purchase gilts from private investors such as pension funds and insurance companies. These investors typically do not want to hold on to this money, because it yields a low return. So they tend to use it to purchase other assets, such as corporate bonds and shares. That lowers longer-term borrowing costs and encourages the issuance of new equities and bonds to stimulate spending and keep inflation on track to meet the government’s target.

However, the critics of QE have become increasingly loud. It is untested, no one is quite sure what the long term consequences will be of the amounts that have been invested in this way and many of the short term benefits appear to have been benefitting the wrong people once the initial emergency receded. Perhaps partly as a result of these criticisms, there has been no new QE since July 2012.

Alternatives have increasingly been tossed around between economists and other commentators. One of which is the notion of helicopter money. Drop it from the skies, cut out the banks, and the effects will be more immediate, its supporters say.

If the target of QE is investors, and the aim of the policy is to make them invest in corporate bonds and shares rather than gilts, in order to encourage companies to raise more money in the markets to fund expansion, could the paper profit of £1.7 billion (compared to the £375 billion of QE so far) be a micro-experiment in a different type of QE?

There is other evidence to support this. At the end of 2011, Spencer Dale, the Bank’s chief economist, gave a speech about flaws in the QE approach:

I have considerable sympathy for the argument that the MPC’s asset purchase programme provides relatively limited direct support to SMEs (ie small and medium sized businesses). It will provide indirect support by stimulating spending and activity in our economy. But most SMEs are heavily dependent on bank credit and so not able to benefit directly from the increased demand for corporate debt and equity triggered by our asset purchases. But therein lies the problem. The majority of SMEs do not issue marketable securities that the MPC could purchase…..Instead, we need to find ways to incentivise the banks to lend more to SMEs.

So would a few hundred pounds each help SMEs? Well, some of the owners will have applied for shares and benefitted directly, as they are likely to be in the more financially aware section of the public. This may also explain the decision to set a minimum stake of £750 in the Royal Mail offer. Others may benefit from any increase in consumer spending that results from people spending their winnings. The longer term stimulus effect the Bank is trying to produce will depend more on the actions of the institutional investors who bought 70% of the offering.

One of the other criticisms of QE is the impact on interest rates, although the size of the impact is difficult to determine and those who complain about the implications on annuity rates, for instance, tend to ignore the stoking up of asset prices it is also likely to have achieved. However Charlie Bean, one of the Bank’s deputy governors, gave some support to this criticism in May 2012:

A long period of abnormal monetary policy strains social support for a central bank’s actions. Changes in policy always have distributional consequences, shifting income from savers to borrowers or vice versa. That is an unavoidable by-product, rather than the aim, of policy. Society usually accepts such consequences because they are transitory, and what one loses on the swings today, one may gain on the roundabouts tomorrow. But the sustained period of very low interest rates has, quite reasonably, prompted complaints from savers who feel they are bearing an unfair burden.

So any vehicle for putting money in people’s hands without affecting interest rates would, we assume, at least get a fair hearing at the Bank.

When QE appears to have run out of steam, and the “Help to Buy” home ownership schemes are causing increasing unease about the property bubble they seem almost certain to create, should we expect to see further privatisations on the Royal Mail model if the recovery stalls? It wouldn’t surprise me in the least.

The Phoenix has landed

14. October 2013 · Write a comment · Categories: Birmingham, Cartoons, Economics, Regulation

Mention the Phoenix Four in Birmingham and you are likely to get a strong reaction. Most people knew someone who worked at MG Rover’s Longbridge plant, and many local families supplied workers for generation after generation. A huge rally brought tens of thousands onto the streets in 2000 when BMW put MG Rover up for sale, protesting against what had appeared at the time to be the most likely outcome of Alchemy Partners buying it and turning it into a low volume car manufacturer with only 2,000-3,000 of the 6,500 jobs there remaining. So there was jubilation when the ‘Phoenix Four’ group of businessmen (John Towers, John Edwards, Peter Beale and Nick Stephenson) stepped in to take the business off BMW’s hands for £10 with a further £500 million accompanying the business from BMW to sweeten the deal. By 2005 all the jobs had been lost.

A Government inquiry into Phoenix Venture Holdings (PVH – the Four’s company) reported in 2009 that The Four had managed to extract £42 million in salaries and pensions by this time. The inquiry spent 4 years and £16 million getting to grips with the convoluted machinations by which this was achieved. No criminal charges resulted. The Four were not even disqualified from being company directors. Instead, in 2011, they belatedly agreed voluntarily not to serve as directors for 3 (Edwards), 5 (Towers and Stephenson) and 6 (Beale) years respectively.

