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Interest rate risk? What interest rate risk?

27 Oct


Growth in the third quarter of 2016 seems to be on track to remain consistent with that of Q2, at the identical figure of 2.1%. Which will doubtless engender much self-congratulatory patting of backs among the BOE’s Monetary Policy Committee, for steering the country through a potential capacity surplus and dip in employment. Do they really deserve this round of applause?

There is an opinion held in some quarters that central bank control is the main obstacle standing in the way of the perfect equilibrium that would be achieved if interest rates were allowed to compete in a free market. While I do not necessarily believe that free-market capitalism always acts in favour of the greatest good of the greatest number of people, the tried-and-tested sticking plaster of QE does not reach the deeper systemic problems – something the BOE itself admits.

As well as announcing the continuation of its asset repurchase policy (quantitative easing), the BOE’s Monetary Policy Committee decided in August to cut bank rate to a growth-stimulating – at least in theory – 0.25%. The negative effect this would have on bank’s lending profit margins they hoped would be countered by the Term Funding Scheme (TFS) they were offering to institutions affected.

They elaborated in the August Inflation Report that “the Term Funding Scheme (TFS)… will provide funding for banks at interest rates close to Bank Rate.  This monetary policy action should help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that households and firms benefit from the MPC’s actions.  In addition, the TFS provides participants with a cost-effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets.”

This is all very good and of noble intention, but it is doubtful this alone would counteract the many factors acting against the free lending by banks to needy applicants. For one, the alternative finance market is proving serious competition, as the nimbler new competitors are far more proactive in sourcing customers, using sophisticated data analysis to find leads; and their pricing algorithms bypass the more thorough risk profiling traditional banks undergo. In addition, they often avoid taking direct liability for issuing the loans, doing this instead through partner banks. By keeping their balance sheets free of these liabilities, they avoid the imposition of different tiered capital ratios along the lines of Basel III.

Let’s get Specific

Interest Rate Risk in the Banking Book (IRRBB) is a quantified metric which is itself the subject of constant, international regulatory scrutiny. In a report released April 2016, the Basel Committee on Banking Supervision succinctly explains the complex relationship between different loan products:

IRRBB arises because interest rates can vary significantly over time, while the business of banking typically involves intermediation activity that produces exposures to both maturity mismatch (e.g. long-maturity assets funded by short-term liabilities) and rate mismatch (e.g. fixed rate loans funded by variable rate deposits). In addition, there are optionalities embedded in many of the common banking products (e.g. non-maturity deposits, term deposits, fixed rate loans) that are triggered in accordance with changes in interest rates.”

An option is linked to a specified contingency which, if occurring, gives you the right but not the obligation to exercise that option. For example if you end up stuck with a loan at 4% interest which was originated when base interest rates were at 1.2%, and then base interest falls to 0.5%, your interest payments will be overpriced relative to the rest of the market. The option might specify that if interest rates fall below a certain point, you can choose to switch to a floating-rate linked to a benchmark like LIBOR. (London Interbank Offered Rate, administered by ICE or IntercontinentalExchange group)

Definitions, definitions, definitions

‘Option risk’ is just one of three defined types of interest rate risk that can occur; the others being ‘gap risk’ and ‘basic risk’. Automatic option risk is when an optionality is included as part of a synthetic product, be it an asset, liability and/ or off-balance sheet item. Behavioural option risk is where the change in cash flow results from the autonomous human decision to exercise an option.

So-called gap risk describes the shortfall that arises when banks’ debt instruments undergo rate changes which occur at different times. Some loans, particularly for construction or infrastructure projects, are staggered so interest payments increase towards the end of the loan’s duration, as during the early set-up phase there is little to no cash flow or income.

Basis risk is classified as the impact of relative changes in interest rates between instruments which are linked to different pricing benchmarks; say for EM bonds over Treasuries, which are priced by different market factors and whose basis points might change at different rates, though their tenors are the same. One might even be used to hedge the other, and basis risk quantifies the effectiveness – or not – of this hedge.

The regulator admitted it was having difficulty persuading banks to fully assess the IR risk on their books, as in their internal assessments they tended to focus on earnings measures over the period under review, rather than economic value measures which examine assets and liabilities right until their expiration. In their guidance the Basel supervisory committee stressed the importance of having both types of assessment compliment each other.

