Banks and small businesses

Banks traditionally lent to UK small/medium sized companies against security which included a debenture charging all their assets.

The security afforded by such a debenture is far less today than it used to be. If a business failed, all recoveries (less fees) would usually have gone to the bank holding a debenture, often leaving nothing for ordinary creditors. In that scenario, banks more readily lent to small businesses than now – thereby stimulating the economy. Why do small companies now find it more difficult to obtain bank facilities?

Bankers (incorrectly) believed a debenture gave them a fixed charge over the company’s debts – now they have only a floating charge ranking behind employees and other preferential creditors. Charges over stock increasingly suffer from retention of title claims. Legislation has reinstated the priority of liquidation expenses and a pool of funds for unsecured creditors has to be set aside from floating charge assets.

The proposed new s 176ZB of the Insolvency Act 1986 will mean that recoveries from fraudulent trading, wrongful trading, transactions at an undervalue, voidable preferences and extortionate credit transactions will not be caught by a floating charge but pass to creditors generally.

Again, debenture holders (with some exceptions) no longer have the ability to appoint an administrative receiver of their choosing nor to prevent the making of an administration order. They will normally have the right to appoint an administrator, but he (unlike a receiver) will owe duties to all creditors (albeit aware of who chose him).

Has UK insolvency law swung too far against the banks which it used to protect?

Bank Reform (2) / The Economy

BANK REFORM (2)

My July paper on Bank Reform published in the Risk Library was forwarded to and considered by UK Authorities. Some proposals have already been actioned; others rejected. This paper adds further suggestions and reviews progress – words in italics are quotes from the original paper.

BANK REFORM

          There has been a temptation to leave recruitment of a Chief Executive to the Board of the bank concerned, but this very properly contains industrialists and investors whose primary concern is profitability. There is a conflict of interest between probity and profitability.

          This conflict was clearly exemplified by Barclays. When the Chief Executive resigned, the then Chairman was inclined to recruit an investment banker with similar profit making motivation. The Bank of England intervened and the Board appointed Sir David Walker, a former Deputy Governor of the B of E.

          The Treasury Select Committee has expressed disapproval at the intervention – believing that such matters should be left to the Board. Surely, it is essential for the future that no such appointment be made without regulatory approval of the appointment proposed.

          Professionals sit rigorous examinations but are not allowed to practice without serving as trainees. — Would it be appropriate to have a Chief Inspector who had never been a branch manager or personally inspected a number of branches?

          Sir David Walker has suggested that bankers should become members of a professional body which has a Disciplinary Committee empowered to strike them off. Such a body could usefully be modelled on the Institute of Chartered Accountants.

          Recent events suggest that the malaise in banking extends well below senior management to relatively junior staff who sell inappropriate products to the public in order to obtain bonuses. It is for consideration whether bonuses at all but the senior level should be banned and replaced by pay rises.

          The Financial Services Authority has recently instituted an inquiry into bonuses at branch level.

The nub of the reforms now required is (a) the protection of depositors —

Current UK Government proposals envisage making depositors preferential creditors in the liquidation of a retail bank. Such depositors are likely to comprise a substantial percentage of a retail bank’s total funding. A consequence of making deposits preferential is that if the bank’s bad debts are considerable there will be few assets left for ordinary creditors.

Preference for depositors will impact on other banks willingness to make funds available to retail banks on the Interbank market. What will the credit rating of such retail banks be?

The concept of allowing a ring-fenced bank to fail ignores the fact that there will then be one less lender operating in the market. Contrast the rescued Halifax which does continue to lend.

— and (b) promotion of the UK economy by ensuring that retail deposits are used to finance UK businesses and house purchases.

The UK Government has confirmed its intention to ring-fence banks’ retail operations but stop short of full separation, the details to be set out in secondary legislation. The European Central Bank may impose a stricter separation which in practice UK banks would have to observe, particularly if the Americans also condemn partial separation as doomed to fail.