In January last year, the Executive Counsel to the Financial Reporting Council (FRC) finally turned to the advice The Four had been receiving during the whole saga, from Deloitte and specifically their head of UK corporate practice Maghsoud Einollahi, alleging that their conduct fell short of the standards reasonably expected of them in relation to Project Platinum (the project to put a deal together) and Project Aircraft (the specific deal to transfer MG Rover Group’s (MGRG’s) accumulated tax losses to a subsidiary of PVH). The tribunal ruled on these allegations last month. It makes entertaining reading unless you happen to be a former MG Rover employee.

One of the issues was that Deloitte had muddied the waters about who they were representing (MGRG or PVH) in order to mask a massive conflict of interest. As the tribunal states:

If the identity of the client is not known it is not possible to identify and consider whether there is any conflict existing or potential. That is the real importance of identifying the client. Here the client was known to the Respondents (ie Deloitte and Einollahi) a substantial time before the final existence of a letter of engagement and nothing was done about it.

The Phoenix Four were always the client. Deloitte were at all times acting on their behalf. We know too that the Respondents were represented at an MG Rover Group Limited Board Meeting and made a presentation to the Board thus suggesting that they were acting for MG Rover and not the Phoenix Four.

But my favourite bit is the extract of Einollahi’s testimony on who his client was:

Q: (reading his previous testimony) “…you did not think you had a client…”
A: (Pause) I think that is fair, that I didn’t believe I contractually had a client.
Q: Exactly
A: But
Q: And the problem is the one that I have alluded to already, that you would be holding yourself out to third parties as acting for, in this case, the group (ie MG Rover)
A: (Nods)

Following this Pinteresque dialogue, the tribunal moved on to Deloitte’s fee of £7.5 million. Part of the defence case had been that £7.5 million was not a very large fee within the context of Deloitte’s annual fee income, that contingency fees (ie which were paid only if a given result was achieved) were common and that clients were not prepared to accept different arrangements. The tribunal was not impressed:

It seems to us that Mr Einollahi would charge a contingency fee of a size he thought that he would be paid by the client without considering whether it was appropriate or not. Again when he gave evidence he was cross-examined and we refer to one question and answer.
Q: …you did not like to negotiate fees downward?
A: I didn’t – I didn’t act for people who wanted to negotiate my fees downward. I didn’t need to.

The tribunal concluded:

He wanted that fee of £7.5 million and realised that his best prospects of achieving that fee were by a deal between the Phoenix Four and HBOS rather than between MGRG and First National Finance or MGRG and HBOS

Project Aircraft, the scheme involving moving around MG Rover tax losses, had been attempted before under the title Project Salt/Slag and rejected by the Inland Revenue. Aircraft succeeded where Slag failed largely because the Revenue believed this time that MG Rover would benefit from the profits generated by the scheme.

Mr Towers said “frankly, for us, what mattered was there was a possibility here of creating cash, additional cash for the group and most particularly, for the cash-consuming part of the group which was the car company”. Mr Beale’s evidence was to the effect that MGRG benefited from the transaction because “it gave the group additional cash reserves which it could lend to MG Rover as and when required”. The Inspectors (from the Government inquiry) said at Chapter XI paragraph 17 “in practice, much of the money which the group generated from Project Aircraft was used to fund a payment to the Guernsey Trust”. (The beneficiaries of which included Messrs Beale, Edwards, Stephenson and Towers.) The Inspectors continued “immediately before Barclays Bank made its £121 million loan (which also paid off a previous loan and some other creditors), PVH had credit balances on its bank accounts totalling £2,184,083. The loan increased the credit balances to £14,736,629, enabling the company on 26 June 2002, without having received any money from any outside source in the interim, to pay £7,905,125 to the Guernsey trust (as well as paying £2,261,875 to Deloitte in respect of fees for Project Aircraft). No payment was made by PVH to MGRG at this stage, or in fact at any time before November 2003.

The tribunal continued:

Mr Einollahi undoubtedly played a significant part in Project Aircraft. He must have been aware, and admits that he was so aware, that the Phoenix Four were on holiday in Portugal in 2001 and while on holiday agreed between themselves to pay themselves very substantial bonuses. They in fact paid themselves collectively about £7 million after the conclusion of the Project Aircraft transaction. These sums came essentially from assets of MGRG and were used to make these very substantial payments to the Phoenix Four. They received the whole of the proceeds and MGRG received none.

In conclusion, the tribunal said:

They (ie Deloitte and Einollahi) placed their own interests ahead of that of the public and compromised their own objectivity. This was a flagrant disregard of the professional standards expected and required and was in each individual case, and of its own, serious misconduct.