If the late troubles of Deutsche Bank are any indicator, it is that banks can struggle to reconcile their regulatory obligations with taking on high enough risk assets to turn a viable profit. That, and the importance of having a smoothly running infrastructure and back-end. On the other hand, JP Morgan’s recent triumphant quarter shows you can make a killing out of trading bonds, if you know what you are doing.


Why ‘Defined Benefit’ should become ‘Pre-Defined Benefit Re-Defined in Light of Changing Conditions’

4 Sep


A recent well-intentioned but technically inaccurate FT article laid out the pitfalls of employers continuing to offer Defined Benefit (DB) schemes, in light of the recent bout of QE and interest rate revisions. Briefly, in a separate article it reported that consultancy Hymans Robertson had conducted research analysis which hypothesised the BOE’s announcement of a £70bn QE programme would lead directly to another £70bn DB shortfall.

The BOE also announced it would cut interest rates by 0.25%, which will hit all fixed-income returns by reducing the value of gilts and ‘safe haven’ government securities, and correspondingly increase the demand for, and price of, riskier fixed-income products. Pension trustees had better make some shrewd investment choices.

The writer argued that in order to solve the deficit overhang, the government needed further legislation to prevent the proliferation and even the continuation of DB schemes. He stopped just short of saying they should be outright banned.

A Lighter Touch

What the government has done, under the 2014 Pensions Act, is more of a soft-touch approach which controls market incentives to withdraw money from schemes, and window-shop continually for better ones. This provides more security for scheme managers, in terms of the available capital for investment.

To issue a ban on Defined Benefit schemes would be a hostile move, which might be resisted by certain interest groups and create a conflict both sides are surely keen to avoid. When a legislator has a choice between prohibition measures and providing incentives for industry participants to behave a certain way, a collaborative approach is usually more effective.

Though that is not to say that the government hasn’t laid down some firm rules on scheme governance and providing Value for Money.

Can Members Leave a Scheme if they Want to?

Although members are technically free to leave the scheme at any time, there are a number of barriers which impede them from doing so. Many funds impose exit fees, to try and keep investments safely enclosed in the fund and prevent a deficit from occurring.

Another barrier is that administrative provisions for transfer of their pension pot might be insufficient or incomplete. Scheme member data storage and integrity has recently been the subject of widespread audits and reforms, because so much information was missing or compromised. For example, employees would be classed as ‘absent’ from the scheme and hence the records, when in fact they had a Personal Pension Plan that the employer made regular contributions to.

Pre-existing pension legislation held that if you had been in the scheme less than 2 years, and the scheme rules permitted it, you were entitled to a refund of the contributions already made. Though having received the refund you would not be entitled to any benefits for the period to which the refund relates. However, the Pensions Act 2014 made it harder to leave or withdraw money from a scheme in several new ways, one of which was the abolition of these ‘short service’ refunds, for people who leave a money purchase occupational pension scheme after the mandatory 30-day period, and within 2 years of entering the scheme.

Mandatory Disclosure

Money purchase schemes are simply Defined Contribution (DC) by another name, where an employee contributes an agreed percentage of their salary at set intervals, with no guaranteed level of return. Targets and benchmarks are shared with scheme members, and indeed it is a legal requirement that trustees provide members with an annual statutory money purchase illustration (SMP), which states the likely pension at retirement based on in-house assumptions about market conditions including inflation. Also with details of contributions credited (before deductions) to the member in the preceding scheme year.

So a major advantage of DC schemes is that the governing directors’ expectations and projections of expected returns are continually revised. In the current fixed-income investment climate, with the BOE still steering interest rates on a tight rein particularly in the uncertainty surrounding Brexit, to make the kind of gold-plated promise to employees which Defined Benefit schemes make does not seem… prudent.

This enhanced level of disclosure was also introduced in the recent reforms governing trustee accountability. Not that I’m biased, but the now fairly stringent requirements on trustees of money purchase schemes seem to make them the better option. Among the other provisions are that:

–              Investments made with each contribution should be documented, recording the date of each. Best practice is that every new contribution be invested within five working days; where a member’s contributions are invested in more than one fund, and “the total amount contributed in a period is recorded explicitly”, verify the sum of the individual transactions elements equals the total contribution.

–              To this end, there should be a record of every investment sold, date sold and amount realised. This does not have to be recorded separately for each contributor, but must be categorised by investment fund.

