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In 2008 Malcolm Gladwell talked about 10,000 hours of practice in the sense that the more you do the better you become. This has a certain resonance. The more sportsmen train the better they are. So too in music, art and even the professions. Whilst Gladwell's theory has its detractors Jim Slater discussed something similar in the "Zulu Principle". Research leads to expertise whether this is in anthropology (Zulus) or investment (shares). Surely it follows, that by application, you as an investor can beat the market. Even better, a fund manager could do all the hard work giving you superior returns. But overwhelming evidence tells you otherwise. When I was trading any other dealer was fair game. That’s exactly how fund management works but this time the prey is a financially illiterate public who end up with pension values reduced by one third to one half. Americans call this a turkey shoot. This will no doubt continue despite FCA investigation. If keeping more of your money is important what can you do? Minimise costs. Ongoing charges compound horribly and damage your wealth; Decide on asset allocation. This is the proportion in equities and bonds you hold; Ask yourself what's better that low cost index funds and similar ETFs? Remember finding a fund manager who can demonstrate superior performance over a meaningful period is nigh on impossible. Do it yourself stock selection isn’t the answer either. Any acquired expertise will be eaten by transaction costs. After all what do you know that professional investors don't? This is the paradox. Investment doesn't need a huge amount of effort to give you returns that will outperform 90% of fund managers. In that sense 10,000 hours could be better spent.

Drive in London and you can pay £21.50 for the privilege. That's the effect of the new T-charge. The mayor tells us it will cost taxpayers £7m to implement. That makes no sense whatsoever. This isn't an isolated incident. Over the last decade we have squandered a lot of benefits that should have arisen from two sources namely improved I.T. and simplified "industrial" processes. Opening a bank account - it takes half a day or more. Need a criminal records check for a new job – I'm told it’s a wait of 12 weeks. Motorway roadworks - longer than the time it took to build the road (not funny but true). £5 of coins to the bank for a £5 note - you must pay into your account first. Switch a bank account - take half a day of form filling plus two bits of I.D. (This goes missing in the post). Claim a discount on council tax - 6 weeks of delay. Transfer a pension - it's independent advice costing hundreds before you can decide what to do Buy a car - sit in the sales office for half a day with the paperwork....... There’s a serious point here. Productivity has collapsed and it’s not difficult to see why. Everything that was once straight forward is now burdensome and costly. What’s happening is that resources are being misdirected. It's therefore no surprise that in the last decade finance, telecoms and energy have all suffered poor productivity growth. They are after all at the forefront of regulation. The T-charge is a small but understandable example. The money is out of your pocket - you have less to spend on the things you want. Who wins? No one.

When two parties separate there’s often a settlement involved. Normally this is an up-front payment and may include ongoing maintenance. The amount is subject to assets, dependents and time. A 50/50 split is often considered equitable. Breaking up isn’t just for the family courts it happens elsewhere too. Exit a contract early and pay the penalty fee. It could be for your insurance, mobile or energy. The amount depends on the small print. In financial markets if you want “out” it can be simple. Just “hit the bid”. For derivatives it’s different. You need to agree the value using all the incoming and outgoing cash flows. This isn’t as straightforward. What you both want can be entirely different. Partly this is explained by bid – offer spread but a lot’s down to how much you can get away with. For complex deals negotiating leverage proves to be most valuable. What then is the fair price of Brexit? Given that the future commitments aren’t clear agreement will be based on approximation. But there is something that we need to know. In markets salesmen extoll the virtues of entering trades. But change your mind and they want their profit up-front before you go. Over the years we’ve been told that being a member of the EU is advantageous. I am sure this is true of the non-financial aspects of membership. Which incidentally also accrue to the EU. But if the UK pays a substantial sum to leave it implies two things: That we are net financial contributors. The EU has a better negotiating position vis a vis the UK. If either party presses too hard it will be counterproductive. Both sides need to feel the deal is “fair” and that’s up to those doing the negotiating. What's at stake are all those mutually beneficial things that aren't measured in money.