The Executive Counsel, who had made the complaints, asked for a severe reprimand and a fine of between £15 million and £20 million. They also requested that Einollahi be excluded from membership of the Institute of Chartered Accountants in England and wales (ICAEW) for 6 months and fined an amount based on an assessment of his financial resources. Deloitte suggested instead that the fine should only be £1 million and Einollahi should not be fined at all.

At this point, in my view, the tribunal lost its way a little. They decided on a severe reprimand and a fine of £14 million for Deloitte. This was calculated as follows:

We have assessed the financial gain from the fees attributable to both Project Platinum and Project Aircraft with a deduction for the total amount of recorded costs against these projects. We have added interest at 1% over base rate to deny Deloitte any financial gain from the misconduct.

This raises an interesting question about what calculations other firms might make in the future about the chances of ending up in a tribunal like this and the likely consequences against the rewards of the deals themselves. If worst case scenario is that they won’t make a profit, I remain unconvinced that this will prove much of a deterrent.

They added:

We have borne very much in mind that Deloitte is not insured against the imposition of a fine and has undertaken to indemnify Mr Einollahi against any fine imposed upon him.

It is heartwarming to see them looking after their errant employee in this way, but their insurance arrangements should be of no interest to anyone.

Einollahi himself was excluded for 3 years rather than the 6 months requested by the Counsel, but only because he was not prepared to voluntarily relinquish his practising certificate. He also refused to cooperate with the assessment of his financial resources, leading to the tribunal to put a bit of a finger in the air and opt for a fine of £250,000.

So what now? The tribunal made much of the public interest in the hearings:

It was particularly important in the case of both Project Platinum and Project Aircraft that the public interest be considered because of the concern of inter alia the Government, employees, other employers, particularly in the West Midlands, creditors and the general public about the continuation of large scale car manufacturing in the West Midlands.

The importance of considering the public interest is further emphasised because both the Projects resulted in very large sums of money that might have been utilised for the benefit of the MG Rover Group in the running of its business instead, being used for the benefit of individuals, including the Phoenix Four.

But what is the public interest? My assumption would have been that it must primarily be about the portion of the general public which was most damaged by all this, namely the MG Rover workers who lost their jobs and their communities. The local MP, Richard Burden, agrees. The Trust Fund for former MG Rover workers, which John Towers had at one point said would have over £50 million in it, was finally wound up earlier this year when the £23,000 actually available was donated by the workers to a local hospice.

The £14.25 million awarded in fines would normally go to the Consultative Committee of Accounting Bodies (CCAB), an umbrella group for several professional bodies, which pays the costs of FRC disciplinary cases. However in this case the costs of the proceedings of just under £4 million have already been charged to Deloitte on top. Is the case for meeting the costs of future disciplined accountants really greater than the public interest in making some contribution to the communities that the FRC’s members have facilitated into the ground?

There will be some time to make this decision in. Depressingly, Deloitte and Einollahi filed formal notice on 1 October that they are appealing the decision, as indeed they have contested everything that wasn’t nailed down throughout the process. Their joint statement read as follows:

“We recognise the general desire to move on from this case but do not agree with the main conclusions of the tribunal which we feel could create significant uncertainty for individual members and member firms of the ICAEW.”

After all, if it ever became accepted that consultants had any responsibility to the most vulnerable people affected by their less-than-professional manoeuvrings, where might it end? There is no time limit on the tribunal member hearing the appeal to make a decision on whether an appeal can go forward.

Enough is enough. Deloitte should do the right thing and drop their appeal now.

Faced with Philip Booth’s free market fanaticism, I’d rather be Frank

07. October 2013 · Write a comment · Categories: Economics, Regulation, Risk

This was a letter sent to The Actuary on 12 September, but which they chose to publish neither in the magazine nor on the website.

Dear Sir

In response to the interview with Philip Booth in the September issue, I would just like to point out that the banks did not know during the 2007 financial crisis that they would be bailed out. The day before Alistair Darling announced a £500 billion rescue package in October 2008, shares in RBS fell by almost 40 per cent to a 15-year low, HBOS fell by over 40 per cent, Lloyds TSB dropped by 13 per cent and Barclays by 9 per cent precisely because a bailout was not assumed.

As regards how prudently financial institutions behaved before the changes in insurance regulation in the 1970s and 1980s, I would prefer to listen to the views of someone who was actually there. Frank Redington, in his submission to the Institute of Actuaries in 1981 entitled The Flock and the Sheep and Other Essays, says:

“We have no means now of telling how the profession would have emerged from what would have been the only real test of its collective character which it has had to endure in the last 100 years. When the curtain fell in 1939 the profession was not cutting a very brave figure. Valuation bases were too weak, the rate of bonus was some £5 too high and new business was being sold on prospects which were not achieved until 18 years later. A few reputable offices had their backs to the wall.