There is an urgent need to revive bank lending in order to promote small businesses and facilitate house purchases. This must not await the slow process of bank reform.

Banks are under pressure to increase their capital to comply with Basle III; pressure which makes them reluctant to finance customers of no commercial significance to them. It is unhelpful to apply this pressure whilst the recession persists. Preferably, banks should reduce their need for capital by divesting themselves of peripheral activities rather than cutting back on lending.

A primary purpose of having banks is to provide finance essential to economic growth. Regulators need to monitor monthly new lending by each bank to small businesses and to facilitate house purchases. If such lending is inadequate, Central Bank lending to the defaulter could be on more onerous terms. Banks need regulatory guidance.

          A solution surely is that in return for having deposits with them protected under the Deposit Protection Scheme, deposit taking banks and building societies must (apply) — a specified percentage of deposits — for lending to UK small businesses / house purchases.

 LIBOR

The Wheatley Review of Libor alludes to the possibility of determining the rate from actual money market transactions with automated collection.

It then proceeds to reject this idyllic solution for a number of controversial reasons discussed in a separate paper 

          The impact on Libor of the proposed ring-fencing of retail banks needs to be considered. Will the retail banks be panel members? If so, will their potentially low credit rating significantly distort Libor rates to the detriment of borrowers and the economy?

THE ECONOMY

          Politicians are divided about whether to pursue a policy of austerity and thereby reduce public expenditure and the national debt or a policy of growth to reduce unemployment and social unrest. Too much austerity leads to a waste of resources and deterioration in the national infrastructure. The country needs more houses, better railways, roads and airports. 

          It is for consideration whether Government debt acquired by the Bank of England with Quantitative Easing could be ‘monetised’ i.e. cancelled and replaced with new debt borrowed to fund construction projects and restart economic activity. In the 1930s, Britain came off the gold standard. Printing a controlled amount of new money is the modern equivalent. All through our history, currency has been devalued to promote growth.

          Austerity is required to stem waste of public money and preserve confidence in the currency, but this must not impinge on the infrastructure, housing and other projects needed to kick start the economy. Investment in such projects must focus on British companies – it is counterproductive to kick start the German economy!

James Lingard

James Lingard is a retired partner in Norton Rose who specialised in banking and insolvency law. He was Chairman of the Banking Law Sub Committee of the City of London Law Society for nine years and is the original author of Lingard’s Bank Security Documents now in its 5^thedition (LexisNexis Butterworths).

THE LIBOR CRISIS

THE LIBOR CRISIS

Spurred by the burgeoning derivatives markets, in 1985 bankers invented Libor based on the London Interbank Offered Rates for the relevant currencies and periods. The actual offered rates vary according to the credit rating of the borrowing bank.

The British Bankers Association selected panels of banks for each currency – 16 for sterling comprising the main High Street banks and 11 overseas banks active in the London market. These report their perception of what the cost of funds to them would be in the Interbank market at 11am each business day. The highest and lowest quartiles are disregarded and the average of the rates perceived to be offered to the remaining panel members become Libor for that day. This system worked well for two decades and acquired world wide recognition.

The Banking Crisis

When the Banking Crisis struck in late 2007, banks ceased to lend on the Interbank market in an orderly way. HMG and the Bank of England came to the rescue of the Royal Bank of Scotland, Lloyds Banking Group and others. The rescued banks became flush with funds (which for reasons best known to themselves, they hoarded and failed to lend out to the struggling businesses which needed their support).

Being flush with funds, the rescued banks did not need funding from the Interbank market. However, Libor continued to be announced to prevent chaos in the derivatives markets. But how to calculate it when the market knew that major panel members would not be borrowing – their other sources of funding being cheaper.

Panel members in that position should simply have declined to quote but felt obliged to estimate what the cost of funds to them would be in the Interbank market – a purely theoretical exercise. Once this occurred, some individuals saw the possibility of manipulating the rates they quoted. Borrowers will have benefited by paying lower rates, but those gambling with derivatives have chosen the wrong casino!

