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?
Comments