“The outcome, if the war had not interrupted the story, would probably have taught us a valuable lesson. As it is we have to conclude regretfully that the profession had not – and, I am sure, has not – learned how to live with its salemen’s promises. To put it another way, we are driving a powerful car but have not yet proved our ability to handle the brakes.”

Regulation was inevitable. The problem which remains is that financial institutions in many cases are too complicated in their current form to regulate effectively. As Robert Reich, former US Secretary of Labor, puts it when arguing for the need to split Wall Street banks, they are “too big to fail, too big to jail, too big to curtail”!

Yours faithfully
Nick Foster

The mortality of fairness

07. October 2013 · Write a comment · Categories: Actuarial, Pensions, Regulation

There are many reasons why it is much harder for a small actuarial consulting firm to do business than a large one. Large firms can obviously afford to put people on the committees which design actuarial regulation, whereas small practitioners tend not to be able to spare the billing time lost. This has resulted in many recent developments, in regulation in particular, disproportionately favouring larger firms.

The Technical Actuarial Standards (TAS), whatever your opinion of them and I am generally in favour, have spawned TAS committees in larger firms and, in all firms, has required a redesign of most advice given by pensions actuaries. This has been bad enough for large firms, but much more difficult for firms with one or two actuaries. Large firms can devote resources to producing the personality-free template documents we see springing up all over the place and have a ready source of peer advice to help apply the TASs to new documents as they become necessary. The “tick list” approach of GN9, GN11, GN16, GN19 and the rest, so heavily criticised by the now defunct Board for Actuarial Standards (BAS) when introducing the TASs, did at least make compliance relatively straightforward for small firms, allowing them to concentrate on the far more important and personal task of tailoring advice to the specific needs of their clients.

The new guidance for actuaries on conflicts of interest is similarly slanted. The suggestions are almost all big company solutions, from separation of teams to information barriers to setting up conflicts committees, designed to protect the income of firms with multiple offices from the loss of the ability to provide advice to connected parties. The one man business is pretty much left with “ceasing to act” as a strategy, leaving the field even clearer for the bigger firms.

I have been vaguely aware of this for some time, but since I left a medium-sized consultancy last year and started providing peer review services to small firms, it has been harder to ignore. I do not expect to continue as a sole trader over the long term, but I fear for those who do.

And the latest example that has struck me is the recent behaviour of the Continuous Mortality Investigation (CMI). This is an organisation with a proud tradition of providing analysis and resources on all aspects of mortality, longevity and morbidity to the Actuarial Profession. Anyone could access their materials for free, unlike Hymans Robertson’s Club Vita or the postcode analyses provided by companies like Longevitas. It was public data, available and accessible to public, academics, journalists and actuaries alike, working in the public interest.

No more. A fee structure has been put in place with effect from 1 April this year. Large consultancies will pay what, for them, is a flea bite of a fee. But I imagine some of the small firms will think twice about the relative costs of being locked out or the fee for continued access. And to demonstrate just how unfair it is, I have graphed the cost per qualified UK actuary below:

Apart from the fun to be had seeing how the formula impacts different consultancies (and speculating about some of the lobbying that might have been going on to achieve this) the graph shows us that the average cost starts at £250 for a firm with one actuary, but ends at around £30 per actuary for a firm the size of Towers Watson (mainly based on the number of UK actuaries listed in the latest actuarial directory – my apologies if any of these are out of date).

There are anomalies too. A firm with 20 actuaries pays £210 per actuary, whereas one with 21 pays £352 (the highest per actuary cost of all).

It is not as if these are avoidable costs. Funding and accounting cost mortality assumptions may not need to be updated every year but other routine work will. For instance, thanks to changes to the Statutory Money Purchase Illustrations (SMPI) technical memorandums since December 2011 (overseen by the Financial Reporting Council’s (FRC’s) actuarial council with, you guessed it, no one from a small actuarial firm on board), anyone without access to the CMI 2013 projections (which are the first to be pay-to-view) will be unable to provide SMPIs from 6 April next year.

