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Asset valuation is of major importance to banks. It is required for a host of reasons including statutory reporting, credit exposures, liquidity, capital and P&L. However firms often get different results. The magnitude of which may be trivial or material. Subjectivity is often to blame. You would expect that for liquid assets such conjecture would be minimal. For example valuing on-the-run G7 debt isn’t complex is it? Other than bid-offer spreads and the time of day it is done what more is there to discuss? But there is a complication – liquidity. In today’s market we have been lulled (partly by regulation) to assume that government debt is always liquid. What seems to be missing is the question concerning how much selling volume the bond market can absorb on a bad day. Given market makers have largely disappeared probably not much as we might expect. In the past I would have thought that quoted market prices were the best measure of value. But today government debt has ballooned and banks’ trading books are stifled. It therefore seems that bond markets are an accident in the making. Perhaps for the buy and hold investor the potential price volatility is of less a concern. Whilst it may be painful to watch prices falling, coupons and principle will be received (unless there is default). However those reliant on converting bonds to cash at any given instant may get a nasty surprise. Structural changes have magnified potential price volatility. The only way out is for central banks to “sit on the bid”. Aka support the market. Their willingness and ability to participate to the required extent is unknown. The simple conclusion is that even for prime quality assets if you need to liquidate in a hurry current market prices are not necessarily good indicators of what you will get. In other words cash is king.

In banking stress testing is in vogue. But how effective is it? For engineers the bar on safety is high after all life itself is at risk. But in banking behavioural problems (people and markets) make things difficult to model. Indeed banking has been and always will be risky. Trying to eliminate risk will just make finance very expensive to undertake. This creates a conflict of interest. Cutting corners reduces costs and boosts profits (and remuneration). Furthermore in an indirect way behavioural issues provide the “get out of jail card” for those in charge whether they are regulators, central or commercial bankers. In this respect no one carries the can. We should therefore be very careful with our use of stress testing and how it applies to banking. It fails to model how things really work and it is riddled with conflicts of interest. The real value of stress testing is surely to challenge management flexibility and that’s about it.

Crossbred dogs may not win shows but they are supposed to be more robust than thoroughbreds. It means that a pooch that is a mixture should cost less at the vet. With this in mind I wonder whether regulation leads to deep-seated problems. Regulators seem to be amassing lots of data and this appears to be used to define what the “best of breed” looks like. Armed with this knowledge a set of rules are emerging that mean that in order to conform banks are becoming homogenous. At first sight this is sensible. It is certainly easier to administer. You can compare and contrast firms in order to see who stands out. Outliers then need to be modified in order that they fit in. There is however one big problem. It assumes that we know what the best of breed really looks like. This assumption is of course erroneous. A bank that works in today’s environment won’t necessarily be successful tomorrow. The danger is that far from making banking safer regulation is making it more the same and therefore vulnerable to the risks we don’t understand (and there a lot of these). In order to overcome this “one size fits all” approach regulation must itself change so that banks have greater individual freedom. That’s once the retail business is properly ring fenced. What dog owners then do is up to them. A market full of mongrels may prove a lot healthier.

In the recent shake up of pensions it seems likely that retirees will be able to sell their existing annuities. This indeed offers flexibility, however whether “fair-value” on sale is achieved is another thing. Valuing an annuity is far from trivial. It requires present valuing future cash flows that are dependent on life expectancy. Retail customers are unable to do this for themselves. They are reliant on the potential buyer’s valuation. The up-front valuation for a person in good health who took out an annuity some time ago may appear surprisingly generous. That’s because interest rates have fallen. However you can appear to be better off by selling but in fact your wealth may fall. Suppose you bought an annuity some time ago for £100K and receive £7K per annum. Fair value of this £7K annuity may now be £175K. But the danger is in being duped. Being offered £150K (pocketing £50K profit) may be tempting but it’s far from good value. It is tantamount to giving the buyer a cheque for £25K. How can you guard against this? It’s very difficult. Professional investors often line up counterparties for a simultaneous quote accepting the best. This is not something that the average retail customer will be able to do. Indeed it’s likely that if you do shop around valuations will be done at different times muddying the water further. Therein is the regulatory challenge. How do you stop retail customers getting scalped rather than having a short back and sides in this nascent market?

Retail experts tell me that German shoppers are somewhat different from their British counterparts. Apparently Germans like to buy different things from different stores. The British on the other hand prefer to buy from just one place. This generalisation is, I think, also true of banking services. Whether you are a retail customer, SME or larger business the attraction to use just one bank is obvious. It’s simple. But it may cost your dearly. Yes, shopping around will get you better deals but it doesn’t just stop there. Companies in particular need to consider how vulnerable they are when they rely on one main bank whether that is for loans, deposits, payments or hedging transactions. This concentration risk is only apparent when banks say “no”. A problem faced by credit worthy businesses as well borrowers in all product types from deposits and payments right through to derivatives. There is much talk of “challenger banks” but the truth is that a concentrated market place prevails. Widening your pool of banks has become a slow process. Even account opening is problematic thanks to regulation. With this in mind the corporate treasurer needs to look at the German shopper. Examine the marketplace. Know where to find things. Try different brands. Reassess the shopping list. Do you need all those things? This requires time and effort. Above all don’t stick to one shop only to find it shuts its doors when you least expect it.