Legacy business - something you wish you didn't have The balance sheets of building societies often contain legacy assets. That’s business that you wish you hadn’t got. It can be on either side of the accounts and typically it’s base rate, Libor or lifetime linked. The customer may also have flexibility concerning drawdown and repayment, and this makes things worse. The net effect is to cut income whilst taking up management time – and it just keeps giving. Is there anything that top investors do that could help you? Rabbit, hunter or assassin? In his book, The Art of Execution, Lee Freeman-Shor studied investors and identifies three types of individual, the rabbit, the hunter and the assassin. Assassins are ruthless at getting rid of bad investments and it is this trait that gives them superior returns. Could this benefit you too? These investors are disciplined enough to sell once a certain loss is incurred. This stops them holding things that don’t perform as anticipated. It also gives them the opportunity to stand back and reassess the situation without having the emotional upset that goes with holding loss making positions – a sort of emotional circuit breaker. As buy and hold investors we don’t do this and there are good reasons why. We manage for the long term and accrue interest. This reduces the volatility of the profit and loss but doesn’t stop us losing money. It is just that the losses are felt over a much longer period and therefore appear more palatable. Nevertheless, their cumulative effect eats into earnings and capital and may threaten solvency. Is there anything that we can do that could flag this risk earlier and give us time to deal with it? I think there is. We could use an approach similar to a top investor but modify it for our business. Using the size, margin and duration of the legacy business your risk team should be able to answer two questions: ·      What is its effect on the Net Interest Margin? ·      How long does this last for? What's it costing? Looking at things from this perspective the risk may appear less benign and the legacy may be costing you an awful lot more than you thought. The best investors would have already pulled the trigger, but our accounting techniques have left us asking questions much later. Looking for the exit may not be viable but is there anything else we can do? It would be beneficial to understand more about the behaviour of the legacy. What are the contractual maturities? Are there prepayments/extensions? Can the customer opt for changes that hurt us? Above all we need to understand more about worst case scenarios. How could this change? What could it cost us? How does it compare with our profit and capital position? Can you migrate the business in a way that is fair to the customer? Time to pull the trigger? In this way understanding the role legacy products play in the net interest margin will help you explore your risk appetite and what drives it. In this context investing like an assassin may not be an option but you may ask a lot more questions about new products particularly those that are long in duration. Are their returns adequately compensating you for a changing business, political and regulatory landscape? Or should you pull the trigger on tomorrow’s legacy now?

Should we target net interest income? For many banks and building societies Net Interest Income (NII) is a substantial part of “earnings”. Earnings allow us to add to capital, pay dividends and grow the business.  Given its importance should NII be targeted by the Board? By targeting I’m referring to establishing a process that tells you what is happening and where necessary acting on that information. My interest (no pun intended) comes from seeing executives struggle with this question and more often than not it’s kicked into the long grass. It’s this uncertainty that I want to address. Are we failing to consider a key component of our profitability? Should we do something? A comparison One target we are familiar with is inflation, it affects our lives and since the 1990s monetary policy has focussed controlling it, as The Bank of England’s website succinctly puts it: “The Government sets us a 2% inflation target….. This helps everyone plan for the future. If inflation is too high or it moves around a lot, it’s hard for businesses to set the right prices and for people to plan their spending. But if inflation is too low, or negative, then some people may put off spending because they expect prices to fall. Although lower prices sounds like a good thing, if everybody reduced their spending then companies could fail and people might lose their jobs. If we miss the inflation target by more than 1 percentage point either side of the target, we must tell the Government why. So if the Consumer Prices Index (CPI) inflation rate is more than 3% or less than 1%, our Governor writes a letter to the Chancellor to explain why and they set out what we'll do to get it back to 2%”. The Bank informs us there is a target (2%), it’s reported and there is action to maintain it. The reason why the government targets inflation is because it acknowledges that it can cause problems when it is too high or too low. Could the same be said about your NII? If it’s too low, you are in danger of not covering costs and if it’s high you have to ask what risks you are taking to get there. NII is therefore a major determinant of your long run success. However, because NII is important it doesn’t automatically follow that it should be targeted and two questions are frequently raised in this respect: We don’t know what the future holds so how can we decide what our NII will be? By targeting NII aren’t we increasing risk? The Bank isn’t certain on inflation, but it doesn’t stop it from being targeted. The important thing is to believe that in some way your action can influence the NII and surely this must be true otherwise your business is wholly dependent on luck not skill. Furthermore, by not paying close attention to the NII isn’t your risk going up, not down? The right controls that curtail excess in credit, rates and liquidity together with the appropriate cultural and remuneration policies should protect you. Risk taking only gets out of hand if you allow it to happen. Inertia Given its importance why is it that many firms don’t target NII? It’s just not a regulatory priority. The main concern for the regulator is whether the capital supports the business. Just as night follows day preoccupation by the regulator on certain things draws in management too. The PRA concentrates on solvency not what makes you solvent.  Basis risk also attracts regulatory scrutiny and in a similar way management attention is pulled towards it.  Capital and basis risk are linked by the NII. NII contributes to capital but is partly derived from basis risk. Basis risk itself comes from the strategic decisions made some time ago about how you borrow and lend. NII therefore provides feedback on how effective your strategy is - something any Board should want to know. In other words, NII is the real effect whereas basis risk is the abstract cause and real things are just a lot easier for us to talk about. Boards therefore should have relevant information about the NII. Whether the NII ought to be subject to a limit is a much harder question to answer. My definition of a limit is a maximum or minimum exposure to an identifiable risk where situations outside the limit are acted on. These actions may include reduction of the risk, changes to the limit or waiting. Limits themselves are linked to risk appetite on which the board should have a clear view. In this respect the target the Bank of England operates is a type of limit set by the government, it’s not set in stone, there’s a 1% leeway either side and this makes sense because there are many variables that influence inflation and its management is nuanced. Having a minimum NII level to warn you about not covering costs and a higher level to prompt you to think about where the money comes from appears sensible. Just like inflation there may be times when you need to look through the monthly figures to gauge where NII is heading. In doing so these limits should stimulate debate. How much interest do we need to break even? What generates the margin? Why is it changing? Important questions that help us understand our business and what action we need to take to keep it going.