This does not appear to me to be fair treatment of smaller actuarial firms, nor of their clients, who are also small firms. According to the Association of Consulting Actuaries’ (ACA’s) Second Report of the ACA Smaller Firms’ Pensions Survey, published earlier this year, small firms, which the larger consultancies increasingly are finding not cost-effective to service, represent a more and more important sector of the economy:

The small and medium-sized enterprises (SME) sector, here defined as businesses employing 250 or fewer employees, is the largest part of the UK private sector economy in terms of employment. These smaller firms employ over half of the UK’s private sector employees (59.1%) and generate just short of a half (48.8%) of all private sector turnover, amounting to some £1,500 billion per year. They make up over 99% of all UK private sector enterprises. The number of these SMEs has increased by 39% since 2000, whereas there are only just over 6,500 UK private sector enterprises that now employ 250 or more employees compared to 7,200 a decade or so ago (a reduction of 10% over the period).

If the CMI does have to charge for its services, then I would propose a flat per actuary fee, set at a rate designed to generate the same level of income, as a much fairer approach. Assuming this aimed at raising between £250,000 and £300,000 from consultancies next year, I estimate this should result in a per actuary fee of around £100. In my view that would be replacing the mortality of fairness with fairness of mortality.

Needles and Pin September 2013 – The Rise of a Pin

30. September 2013 · Write a comment · Categories: Cartoons

Magical Realism and the Pensions of Europe

23. September 2013 · Write a comment · Categories: EIOPA, Pensions, Regulation

The Wizard of EIOPA is back. Gabriel Bernardino, the chairman of the European Insurance and Occupational Pensions Authority (EIOPA), outlined in May the powers he thought were necessary for EIOPA to enhance its role as a European Supervisory Authority for the insurance market. Insurers are currently busily opposing such calls.

On 5 September, therefore, he changed tack with a speech about pensions instead, entitled Creation of a sustainable and adequate pension system in the EU and the role of EIOPA.

“The creation of an adequate, safe and sustainable pensions system is one of the key objectives of the European Union and EIOPA is committed to contribute by all means to the development of such a system,” he boomed, despite the EU’s Constitutional Treaty not mentioning pensions anywhere among its objectives. He went on to state that EIOPA approved of assets and liabilities being valued on a market consistent basis. So far, so uncontroversial.

But then he continued. “EIOPA suggested a number of elements to reinforce the governance of IORPs: for example the performance of an own risk and solvency assessment.” What? An ORSA? You mean that thing that has led the insurance industry to spend millions on consultants, conferences and which, 5 years on from when it was first mooted, is only currently fully implementable by 24% of European insurers with all of the resources available to them? (Moody’s Analytics, in their July 2013 survey of 45 European insurers, concluded that 24% of the insurers interviewed had their processes, methodologies and models in place to fulfil Pillar 2 requirements – the key one being the ORSA).

He wasn’t finished. EIOPA proposed to require defined contributions (DC) schemes to produce a Key Information Document (KID). This would contain “information about the objectives and investment policies, performance, costs and charges, contribution arrangements, a risk/reward profile and/or the time horizon adopted for the investment policy”. So, a massive amount of additional bureaucracy around the default funds in a DC scheme by the sound of it, with no appearance of understanding that members of DC schemes can choose their own investment policies, nor a word about the hottest issue in DC provision at the moment, ie the level of charges. Surely he is KIDding?

Next he carried on a bit about the “holistic balance sheet” concept, despite it having recently been kicked into the long grass for implementation by pension schemes he clearly desperately wants to bring it back if he can, before giving his interpretation of the findings of the quantitative impact study (QIS) as part of the process to advise the European Commission on the review of the IORP Directive. This boiled down to:

Some pension schemes have surpluses, others have deficits.
Schemes can either make up deficits by paying more contributions (“It is not unusual that future sponsor support needs to cover as much as 25% of liabilities.” Said the Wizard, with the air of a man discovering a new physical law) or by reducing benefits.

I think we can all agree that however much the QIS cost it was worth the money.

Then we moved onto the Swedish part of the speech. “I would like to take this opportunity to thank the Swedish pension industry, the Swedish pension protection scheme (PRI Pensionsgaranti) and the Swedish supervisor (Finansinspektionen) for their contributions to the QIS. Sweden was the only member state with sufficient financial assets to cover the pension liabilities as well as the solvency capital requirement. Pension funds showed on average even a substantial surplus over the SCR of 13% of liabilities. Of course, an important reason for these positive outcomes is that Sweden already imposes a prudential regime that is market consistent and risk based, by using the quarterly Traffic Light stress test. In my view, this clearly illustrates that a future European regulatory regime should be market consistent in order to ensure a comparable and realistic assessment of the financial situation of pension funds; and risk based in order to provide IORPs with the right incentives for managing risks.”