Shortly before his retirement Mervin King the last Governor of the Bank of England explained that as a result of central bank policy investors had experienced lower returns however this was offset by a rise in asset prices. In other words reduced yield creates capital gains. This in many respects is true however the distribution of losses in income and gains in capital are not equally distributed across investors. In the short run investors in cash are losers and those in bonds and equities gain. However, both to the detriment of bond and stock investors extended low rates mean redemptions and dividends attract lower reinvestment rates too. What happens when rates rise? It’s easy to see returns on cash improve but what about bonds and equities? Bonds lose money. The extent of the losses being a reflection of duration. For equities it’s harder to say. Do rising rates increase the discount on future dividends or are rate rises a reflection of economic growth which should be good for earnings and dividends? This remains conjecture. What is certain is that that normalisation will leave many investors worse off under QE than they would have been without it. The net beneficiaries will have been borrowers and in particular credit worthy governments. To avoid the bear trap you need to get the market timing right. In this environment it means guessing policy action. “Guess” is the best description and it’s something we should feel uncomfortable about because it’s speculation. In other words another group of beneficiaries from QE will be speculators who by luck or judgment just get to the exit before the crowd.

Years ago bank traders treated FX markets with caution (particularly if they weren’t experienced currency dealers) indeed other areas of the bank were specifically prohibited from running FX positions. This wasn’t a turf war. It was sound risk management. There was always the fear that some unexpected event would leave you on the wrong side of a trade. Similarly unmatched borrowing in low interest rate currencies was not a recommended strategy. From time to time even the big boys dropped a ton. Evidence that this has been forgotten emerged recently when Swissy revalued. Punters took a hit often magnified by using margin (aka leverage). This prompts questions. Do “retail” customers understand the risks they face? How do brokers manage margins? Was there mis-selling? Like most things in markets there’s a lot of subjectivity. Is there anything we can learn? I think so. Central banks have created the mirage of a benign environment.  At the same time regulators have reduced the market’s capacity to act as a buffer. This increases the risk of a stampede to the exit when the door is locked and bolted. Under such conditions price adjustment is swift and discontinuous. As a consequence standard risk measures like VAR become useless. Even stress testing is limited in its efficacy. Based on plausible events the stresses themselves become influenced by a bias to short term experiences. Is there anything you can do? Apply a swift and extreme market move (much greater than a plausible stress event suggests), assume no trading and look at the result. Can you live with it? Nursing a big loss is one thing but does it bankrupt you? In other words mind the gap.

When we deal with money how reliant are we on the digital world? Save, borrow or pay when you deal with banks you will almost always be obliged to do so using digital means. It makes controlling your money a lot easier and of course makes the investment in bricks and mortar unnecessary. On the face of it investing in systems is the way to go – that’s assuming they work. Readers of this blog will note that I often refer to anecdotal experience. Whilst this can be unreliable I know that it is information in an uncorrupted format. It’s something I’ve been witness to and in many cases is corroborated by friends and acquaintances. This is preferable to the advertising that frequently glosses over the facts. One thing that’s clear is that all is not well. Last year obsolete IT infrastructure caused some banks outright failure in their payment systems. Let’s call this a plumbing failure. It was obvious and severe and led to fines. What is equally insidious is the “unequal application” of IT across the business.  As this is not something banks are willing to openly discuss I rely on anecdote. Many bank accounts are now operated by the customer across the web. In general this 24/7 process works. Compare this with opening and closing accounts which remains a relatively manual process that just hasn’t kept up with times and is fraught with delay, lost documents and late payments. Statements too are accessed via the web. However cash and/or securities have disappeared as a result of manual errors or infrastructure upgrades. Something that’s not easy to spot unless you keep paper records. Is it possible that a bank could permanently lose customer records? These problems aren’t just retail. Wholesale risk management and reporting varies in its depth, quality and accuracy to such a degree that it is likely that there are significant shortfalls. In other words it shows the direction of travel rather than the speed. More often than not the problem isn’t one of plumbing. It’s more to do with operational risk (behaviour and assumptions). Whilst successful application of technology puts banks in a better competitive position it’s clearly something the incumbents struggle with. Not least because it’s complex and expensive problem that touches all parts of the business. In a recent FT interview Sir David Walker explained that subsequent to his 2009 recommendations boards should now include individuals cognisant with the relevant technology. This seems to be eminently sensible.