Three types of stress test If you run a Google search for “stress testing” you will find over 900m results and one near the top is from the Bank of England: “Banking stress tests assess how banks can cope with severe economic scenarios. We look at banks’ resilience, making sure they have enough capital to withstand extreme shocks and are able to support the economy.” I’ve always felt uneasy about stress tests, it’s a bit surprising, after all, they should provide comfort that, if the unexpected happens we have cover. Are we right to think they strengthen what we do? Tests fall into three categories: Those where the results are certain. By applying a load, you can test a material to destruction. Repeating the test will confirm your results. “Everything breaks at some point – the important thing is to know when that will happen.” TÜV Rheinland. Those where subjectivity must be applied to the results. A patient that has an irregular heartbeat would require an expert diagnosis to determine the cause. “A stress test is often used as a screening test. If the result is normal, then typically you won’t need further tests. If it’s not, you may require further tests, depending on the type of problem identified”. British Heart Foundation Those where subjectivity exists beforehand and afterwards. “Nevertheless, given that our measurement of risk is at best a prediction - hopefully a well-founded prediction, but nevertheless still involving a high degree of judgment - we will not always get it right. In such an environment, when leverage is high and the room for error is low, we need a strong safety net in case risk may be underestimated”. Mr Stefan Ingves, Governor of Sveriges Riksbank, 2014. Our uncertainties Victorian bridges (or any other long-lasting structure) remain functional because the engineering was known. Herein lies a problem our business contains a lot of uncertainty and subjectivity: What triggers customers to withdraw money? Are wholesale markets riskier than retail? Are government guarantees like the FSCS helpful, if so, how do they affect withdrawal rates? Is it the full balance or the excess over £85,000? How does the channel effect the capacity to withdraw? How price sensitive are customers and how is this affected by competitor’s rates? Are new customers more unpredictable than old? We look back at what happened and guess about the future, there is little of known fact. At best we get an approximation of what may happen and whether this is “severe but plausible” is a matter of opinion.  All we know for certain is that, when customers perceive there are problems, they will want their money back sooner rather than later. To assume anything else would be rash. The economic uncertainties Furthermore, if we don’t know where the economy is going from one day to the next how can we verify the amount of capital we need in a leveraged business? “Any changes made to ECL (Expected Credit Losses) to estimate the overall impact of Covid-19 will be subject to very high levels of uncertainty as so little reasonable and supportable forward-looking information is currently available on which to base those changes. ………such an implementation ought to reduce the risk of firms recognising inappropriate levels of ECL, which is very important bearing in mind that a significant overstatement of ECL could prompt behaviour that leads to unnecessary tightening in credit conditions.” Sam Woods, Deputy Governor and CEO of the PRA Is it just speculation? The way engineers look at the world, indeed have to look at the world, differs from ours. Theirs is a one of “pass” or “fail” but for us this would be a big mistake as it fails to acknowledge the uncertainty we face. For this reason, looking for red, amber or green may be expedient but it can get us in trouble. It also assumes the calculations are correct in the first place…… “…. the question is whether the numbers are now so layered in detail that it’s not straightforward to identify an error in the first place.” Financial Times correspondent, Thomas Hale, on 13th December 2019, commenting or errors in capital calculations at Metro Bank and Coventry Building Society. I’ll draw a few strands together: There are three types of stress test and you need to be aware of which you are using. In our business we have assumptions and guesses about people’s behaviour and the future. This means our tests are approximations of risk. We aren’t dealing with construction and we aren’t engineers therefore red, amber and green paints a simple but potentially misleading picture. In Part Two I’ll consider some of the beneficial things we can do, in particular the importance of responding flexibly.

In Part One I summarised that: There are three types of stress test and you need to be aware of which you are using. In our business we have assumptions and guesses about people’s behaviour and the future. This means our tests are approximations of risk. We aren’t dealing with construction and we aren’t engineers therefore red, amber and green paints a simple but potentially misleading picture. Models and approximations Following on, one of the main threats we now face is Covid 19. It’s a fact that no stress test contained it, why would it? But now it’s happened it highlights the weaknesses of our models. What’s more the uncertainty in health now widens the range of economic outcomes: “In all of the countries whose data we analysed, the best fit to that data favours the second explanation…….the infection may have spread far enough to mean that the trajectory of falling new cases could be maintained with some easing of restrictions. Policy on how far to ease restrictions will inevitably have to be made in a fog of considerable uncertainty.” “Assessing the spread of the novel coronavirus in the absence of mass testing”. Oscar Dimdore-Miles, Department of Physics, Oxford University and David Miles Professor of Financial Economics, Imperial College Business School With such uncertainty we should ask how we can make better use of our models, which are