Suggested Reforms 

1. Substitute the actual rate (if any) last paid by each panel member that morning before 11am on a standard trade for its perception of what the cost of funds would be. If fewer than eight panel members can so report, Libor should remain unchanged until eventually suspended.

2. The computation of Libor plainly requires to be overseen by the Bank of England empowered to disqualify those who falsify their returns.

James Lingard

James Lingard is a retired partner in Norton Rose who specialised in banking and insolvency law. He was Chairman of the Banking Law Sub Committee of the City of London Law Society and the original author of Lingard’s Bank Security Documents now in its 5^th edition(LexisNexis) and Bankers to Bankruptcy (Kindle/M-Y ebooks).

Bank Governance

Bank Governance.

Bank Governance

Current UK banking legislation requires every director, controller or manager to be a fit and proper person to hold the particular position which he holds. Regard is had to probity, competence, diligence, soundness of judgment and oppressive or ‘improper’ business practices. There is a conflict between profit motivation and acceptable banking practice.
The nub of the reforms now required is: (a) the protection of depositors; and (b) promotion of the UK economy by ensuring that retail deposits are used to finance UK businesses and house purchases. It is unacceptable that protected deposits are used to fund investment banking speculations. These may be profitable but are akin to gambling with taxpayer’s money.
For a fuller discussion on Bank Reform go to http://www.risklibrary.net/abstract/heading-bank-uk-law-vs-prudential-risk-assessments-14075

Bank governance

BANK REFORM

GOVERNANCE 

          Under current legislation, at least two individuals must effectively direct the business of all UK banks and every director, controller or manager must be a fit and proper person to hold the particular position which he holds. In so determining, the Regulator may consider his probity, competence, diligence, soundness of judgement, financial standing and, indeed, “any business practices appearing to be deceitful or oppressive or otherwise improper (whether unlawful or not)”.

          So, what is the problem? Simply that everyone considers themselves to be fit and proper. Regulators have found it difficult to accuse individuals of failing the test without compelling evidence. ‘Whether unlawful or not’ sounds fine, but it is a matter of opinion whether a lawful and profitable business practice is such as merits banning a Banker. Would disqualification be upheld on appeal?

          There has been a temptation to leave recruitment of a Chief Executive to the Board of the bank concerned, but this very properly contains industrialists and investors whose primary concern is profitability.

          There are two areas where regulation can and should be tightened:-

          First, who are the individuals effectively directing the business? It is ludicrous to believe that anyone could effectively direct the mammoth clearing banks of today other than by means of a Chairman’s office comprising a small number of heads of divisions frequently updating the Chief Executive.

          Secondly, having identified the individuals concerned, are they competent in having the necessary skills and experience. Do they, for example, understand the complexities and risks inherent in the latest derivatives which their bank is trading?

          One pair of eyes who understands is not sufficient. There must be two individuals. When banks were better run, the two individuals were normally a full time executive Chairman and a Chief Executive backed up by two deputies. Now, Chairmen are sometimes part time with other business interests.

          Moreover, theoretical knowledge is rarely adequate. Professionals sit rigorous examinations but are not allowed to practice without serving as trainees. For example, would it be appropriate to have a Chief Inspector who had never been a branch manager or personally inspected a number of branches?

          Recent events suggest that the malaise in banking extends well below senior management to relatively junior staff who sell inappropriate products to the public in order to obtain bonuses. It is for consideration whether bonuses at all but the senior level should be banned and replaced by pay rises.

RECENT HISTORY

          The Preface to the first edition of Lingard’s Bank Security Documents published in March 1985 contains the following:-

‘Unfortunately, – – – banks from overseas – – – flood into London. Such banks often lend at highly competitive rates to strong customers. The result has been to increase the competitive pressures on banks to a point where they are sometimes denied the detailed financial information needed to make a proper assessment of the prospects of a company – – -. Unless these pressures abate, the authorities may well find they have to mount some bank rescues.’ 