What? According to the Swedish Pension Agency’s annual report on the Swedish Pension System for 2012, it consists of a pay-as-you-go scheme (the inkomstpension) and effectively an insured personal pension (the premium pension). So it clearly illustrates precisely nothing for a defined benefit occupational pension system like that of the UK with total buy out liabilities of around £1,700 billion (according to the UK Pensions Regulator’s Purple Book for 2012). However, did I mention where this speech was taking place? Sweden.

It was time for the Wizard to return to building his empire. EIOPA need more resources, more powers and now, apparently, more of a mandate. Obviously the m-word is a bit of a problem for all European institutions but it grates on the Wizard particularly. Despite the Solvency II omnibus grinding along on the hard shoulder and the first attempt at new funding targets for occupational schemes being rebuffed, he believes that now the time is right for a foray into personal pensions. He refers to occupational pensions as “the so called 2nd pillar” which confused me at first as I thought that was the risk management part of Solvency 2. However, then I realised that it was just that Eurocrats are obsessed with pillars because now he is calling personal pensions “the so called 3rd pillar”. And he wants to run them with the same efficient competence we have come to associate with the Wizard.

The Wizard wants a new sort of personal pension known as an “EU retirement savings product”. This would avoid “the traps of the short term horizon” (ie pesky scheme members deciding they need their money earlier than EIOPA decree they can have it) and “managed using robust and modern risk management tools” (does he mean things like the stochastic techniques and Value at Risk methodologies which have shown no discernible ability to manage risk in banks to date?). Finally “it should have access to a European passport allowing for cross border selling”. There has been scope for UK occupational pension schemes to become cross border schemes for some time now. Hardly any have taken up this “opportunity” so far because it came with a requirement to immediately increase the level of funding of a defined benefit scheme to buy out level. For defined contribution schemes, as we saw with the fate of stakeholder pensions, the appropriate vehicle very much depends on the form of social security system in place, the degree of means testing and when it happens and, most importantly, how it interacts with the state pension system. One size will definitely not fit all, and I expect that the Wizard’s EU retirement savings product will remain a largely theoretical entity for this reason.

However, my favourite part of the Wizard’s speech was left until last. “It is our collective responsibility to face reality,” he offered, with no hint of irony. I fear that the Wizard’s sense of reality is more a type of magical realism where people can fly, or turn into unicorns and EU officials can regulate things they don’t understand without unintended consequences.

“Please help us to move in the right direction,” he concluded. I think we should all do precisely that, by opposing what the Wizard of EIOPA proposes for pension schemes of all kinds.

Lawyers Go Negative

16. September 2013 · Write a comment · Categories: Legal, Regulation

The Advertising Standards Authority (ASA) has decided that no action will be taken against the Law Society as a result of their Don’t Get Mugged campaign, which ran during July and August. The advert encouraged accident victims to seek legal representation from solicitors rather than rely on a third-party capture offer from an insurer. The ASA considered that it neither denigrated insurers nor was likely to distress victims of actual muggings.

What this campaign does appear to do is open the door to professionals attacking each other overtly in their advertising (what US presidential candidates call “going negative” with “attack ads”) in their desire to get more business from the public. Supermarkets have done this from time to time, but it is relatively rare elsewhere. I still remember the Dillons advert from the eighties aimed at its main competitor, Foyles, (Foyled again? Try Dillons) because of its rarity. However it looks like we may be about to see a lot more of it. Will this give rise to insurers and banks going at it with independent financial advisers even more loudly over the level of independence of the advice being received, or solicitors and licensed conveyancers escalating hostilities? Will this help informed decision making by anyone? I somehow doubt it.

It seems unlikely that solicitors will turn the same type of emotional manipulation on each other any time soon, as the Solicitors’ Regulatory Authority sets out as one of its principles that solicitors should “behave in a way that maintains the trust the public places in you and in the provision of legal services”. So that leaves the field clear for other professions to get in there. I would suggest something like this (add the name of your profession as appropriate):

Let the games commence!

Boomers versus Y and Z

10. September 2013 · Write a comment · Categories: Economics

When the GCSE results came out the other week I had a special reason to be interested as my daughter Polly was one of the anxious students waiting for them. As it turned out, she did very well, but I ended up listening to news coverage of the event which perhaps ordinarily I would have missed.

And how obnoxious it was! Despite a reassuring increase in students taking the more difficult subjects, and pass rates at all grades statistically no different from the previous year (nearly every media outlet seemed to report a drop, once again the direction deemed more important than the amount). Unless the numbers go up every year, apparently, none of us are happy.

When the steam (or hot air at least) had run out of these criticisms, people of my age seemed to be queuing up to appear on radio stations to tell today’s students that what they lacked was something called “grit”. We need to introduce a GCSE in Grit, they cried.