after all approximations, to find out more about uncertain things, things like: What if? – Make small changes to the assumptions going into your model and find out what happens to capital, liquidity and survivability. Behaviour – Are you offering customers free options where they can drawdown or repay on their terms? Can you quantify what this could cost? Are there surprises? Can you redesign products to mitigate the effects? Concentration – Is there a particular counterparty, market, product, channel etc that if it ceases to operate leaves you over exposed? Could it take you down? Risk appetite – How much risk can we sustain? How do we link it to profit and capital resources? Is our exposure in an area where we have an edge? Are we being sufficiently well paid for the risk we take? Buffers – How are these insurance policies, that build in reserves, sufficient to see us through? How do we link the period we expect them to last to our risk appetite? In a world where our risk has now increased the natural inclination is to add to buffers as a way of protection, but this can become ruinously expensive. To offset this, the more levers you can pull and the more effective they are, the more you manage such costs. There are big gains therefore to be had from understanding this and also the role flexibility, (aka management action), plays in determining self-insurance. They key is to determine whether you can realistically change the speed of cash flows or mitigate adverse supply or demand conditions on a timely basis by your actions. Something’s missing That’s finding out about unknown threats that can take the business down (the “unknown, unknowns”). This is very difficult to do; it requires an exceptional degree of insight that’s always obvious after the event - hindsight is a wonderful thing. To explore these weaknesses, we are encouraged to use Reverse Stress Testing but what this is and how works is open to conjecture. The Bank of England comments “Reverse stress tests are stress tests that require a firm to assess scenarios and circumstances that would make its business model unworkable, identifying potential business vulnerabilities.” Here’s what I wrote in 2010: “It is the process of uncovering events that, should they occur, have the potential to make your business unviable. Such events can cover credit, market and liquidity risk. It's important to remember that business failure occurs before you run out of capital. It's when counterparties are unwilling to deal with you". Because it’s a disciplined process of finding weaknesses in your business and deciding on the action that needs to be taken. "Tail risks" (low probability high loss events) are dangerous because they occur more frequently than models predict. Identifying these extreme events gives you a better chance of survival. You can decide whether you are within your risk tolerance or whether some form of action needs to be taken. It is an additional risk management tool. Reverse stress testing is about plausible scenarios outside your normal stress testing requirement. Let's look at an analogy. In the world of aviation aircraft are designed to withstand serious and repeated stresses. Engines are run to destruction to ensure that in the normal course of flying the power plant always performs. But what happens if two out of four engines fail? Knowing the answer may help you avoid catastrophe. Let's look at banking What could cause your largest wholesale counterparty to fail? And what are the consequences for you? Does it tell you anything about the level of risk you currently run? What's the role of the Board? To use its experience and understanding about the way the business works to decide on the appropriate reverse stresses, what their impact could be and whether action is required.” One of the greatest difficulties comes from a simple question. “Just how do you do it?”  In the last decade I’ve seen three approaches: Breakpoint - increase a stress to a point where the firm fails. For example, what percentage of retail funding needs to go within 90 days before we fail? Failure – decide on scenarios that are highly unusual, but would if followed through, lead to failure. For example, negative interest rates over a long time period. Backwardation - start with the failure from a stress test and determine whether there is a realistic (albeit most unlikely chance) it could occur. For example, we run out of capital as a result of this stress, what economic scenario could cause this? The important thing is not how you do it but what you make of it. With conventional stress testing you find out whether your business will survive predetermined events, whilst reverse stress will chip away at the foundations and ask how structurally sound your business really is. Done well it’s a useful adjunct to what we do and that’s why I’m surprised more use is not made of it. Surely it would be sensible for any board to take some straightforward information about what causes the firm to fail and then consider whether there are certain plausible scenarios that could make this happen and whether there is something they can do, which over time, will improve the potential outcome. Summary Our industry always faced huge uncertainty and our leverage magnifies the consequences of getting it wrong. Stress testing uses unreliable models and assumptions and for this reason red, amber and green gives us false comfort. We can get more from our models by using estimates of how our business may work and at the same time try to build in management action that improves flexibility. Such self-insurance reduces the cost of idle buffers. This is more important now Covid 19 has widened the range of possible outcomes. Reverse stress is controversial but assessing your vulnerability to unlikely events can help you find weaknesses that would otherwise go unnoticed. This isn’t about predicting pandemics, it’s about seeing things you already face. Do they have the potential to take you down? This is the remit of the Executive and Board.