When it comes to banking SMEs don’t have a lot of choice. If you want the full service range there are only a handful of banks to turn to. Unfortunately the quality on offer falls well below expectations and it’s got worse not better. Anecdotal experience offers valuable insight. Here are a few recent experiences: Call centres: Replace the account manager. 10 minutes call waiting. Call “dropped”. Unworkable security. Internet banking: Replaces everything. No choice. Marketing calls: Bank “Hello, I’m calling you from XZY bank. May I ask you some security questions.” Me “Surely I should be asking you, I’m being always being warned about fraud.” Marketing calls: Bank “Can we lend you some money.” Me “No but I would like to talk about another product.” Bank “Sorry we can’t do that and we can’t help.” Fee paying accounts: Involuntary transfer to these poor value products. Deposit rates: Inferior terms and a second rate product range. Why do retail savers get better deals? If you own a SME and particularly if you borrow money I bet you can add to this. Competition should sort this out so why are we being “done”? The fact is it’s hardly a competitive market. Moving accounts becomes the choice between rock and hard place. In an economy where SMEs account for over 99% of businesses, 33% of private sector turnover and employ nearly 50% of the work force this is not a minor issue. It’s the transfer of value from one sector of the economy to another. That’s why I welcome the Competition and Markets Authorities enquiry into SME banking. Let’s hope this time that the outcome is better. In the meantime if the new entrants can live up to their moniker as “challenger banks” it will be good news.

Do massive fines perpetuate the problem? Terry Smith recently explained to the FT why he didn’t invest in banks. High leverage and complexity made them too risky. This week we have had (yet another) investigation. This time it’s FX. Incidentally, a market that banks wanted ring fenced from tighter regulation. Bluntly it’s fraud on a massive scale committed by some of the world’s biggest players. These firms are not only too big to fail but too big to manage and too big to regulate. $4.3bn of fines may be the regulators answer but it’s clearly not going to stop this happening again. Whistleblowing and discounts for early settlements may help but it’s hardly the sort of stuff that uncovers all. Perhaps some tried and tested deterrents should be considered like: Pursuit: Criminal prosecution and if found guilty jail; Prohibition: Banning senior management; Restitution: Confiscation of all remuneration; Restriction: Removal of the License. These cause pain at an individual level and are therefore effective. But maybe this isn’t what we want. I suppose the escalation of fines is one way of recouping taxpayer’s support. It’s a sort of tax on complexity that guarantees the largest firms will continue to pay. Another reason why investing in banks seems a risk too great for comfort.

At the shop I was charged £44.75 for three weeks of newspapers. The paper costs £10 per week. Delivery was an additional £3.15 per week. A rough calculation £13 x 3 = £39 shows £44.75 is wrong. The assistant couldn’t understand this. After all “the computer gives me the sum you must pay”. Is this anecdote an isolated story or are we in danger of falling into the same trap ourselves? That’s accepting values in reports at face value rather than making an estimate of what we would expect to see. Is this important? You bet. If you rely on management information to steer a business I think you will agree that that it should be accurate. However I think you will also concede that errors creep in (integrity, assumptions, people). Estimates are therefore a useful tool in determining whether you can rely on what you get. In my story I returned at a later time to pay £39.45 (about 10% less). It’s funny how errors with money invariably seem to leave you worse off if you don’t question them.

For the last six years central banks have tried to get us to spend more. One way to do this is to lower interest rates. It makes saving less attractive and encourages borrowing through lower servicing costs. The theory is that as consumption rises it creates more employment and increases tax revenues. There is however something very wrong with the way monetary policy is working. It has lowered interest rates but the levels of growth are anaemic. Furthermore in the UK as employment appears to rise productivity is falling. A conundrum that economists can’t really explain. Indeed some think the growth rates experienced over the last two decades were an aberration. Has a slowdown in technological advancement and an older population has returned us to a much lower trend in the future? Perhaps a crucial question hasn’t been asked. On what do we spend our income? Four things (I’m sure economists have much better explanations): Necessities: they keep things ticking over (food, fuel); Non essentials: nice to have but you can live without (new cars, foreign holidays); Investments that store value (shares, property); Investments that create value (roads, rail, communications). If the boost felt from QE is spent on (2) and (3) is this desirable? Surely it means we suck in imports and boost asset prices but do little for future productive capacity. QE lobbyists would point out that it creates jobs and there is a wealth effect. But are those jobs sustainable and just who benefits from asset price inflation? Furthermore pushing interest rates down expecting business to invest ignores the expected net rate of return. This surely means monetary policy has lost its edge and if anything a large proportion of its effect has leaked away. In this respect what we spend our income or borrowing on matters. The trouble is policy makers don’t seem to focus on it.