Grit. Really? This is the generation which has not had the grit to adequately tackle any issue which threatened the immediate earnings of the already rich and powerful, like climate change for instance, or a just tax system, either globally or even nationally.

But they are right in a way, because a generational war has been declared and the sooner today’s students wake up to this the better. We are not all in it together. The labels of “baby boomer” or Generation X, Y and Z are there to put us into economic camps (definitions vary, but I, at 50, am somewhere on the boomer-X boundary apparently, my children are Y and Z, or both Z, depending on the point someone is trying to squeeze out of the data). When they stumble out into the job market, today’s students risk having insufficient qualifications (because even when the numbers do all go up, employers cry “grade inflation” and pull up the drawbridge even further) for anything but a McJob, on zero hours contracts, or nothing at all, subject to youth curfews, ASBOs and acoustic dispersal devices. If they are lucky enough to be graduates they will have, in addition, a loan of at least £40,000 to repay. If they want to rent somewhere to live, they will be victim to an insufficiently regulated private rental market. If they want to buy, they are highly vulnerable to a property bubble being inflated for all its worth by George Osborne. It would be hard not to conclude that the rest of society had declared war on them while they were preparing for their gritless exams.

Meanwhile, the sense of entitlement amongst the boomers is frequently drowning out any other voices. Low interest rates are bad because they “attack” pensioners’ savings, and make annuities more expensive for those about to become pensioners. However this is just special pleading for one generational group. Low interest rates are good for making the Government’s money go further, and for spending on other priorities than the boomers.

Similarly high inflation is bad news if you’re a pensioner, and if your pension, as most are where the pensioner had a choice, is not inflation-linked. However, provided it is accompanied by earnings and economic growth, ultimately it is how a deficit burden, both private and public, is going to be shrunk most effectively.

The last thing Ys and Zs need is another 50-something lecturing them on what to do, but my plea would be that they don’t let these arguments be lost by default. The battle lines have been drawn. And I know which side I’m on.

Land mines and bank bailouts

28. August 2013 · Write a comment · Categories: Cartoons, Economics, Prediction, Regulation, Risk

A man is sentenced to 7 years in prison for selling bomb detectors which had no hope of detecting bombs. The contrast with the fate of those who have continued to sell complex mathematical models to both large financial institutions and their regulators over 20 years, which have no hope of protecting them from massive losses at the precise point when they are required, is illuminating.

The devices made by Gary Bolton were simply boxes with handles and antennae. The “black boxes” used by banks and insurers to determine their worst loss in a 1 in 200 probability scenario (the Value at Risk or “VaR” approach) are instead filled with mathematical models primed with rather a lot of assumptions.

The prosecution said Gary Bolton sold his boxes for up to £10,000 each, claiming they could detect explosives. Towers Watson’s RiskAgility (the dominant model in the UK insurance market) by contrast is difficult to price, as it is “bespoke” for each client. However, according to Insurance ERM magazine in October 2011, for Igloo, their other financial modelling platform, “software solutions range from £50,000 to £500,000 but there is no upper limit as you can keep adding to your solution”.

Gary Bolton’s prosecutors claimed that “soldiers, police officers, customs officers and many others put their trust in a device which worked no better than random chance”. Similar things could be said about bankers during 2008 about a device which worked worse the further the financial variables being modelled strayed from the normal distribution.

As he passed sentence, Judge Richard Hone QC described the equipment as “useless” and “dross” and said Bolton had damaged the reputation of British trade abroad. By contrast, despite a brief consideration of alternatives to the VaR approach by the Basel Committee on Banking Supervision in 2012, it remains firmly in place as the statutory measure of solvency for both banks and insurers.

The court was told Bolton knew the devices – which were also alleged to be able to detect drugs, tobacco, ivory and cash – did not work, but continued to supply them to be sold to overseas businesses. In Value at Risk: Any Lessons from the Crash of Long-Term Capital Management (LTCM)? Mete Feridun of Loughborough University in Spring 2005 set out to analyse the failure of the Long Term Capital Management (LTCM) hedge fund in 1998 from a risk management perspective, aiming at deriving implications for the managers of financial institutions and for the regulating authorities. This study concluded that the LTCM’s failure could be attributed primarily to its VaR system, which failed to estimate the fund’s potential risk exposure correctly. Many other studies agreed.

“You were determined to bolster the illusion that the devices worked and you knew there was a spurious science to produce that end,” Judge Hone said to Bolton. This brings to mind the actions of Philippe Jorion, Professor of Finance at the Graduate School of Management at the University of California at Irvine, who, by the winter of 2009 was already proclaiming that “VaR itself was not the culprit, however. Rather it was the way this risk management tool was employed.” He also helpfully pointed out that LTCM were very profitable in 2005 and 2006. He and others have been muddying the waters ever since.