Too good? Selling mortgages with interest rates of between 1% and 4% may seem like an opportunity too good to miss, particularly now Bank rate is 0.10%, but is this too good to be true? Let’s see. As a lender if you want to build a mortgage pipeline it’s straight forward, all you need to do is offer lower rates than the market. Every day the market asks you the question “do you want to deal?” Four things will influence your decision, three of which you have no control over: 1.    The current level of interest rates 2.    Your cost of borrowing 3.    The price competitors charge The starting point is the cost of money, the Gilt yield curve, each bank then has an additional funding spread, a further margin is then added, and this gives a loan rate. How much business you then do is constrained by what your competitors offer. To illustrate let’s see some numbers: Gilt yield..................0.10% Funding spread......0.60% Margin.....................2.50% Loan rate.................3.20% The maximum gross margin you can earn is 2.50%, note this is gross and all your costs and expenses need to come out before you are looking at a net earnings figure. Keeping things simple we will assume your competitors undertake a similar exercise, their costs are identical, but they alter their loan margin to 2.30% giving them a lending rate 20 basis points lower at 3.00%. What do you do? A fourth factor now comes into play: 4.    Discretion – you can now choose to re-price at a lower rate or walk away from the market. What’s more this is the only point in the proceedings where you have control, the choice is entirely in your hands, do you want to add to your loan book or not? Warren Buffett talks about a similar choice in stock selection – it’s like baseball or, as I prefer, cricket. The bowler offers the batsman a choice, play or leave and by choosing which ball to strike the batsman uses his skill to accumulate a high score. Picking the wrong ball leads to a long walk. In this way mortgage lending is surely no different. Good loans give you small incremental returns, bad ones soon wipe them out. This prompts the question: “What is a good loan?” A good loan doesn’t really exist in isolation it’s more whether a portfolio or tranche of loans pays both interest and principal on time, something we only know with hindsight. The important question therefore is: “Are we sufficiently using our discretion to build loan books where the probability of a good outcome is in our favour?” This is all about pricing credit risk properly. Whilst you can’t determine what may happen in the future you can see what the market is telling you about its expectations for credit losses. It does this by adjusting the “credit spread” (the margin in our earlier example). If your margin is 2.50% each £100m lent will earn £2.5m per year, if you assumed a recovery rate of nil this margin would cover credit losses of £2.5m. Similarly, a 50% recovery rate would allow £5.0m to default and so on. There is an interplay between credit spreads, recovery rates and default rates (if you know two you can derive the third) and insight into what credit spreads tell you about how the market prices default is valuable information. This introduces the idea that a loan doesn’t have one “fair-value” but a range where value may be fair. This isn’t an exact science, it’s an approach whereby you can look at the market and see whether you think you are being adequately compensated for the risk incurred and then add a “margin for safety”. This won’t stop defaults from happening but does use skill to tip the probability in your favour and that’s what playing games is about - knowing when to strike and when to walk away - the cornerstone of competitive edge. I don’t believe this needs to be complex after all we are dealing with approximations but without doubt there needs to be a process that gives you some comfort that decisions are sensible. Does Covid change things? I believe it does. There is a trap that’s easy to fall into. As interest rates have fallen the margin you can earn may have widened. On the face of it mortgage loans are more profitable. In cricketing terms, the fast bowler has been changed for a spinner. What looks tempting to the batsman could prove his undoing. Until you understand the new conditions (after all the cut to interest rates was brought on by extreme economic uncertainty) your margin for safety needs to increase. This is the compelling reason why: As I write the 30-year gilt yield is 0.74%, the implication for investors is that by investing in UK government debt they will lose money in real terms. How much? If you estimate CPI as 2.1% the real loss is 1.36% each year - £100 invested today will worth £66 in real terms in 30 years time. Whilst Gilt investors could get further short-term gains, does a loss of 34% in real terms look like a great long-term investment? (To underline this point Gilts have a P/E ratio of 135 and offer no prospect of growth). We know Gilt rates affect wider credit markets, dramatically lower Gilt yields make other credit risks look cheap but whether their cheapness is illusory depends on believing the default and loss levels that are baked into loan pricing compensate you for taking a swing or should I say selected shot?

In the beginning This story goes back to 2008, that’s when bank deposit rates (LIBOR) and Base rate (Bank rate) both went South but not together and it took a lot of firms by surprise. One Building Society I worked with at the time lost out from tracker mortgages another gained from LIBOR linked bonds. These windfalls arose from a game of luck; not that we saw it like that at the time. Soon the regulator was interested, because for some, their losses threatened viability. This was basis risk - where different reference interest rates altered the net interest margin. This risk is still very much alive, so how do we form judgement on what our risk appetite should be? I’ll try and answer this by considering three things: 1.    What basis risk looks like 2.    When does it, (basis risk), matter? 3.    