          The pressures increased and were compounded by credit default swaps under which gullible banks participated in bad loans in return for fees which enhanced the bonuses of the ‘bankers’ responsible. Grossly inadequate provisions for the bad debts were made in the audited accounts and regulatory returns.

          The Preface to the fourth edition published in August 2006 – before the crash – again warned of “the distinct possibility of forthcoming troubled economic times”. Senior bankers were giving priority to selling the bank’s products in a highly competitive market and failed to invest adequate resources in risk assessment. Only recently is interest being shown by banks in risk assessing software available from major actuaries such as Towers Watson.

          The fifth edition as at 31^st August 2011 has now been published to assist bankers and their advisers to structure sound security and sound lending and insolvency practitioners to identify defective security.

ESSENTIAL REFORMS

          The regulatory failures of the recent past have now been admitted and the Bank of England will again take charge. However, competitive pressures remain and the policy of the EEC and British Government is to increase competition by splitting some of the larger banks. This is desirable to assist in ensuring adequate governance and to fill voids left by cost cutting branch closures, but past experience has highlighted the dangers of too much competition.

          The question is: how will the regulators ensure that banks do adopt prudential risk assessment? Will overseas banks continue to take big risks to grab the business? And how will credit default swaps and other derivatives be policed?

The nub of the reforms now required is (a) the protection of depositors and (b) promotion of the UK economy by ensuring that retail deposits are used to finance UK businesses and house purchases. It is unacceptable that protected deposits are used to fund investment banking speculations, credit default swaps and such like. These may be profitable but are akin to gambling with other people’s money.

          Cash rich banks have and will inevitably attract predators. Present proposals envisage banks being controlled by supermarkets, grocers and other commercial entities. In the past, British banks have frequently been taken over by banks regulated in cultures which encourage and reward massive risk-taking of a type which caused the present crisis.

          The solution surely is that in return for having deposits with them protected under the Deposit Protection Scheme, deposit taking banks and building societies must (a) be controlled and managed by ‘fit and proper’ retail bankers with relevant lending experience and (b) comply with defined criteria.

1. A cap could be placed by the regulator on the maximum amount lent to any borrower group, region, country or sector.

2. A specified percentage of deposits could be restricted to be used solely for lending to UK small businesses / house purchases – deposits surplus to lending being lodged with the Bank of England.

3. Such activities would no longer require highly paid risk takers.

4. The Bank of England to be empowered to prevent takeovers.

          The above restrictions would not apply to banks which do not take deposits covered by the Deposit Protection Scheme.

          Who would provide the capital for the deposit taking banks? I suggest the present High Street banks hive down and decouple their deposit taking branches, distributing shares in the new entities to their then existing shareholders. Such shares would ideally be listed on the Stock Exchange. 

James Lingard 

James Lingard is a retired partner in Norton Rose who specialised in banking and insolvency law. He was Chairman of the Banking Law Sub Committee of the City of London Law Society and the original author of Lingard’s Bank Security Documents (LexisNexis Butterworths) and Bankers to Bankruptcy (Kindle/M-Y ebooks)

This paper will shortly be available in the Risk Library

Bank Reform

BANK REFORM

 

Recent History

The Preface to the first edition of Lingard’s Bank Security Documents published in March 1985 contains the following:-

 

‘Unfortunately, the evolution of security documents is under pressure as banks from overseas – – – flood into London. Such banks often lend at highly competitive rates to strong customers. The result has been to increase the competitive pressures on banks to a point where they are sometimes denied the detailed financial information needed to make a proper assessment of the prospects of a company.’

 

The pressures increased and were compounded by credit default swaps under which gullible banks participated in bad loans in return for fees which enhanced the bonuses of the ‘bankers’ responsible. Grossly inadequate provisions for the bad debts were made in the audited accounts and regulatory returns.