“They had a random detection rate. They were useless.” concluded Judge Hone. Whereas VaR had a protective effect only within what were regarded as “possible” market environments, ie something similar to what had been seen before during relatively calm market conditions. In fact, VaR became less helpful the more people adopted it, as everyone using it ended up with similar trading positions, which they then attempted to exit at the same time. This meant that buyers could not be found when they were needed and the positions of the hapless VaR customers tanked even further.

Gary Bolton’s jurors concluded that, if you sell people a box that tells them they are safe when they are not, it is morally reprehensible. I think I agree with them.

Risky business

19. August 2013 · Write a comment · Categories: Risk

I think if I were to ask you what you thought the best way to manage risk was, there would be a significant risk that you would give me a very boring answer. I imagine it would involve complicated mathematical valuation systems, stochastic models and spreadsheets, lots of spreadsheets, risk indicators, traffic light arrangements, risk registers. If you work for an insurance company, particularly on the actuarial side, it would be very quantified, with calculations of the reserves required to meet “1 in 200 year” risks featuring heavily. Recently even operational risk is increasingly being approached from a more quantifiable angle, with Big Data being collected across many users to pool and estimate risk probabilities.

Now you can argue about these approaches, and particularly about the Value at Risk (VaR) tool which has brought this 1 in 200 probability over the next year into nearly every risk calculation carried out in the financial sector, and the Gaussian copula which allows you to take advantage of a correlation matrix to take credit for the “fact” that combinations of very bad things happening are vanishingly rare (the “Gaussian” referring to the normal distribution that makes events more than three standard deviations or “sigma” away from the average vanishingly rare), rather than actually quite likely once the market environment gets bleak enough. The losses at Fortis and AIG 2008 were over 5 and 16 sigma above their averages respectively.

The news last week that the US Attorney for the Southern District of New York had charged two JP Morgan traders with fraud in connection with the recent $6.2 billion “London whale” trading losses reminded me that VaR as it is currently used was largely cooked up at JP Morgan in the early 90s. VaR is now inescapable in the financial industry, having now effectively been baked into both the Basel 2 regulatory structure for banks and Solvency 2 for insurers.

The common approaches to so-called “quantifiable” risk may have their critics, but at least they are being widely discussed (the famous debate from 1997 between Phillippe Jorion and Nassim Nicholas Taleb just one such discussion). However, one of the other big problems with risk management is that we rarely get off the above “boring” topics, and people who don’t get the maths often think therefore that risk management is difficult to understand. In my view we should be talking much more about what companies are famous for (because this is also where their vulnerability lies) and the small number of key people they totally rely on (not all of whom they may even be aware of).

If you asked most financial firms what they were famous for, I imagine that having a good reputation as a company that can be trusted with your money would score pretty highly.

A recent survey of the impact of the loss of reputation amongst financial services companies on Wall Street revealed that 44% of them lost 5% or more in business in the past 12 months due to ongoing reputation and customer satisfaction issues. Losses based on total sales of these companies are estimated at hundreds of millions of dollars. There was an average loss of 9% of business among all companies surveyed.

And the key people we totally rely on? Well, just looking at the top five rogue traders (before the London Whale), we have:

1. SocGen losing 4.9 billion Euros in 2008 when Jerome Kerviel was found guilty of breach of trust, forgery and unauthorized use of the bank’s computers in their Paris office with respect to European Stock Index futures.
2. Sumitomo Corp losing $2.6 billion in 1996 when Yasuo Hamanaka made unauthorised trades while controlling 5% of the world’s copper market from Tokyo.
3. UBS losing $2.3 billion in 2011 when Kweku Adoboli was found guilty of abusing his position as an equity trade support analyst in London with unauthorised futures trading.
4. Barings Bank losing $1.3 billion in 1995 when Nick Leeson made unauthorised speculative trades (specifically in Nikkei Index futures) as a derivatives broker also in London.
5. Resona Holdings losing $1.1 billion in 1995 when Toshihide Iguchi made 30,000 unauthorized trades over a period of 11 years beginning in 1984 in US Treasury bonds in Osaka and New York.

None of these traders will, of course, have done anything for the reputations of their respective organisations either.

These are risks that can’t be managed by just throwing money at them or constructing complicated mathematical models. Managing them effectively requires intimate knowledge of your customers and what is most important in your relationship with them, who your key people are (not necessarily the most senior, Jerome Kerviel was only a junior trader at his bank) and what they are up to on a daily basis, ie what has always been understood as good business management.

And that doesn’t involve any boring mathematics at all.