How much control do we really have? What basis risk looks like I’ll assume there are four types of interest rate, Administered, Base, Libor (soon to be overnight index rate) and Fixed. For a building society or bank the simplest balance sheet will consist of all lending (assets) and borrowing (liabilities) to be of the administered rate type - where you determine the rate. A £100m balance sheet of this nature could look like this: Asset             Liability        Net Administered           £100m            £100m          nil This would appear to have no basis risk but, as we will see later, it may or may not be profitable. Now let’s add some fixed rate lending, (say £50m): Asset            Liability        Net Administered         £50m           £100m         £50m Fixed                       £50m                               £50m Total                                                                £100m Now we have mismatches which can be shown as a ratio: The net figure (if all mismatches treated as positive numbers) is £100m, compare this with the savings liabilities of £100m and we get 100/100 = 1.00 or 100%. Let’s suppose we hedge the interest rate risk by taking out swaps paying fixed and receiving OIS (successor to LIBOR): Asset            Liability         Net Administered         £50m            £100m         £50m Fixed                       £50m            £50m           £0m OIS                          £50m                                £50m Total                                                                 £100m The mismatch is still 100/100 = 1 or 100% What you’ve done is to convert fixed interest received to an overnight rate, in theory interest risk is mitigated. Finally, because the Bank of England is a safe place to put money let’s take £25m from administered lending and park it in a Reserve account, the picture is now: Asset              Liability        Net Administered         £25m             £100m           £75m Fixed                       £50m             £50m             £0m OIS                         £50m                                   £50m Bank rate                £25m                                   £25m Total                                                                   £150m The mismatch is now 150/100 = 1.50 or 150% What does this indicate? As we move away from administered rate balance sheets basis risk increases. To the extent that the interest basis themselves move independently there will be an unknown future effect on margins and therefore profitability. It’s something the Board will see in its colour coded information and presumably in our example it’s moved from green, to amber and then to red. Amber and red frequently being the preserve of ratios exceeding one. When does it (basis risk) matter? For most Boards it matters when your basis risk exceeds that of your peer group because you are an “outlier” and therefore you attract regulatory attention. This means that from a regulatory “peace of mind” perspective keeping the basis risk down can be an important point in the psychology of risk appetite. But this raises a dilemma, if customers don’t want administered rate products you need to offer them something else and thereby basis risk will start to increase. Restricting basis risk could put you in a less competitive position, the corollary of which, is that running basis risk is linked to the margins you earn and leads to the question, “should we limit this risk?” Risk appetites seem to vary, nevertheless I like to link them to considerations of how much you can afford to lose. This in turn means making comparisons with things like: a.    Your profitability (past, present and future) b.    Your reserves or capital strength c.     Your excess capital d.    Your expertise – the depth of knowledge and skill you have in dealing with this risk A straightforward way to look at this is to find out how much your earnings are affected should the basis move a little against you. For example, if Base rate moves up/down by 0.01% and all other rates remain the same, what’s the impact on (a), (b) and (c) above? This isn’t perfect but it starts to give you a “feel” for what’s at stake and lends itself to scenarios. It’s also worth considering how far into the future your basis risk exists. Whilst beyond the scope of this article long duration assets or liabilities increase uncertainty and risk. The only way to reduce this is to limit the extent to which you accumulate long dated positions on the balance sheet. How much control do we really have? Probably not as much as you wish for! It’s what makes this business challenging in the current environment. Try this question: “If we suffered a loss and needed to rebuild capital how could this be achieved without reducing the credit quality of our assets or by taking on additional interest rate risk?” The answer will probably lie in your ability to alter Administered rates, ie charge more for mortgages and offer less attractive savings rates. This can be done only within the competitive conditions of the retail savings and lending market you operate in. It means that Administered rates are rates where you have some degree of control and offers an important distinction between administered rates and “others”. Changes to non-administered rates - fixed, LIBOR/OIS and base rates - are outside your control and they involve spreads or relationships that can move for or against you. In this respect, for most, such mismatches offer games of luck not skill. We should therefore think of administered rates as offering some degree of protection in margin adjustment. Whilst they don’t guarantee profitability, (that’s more a function of the competitive position), it’s something you have expertise in, and this allows for a more nuanced judgement of risk and reward. If you decide that you need to offer non-administered rate products, (as will often be the case), you will inevitably incur more basis risk. That’s when you need to be clear that risk and price are aligned and that a margin of safety is built in – is there enough margin built in to absorb the basis risk you are taking? Using mismatches in base, Libor and fixed rates to sustain margins is not a comfortable place to be, that’s unless you are convinced you have better knowledge of capital market and central bank behaviour than market participants. It all comes back to taking risk where you have expertise and pricing that risk into the products you offer - something the regulator will certainly want to know more about if you are an outlier. Summary Basis risk goes back decades, 2008 is a good starting point; Basis risk is a mismatch in reference points for interest paid and received; All but the simplest firms will incur this risk; As basis risk gets larger it matters and simple measures can help you understand the potential cost; This needs to be linked to how much you can afford to lose; Administered rates offer you some degree of control and utilise expertise; Other interest basis are outside your control and their relationships can change unpredictably leading to windfall gains or losses; This leads to a game of luck; If you do take basis risk price in a margin of safety.