 

The Preface to the fourth edition published in August 2006 – before the crash – again warned of “the distinct possibility of forthcoming troubled economic times”. Senior bankers gave priority to selling the bank’s products in a highly competitive market and failed to invest adequate resources in risk assessment. Only now is interest being shown by banks in risk assessing software available from major actuaries such as Towers Watson.

 

The fifth edition as at 31^st August 2011 has now been published to assist bankers and their advisers to structure sound security and sound lending and insolvency practitioners to identify defective security.

 

Essential Reforms

The regulatory failures of the recent past have now been admitted and the Bank of England will again take charge. However, competitive pressures remain and the policy of the EEC and British Government is to increase competition by splitting some of the larger banks. Arguably, there is already too much competition between banks.

 

The nub of the reforms now required is surely (a) the protection of depositors and (b) promotion of the UK economy by ensuring that retail deposits are used to finance UK businesses and house purchases. It is unacceptable that deposits protected under the deposit protection scheme are used to fund investment banking speculations, credit default swaps and such like. These may be profitable but are akin to gambling with other people’s money. But how can the regulators police credit default swaps and other derivatives?

 

Cash rich banks have and will inevitably attract predators. Present proposals envisage banks being controlled by supermarkets, grocers and other commercial entities. In the past, British banks have frequently been taken over by banks regulated in cultures which encourage and reward massive risk-taking of a type which caused the present crisis.

 

The solution surely is to restrict deposit taking in the UK to banks and building societies both controlled and managed by ‘fit and proper’ retail bankers who comply with defined criteria.

1. A cap could be placed on the maximum amount allowed to be lent by any deposit taking banking group to any borrower group, country or sector.

2. A specified percentage of deposits could be restricted to be used solely for lending to stable UK businesses and for prudential house purchases.

3. Such activities would no longer require highly paid risk takers and a cap could be placed on the remuneration of bankers who manage deposit takers.

4. The Bank of England could have a golden share to prevent opportunistic takeovers – in return for the deposit protection scheme.

 

The above restrictions would not apply to banks which do not take deposits covered by the deposit protection scheme. The present High Street banks could hive down and decouple their deposit taking branches, distributing shares in the new entities to their then existing shareholders. Such shares would ideally be listed on the Stock Exchange.

 

Present Dangers

A systemic weakness in the present position is exemplified by the following extract from Bankers to Bankruptcy by James Lingard now available on Kindle:

 

A Banker’s Confession

 

‘One of my team, who had been set the task of checking our holdings of bonds against the latest risk assessment software, identified three holdings which we should never have touched. I cannot really blame my colleagues who made the investments. They were simply following the rest of the market and relied on the rating agencies who had considered the bonds to be triple AAA. The auditors gave no warning of any problem and the regulators seemed to be perfectly content.

‘The potential losses were so large that they exceeded the capital and reserves of the bank. We had become technically insolvent.

‘I immediately went into emergency mode and organised teams of our investment bankers to create parcels mixing the junk bonds with higher grade bonds which I knew to be attractive to the market. With a bit of luck, our sales people would succeed in passing them on to those of our competitors who had failed to invest in the new software.

‘I instructed the sales teams to ensure that nothing was said or done to mislead the victims on whom the junk was about to be unloaded. “Simply tell them what is available, that we are overexposed and a policy decision has been taken to diversify the risk.” Perhaps, the bonds would not default – who could tell. Remember, we could be wrong. None of them have actually defaulted yet.

‘In just three weeks, hard working investment bankers succeeded in unloading all the suspect bonds. OK, we made a loss on those holdings but nothing like the disaster which could have hit us. Those sales guys saved the bank – no question about that. I intend to pay all my people concerned decent bonuses. They’ve earned it. I don’t care what the politicians say.’ The Banker chuckled at the thought. ‘I went to see the regulators this morning and warned about bonds circulating in the market at a gross overvalue.’

But, can it be right to allow banks to operate in the market on a ‘dog eats dog’ basis? Do we really want a free market economy? And did the guys who ‘saved the bank’ deserve million pound bonuses?