Capital isn't gold bars Capital adequacy is right up there in terms of importance and quite rightly too as it’s a measure of the ability to absorb losses. What’s a lot harder to nail down is the way we manage the interest rate risk on capital and that is what this article addresses. The capital or reserves arise from the net value of the firm’s assets and liabilities. In theory it’s what would be available for distribution if we liquidated the business. In the normal course of things capital isn’t identifiable as gold bars sitting in the safe or as an investment in Gilts it’s just used in what we do. But on paper we can isolate it and when we do, we appear to have two businesses, not one. The first is borrowing and lending, the second is asset management - that’s about getting a return on the owner’s wealth. The two are normally linked together by calculating the return on capital. By way of example, a balance sheet of £100m, of which £10m is capital, with a net profit of £1m has a 10% return on capital. Very good in the current environment but should this return fall beneath the rate on safe investments you are subtracting from the owner’s wealth not adding to it. Capital therefore belongs to the shareholders or members and although not specifically identifiable it is deployed in the business. It should provide a return and that return should exceed what is obtainable from passive investment - otherwise why not close the business and hand back the money? Interest rate risk In managing our first activity, borrowing and lending, we limit the mismatch between fixed and variable interest rates in the balance sheet. Without appropriate hedging, changes in interest rates would affect valuations and earnings. One of the main tools we use to monitor this risk is an interest rate gap report. In this, both assets and liabilities are placed into time buckets dependent on when the interest rate is repriced. So, a three-month deposit goes into the three-month bucket, a five-year gilt into the five-year bucket and a five-year variable rate mortgage in the three-month bucket, (because it’s capable of being quickly repriced) and so forth. The gap report shows how much risk we take when the yield curve moves and from here, we appreciate the gains and losses we may face if and when interest rates change. When the risk is considered too large interest rate swaps are used to manage things. If you take a close look at the gap you will see the capital position and it’s my bet that it’s treated differently and doesn’t have a specific time bucket allocated to it. In effect it’s treated as an overnight risk. Is this the right thing to do? Let’s consider the implications. The capital could be placed in one of three time buckets: Overnight 30 years, (representing a long way into the future) Anywhere in between The overnight position would lead to no apparent interest rate risk and wouldn’t need hedging. The 30-year position would lead to a much greater risk and would need to be hedged. Since the capital is a liability the hedge would require a receive fixed swap of a similar maturity. Does this mean that overnight is the correct place? As I discussed earlier the balance sheet can be thought of as two businesses and by excluding the reserves, the day-to-day interest rate risk is all about that arising from borrowing and lending not that from the capital itself. This has implications for earnings. By putting the capital in the one-day bucket it earns the overnight interest rate and by putting it out longer you get the 30-year yield.The decision on what to do must therefore depend on: The interest rate risk appetite on the capital itself, (how far do you want to invest it). Your expertise and judgement on the level of interest rates and the shape of the yield curve. How your balance sheet responds to higher and lower interest rates. It should also be noted that the default position of placing capital in an overnight bucket may appear risk free but is nevertheless at one end of the spectrum. At the time of writing receiving at 0.54% on a 30-year GBP swap doesn’t feel a great place to be in hedging the interest rate risk on capital (but then I remember rates in double digits, and this must affect my opinion). Consideration also needs to be made to the effect of any further falls in rates and their potential to compress margins further. Balanced approach It may therefore be worth evaluating a more balanced approach, for example, spreading equal quantities of capital across some of the shorter dated time buckets, say 20%, 1-5 years. If interest rates increase you are in effect investing capital at rates beneath the market rate and if rates fall further, you are investing capital above the market rate.  This could be beneficial if negative rates lead to further margin compression. With both scenarios the investment horizon is sufficiently short to see a fifth of it rolling off each year. What I find surprising, is that, presumably most firms see their business as long term but invest their capital as if it’s going to disappear tomorrow. I suspect this is largely due to the fact that this is a difficult topic to “nail-down” and by doing nothing you appear not to lose money, well not unless rates go down further. Therefore, it’s something that should be on the Board agenda. Summary Capital is the net value of assets and liabilities - the owner’s funds; It’s normally invisible and is used in the business; For banks and building societies when you separate the capital you have two businesses – borrowing/lending and capital investment; We limit the interest rate risk on our balance sheet; Where is the capital in the interest rate gap? It could be overnight, 30 years or in between; Where should it be? What are the implications in terms of hedging and earnings? How does this fit in with your earnings profile and risk appetite? It’s something the Board should have an opinion on.

What's first strategy or risk appetite? A regular feature in the Investors Chronicle is a column called “Portfolio Clinic”, it evaluates a reader’s investments, appetite for risk and their retirement plans. Often the reader gets a shock - their assumptions about risk and return do not match and they are forced to adjust their plans. In this way investment strategy and risk appetite are inextricably linked. Businesses too have strategies that are closely connected with the risk they are prepared to assume. Firms that need to operate with tight safety, (nuclear power, refining, aircraft manufacturing), have strategies that recognise this as failure is costly - Tokyo Electric, BP, Boeing. In entrepreneurial sectors (technology, pharmacology, alternative energy) the strategy recognises greater variance in returns and the risk appetite accommodates. On this scale I’m sure we would agree that building societies are “conservative”. But does risk appetite drive strategy or vice versa? (A thought-provoking question for any NED). On the "edge" The strategy surely identifies the “edge” your business has and how best to exploit it.  It is only after defining your strategy to benefit from your perceived advantage that you can really see what it means in terms of risk. If you start with the risk appetite and attempt to fit the strategy around it, you are likely to miss out on identifying and exploiting the franchise your business has to offer. To be clear, I’m not suggesting an aggressive lending strategy that overrides risk but by putting the strategy before risk and using iteration to make sure that both work together you end up with a better outcome. It’s about recognising the idiosyncrasies of your business and where possible exploiting them within a risk appetite you are comfortable with. Notwithstanding I recognise that risk appetite in some Societies does drive the strategy and this leads to a further engaging question. How do you determine what your risk appetite is? You could respond with reference to solvency, profitability, franchise, resources, skill, expertise and experience – all sensible starting points. However what matters is the process. Does top down direction work with bottom up insight, to agree an appropriate risk limit? You can now see that by linking member value and the need to operate for extended periods under difficult conditions NEDs can explain how the risk limit(s) supports the strategic objective(s) of the society. What do I see? I’m not privy to what happens in all the sector’s forty plus Board rooms however I know Boards don’t find this easy. Published documents show that some Societies could do more to link strategy and risk together. Furthermore, I’m sure you can find instances in your own firm where it’s hard to determine the role strategy and risk take in driving what you do. When this happens, a common underlying factor appears to be regulation or the fear of falling foul it. As a consequence, sometimes we are guilty of trying to gauge the regulator’s appetite for risk (a bit like spoof). Whilst this may give NEDs some personal comfort it’s not what the regulator intends and what’s more it isn’t benefiting members per se. In Portfolio Clinic, it’s akin to holding only Gilts – great in the short run but ultimately a lot riskier than a balanced portfolio mainly because the return will be sub-optimal. It may seem unfashionable but making money is still important. Summary Strategy and risk appetite are closely linked. My view is that to get the most out of your business strategy comes first; There is an iterative process that connects strategy to your risk appetite and in this way a sensible balance is the outcome; I acknowledge that some Societies may put risk appetite as the driving force – if this is you, where does the risk appetite come from, is it the Regulator? NEDs may feel personally comfortable keeping risk to a minimum, but they should ask whether this is in member’s interests.

If you run your own money this may save you ten years of work, (honestly). My investment journey started over thirty years ago. I didn’t think too much about it, returns were high, my money went into “funds” and who worried about costs? It was easy to do some simple maths, the message couldn’t be clearer, if you wanted to keep your money, costs had to be low. At the time that meant paying at least 1% per annum plus hidden trading commissions. Herein was a problem over an investment lifetime even “modest” fees of 1% lead you to hand half of the investment return whilst still taking all the risk. It’s the simple maths of compounding and it’s like going to a restaurant, paying for a three-course meal and just getting the starter and desert. I started to read about indexing, something that had got going a lot earlier on the other side of the Atlantic. The pioneer, the late John (Jack) C. Bogle, had set up the mutual fund group Vanguard in 1974. My first introduction to his writing was “Don’t Count On it!” Now, over the years I’ve read quite a lot about investment. I really like Buffett’s style, Munger is pithy, Fisher asks the questions and Graham, well he’s the guru. But, to be honest, I’m just not as smart as they are. This is where Bogle differs, his strategy can be followed by anyone. Put 40%-60% in low-cost index trackers, the rest in low-cost bond funds and leave it well alone. It’s a case of the less you do the more you get. It’s even the strategy Buffett has followed for his wife’s trust. This year I picked up a copy of Bogle’s book “The Little Book of Common Sense Investing”, it’s an investment classic and I recommend reading it. In it he sets out the case for low-cost index investing in easy to read and insightful manner. There’s a lifetime of work here but some things really hit home, and I’d like to share them with you: Long run GDP growth is everything: Cumulative long run performance of the stock market is governed by GDP growth; one follows the other. Stock returns: Stock returns have two sources, investment return (dividend yield and earnings) and speculative returns, (the price of those earnings as expressed as the price/earnings multiplier). Investor returns: Returns earned by all investors must equal returns earned by the market. However, returns received by all investors equal returns earned by the market less fees and expenses. Outperformance: All evidence shows that over the long run market outperformance is random. So, although some win over short periods it is not something that can be done consistently. For this reason, by using low-cost index funds, your chance of beating the performance of a fund manager is 90% over 10 years and 98% over 50 years. We are all indexers: If you imagine a pie of all investors’ money and cut out the slice that is index tracking the remaining investors, as a whole, have to be indexers too. But individually they hold different positions and in the short run some win, and some lose. Collectively this group incurs significant trading costs that act as a drag on their returns. Market prediction: Short run predictions are guesses, but dividend yield, earnings and P/E can be used to provide a predictive look at what returns may be in the next ten years, the conclusion is that we are looking at substantially lower returns (3%) on a balanced portfolio over the next decade. After inflation of 2% and investment costs of 1.5% that’s a flat or negative real return only avoided by getting rock bottom costs. Behavioural bias: This plays against the investor. They tend to buy funds that have gone up and sell those that have gone down. This buy high, sell low, strategy acts as a drag on returns leading to a reduction in the order of 1.5% per annum. Keep it simple: Between 1926-2016 total market annual return was 9.8%, for the S&P 500 it was 10%. The S&P 500 index is about 85% of the value of all US stocks and being capital weighted doesn’t need rebalancing. The winning strategy is to own the index at minimum cost and let compounding work in your favour. Exchange traded funds: Bogle’s resistance to ETFs is clarified, he did not like the way they encourage trading but held for long periods broad range low-cost ETFs achieve much the same as an index fund. Asset allocation: Investment performance is dictated by asset allocation; Bogle considers the merits of 50/50 working up to 80/20 stock/bond portfolios. In essence it depends on the risk you can afford to take and what you feel comfortable with. What’s particularly thought-provoking is the common sense view that lower investment costs mean that you can take significantly less risk to achieve the same level of return. It’s not often less leads to more, and what I particularly like is that Bogle is an amusing writer, full of anecdote but above all backs up his case with irrefutable analysis where you can clearly see that he’s on your side. Don’t take my word for it, read the book and in the years to come you won’t regret it, after all he is setting out a strategy, where you will have an investment portfolio, that is worth at least a third more, or as I put it earlier, the option to retire early. I’m sure you too will see John Bogle as one of the greats in the investment world.