Reasons not to Shop Around

The 2014 Pensions Act contained a number of other measures relating to private pensions, many of which strengthen existing legislation. Many seem calculated to try and ring-fence the contributions to existing schemes. They include provision for:

  • a new power to make regulations to prohibit the offering of incentives to transfer pension scheme rights
  • the introduction of a new statutory objective for the Pensions Regulator, to minimise any adverse impact on the sustainable growth of sponsoring employers when exercising its functions relating to scheme funding
  • measures to restructure the Pension Protection Fund compensation cap to better protect long serving scheme members
  • an amendment to the Public Service Pensions Act 2013 to allow smaller public body pension schemes to transfer accrued rights into one of the larger public service schemes

So in conclusion, measures have been taken to make DB schemes vastly less attractive. But to outright ban them would itself be infringing on the rights of those existing DB scheme-holders whose right not to have their scheme fold due to insufficient funds these lobbyists are defending in the first place.

The important thing is for DB scheme managers to have the freedom to adjust their expectations and projected returns to a level which is compatible with their income stream and all their liabilities. Which I suppose would mean they were no longer ‘Defined Benefit’ but ‘Pre-Defined Benefit Re-Defined in Light of Changing Conditions’. If only someone would outline the circumstances in which this decision would be permissible.



Capital Markets Union – Breakdown of EU Roadmap (Part 2)

12 Apr

Share Offerings Will be Made Easier by Reducing Prospectus Requirements

As it stands, the threshold for share offers which must issue a prospectus stands at €5million; though the European regulation leaves leeway for individual states to legislate a lower threshold. The EU proposal is for a higher and universal threshold. This, it is hoped, would reduce onerous requirements for companies to shell out for a professional marketing sheen to give to their business plans and earnings forecasts.

The EC asks stakeholders if it would free smaller companies of some onerous obligations to remove the mandate for a prospectus for follow-on offerings. Instead it would allow them to point to existing info in the public domain, provided they were “released pursuant to the transparency and disclosure requirements to allow sufficient investor disclosure.”

A slightly less drastic solution would be to just raise the threshold required for follow-on prospectuses, from the existing level of 10%, to 20% of existing issued share capital.

Law firm Latham and Watkins makes the still more radical proposal that only “secondary offerings of, for example, up to 50 percent of the issued share capital of the company” would necessitate a prospectus being published.

This would not, however, require regulatory approval before permission was granted to list on Multilateral Trading Facilities (MTFs). As a mitigating measure, the firm posits that the threshold be raised for fully exempt offerings.

This last caveat links us on to the proposal that standard share prospectuses should be approved before trading on MTFs. There is some concern that these marketplaces do not provide the necessary due diligence on all of the securities listed, and an objective assessment is required by a regulator who, unlike the exchange operators, has no vested interest in securing transaction fees.

Some industry commentators, however, feel that increasing the barriers to listing new securities could check growth of the vibrant MTF market in Europe.

The Pan-European Corporate Private Placement Market Guide

This set of guidelines to the process of negotiating contract terms between borrowers and professional investors in large, unlisted bond and note issuances, has already been issued and should be starting to take effect.

Noteworthy considerations to observe from a legal perspective are, firstly, the possibility of a conflict of interests between private loan and note subscription, and trading in listed securities. The mandatory disclosures of non-public information, that full knowledge of the borrower’s debt burden requires, could leave the investor open to accusations of insider dealing, if they then trade in associated listed securities.

Institutional investors in unlisted debt placements should demand loans on equal terms with borrowers’ other debts, which is why disclosure of all information concerning the borrower’s existing debt is essential.

Details of, for example, the hierarchy of priority of repayment; actions in case of a breach in covenant or non-payment of an instalment; any assets that have already been pledged as securities; these are all necessary to ensure the comparability of loan contracts, and to ensure the borrower can meet any new obligations.

The guide provides four model documents by which best practice in this area can be followed:

As regards the ‘term sheet’, the list of terms each side agrees to include in the final contract, – subject to local law, – it is advised firstly that the borrower makes a ‘negative pledge’. This restricts the borrower’s ability to create security over its assets, and thereby enshrines the ranking of the new private placement.

It should also be requested that they disclose any restrictions on disposal of assets. Financial covenants with relevant ratios form another, obvious, clause. It might also be desirable to place restrictions on mergers and corporate restructuring and change of business.

In the event of a change in control, an option should be provided for early redemption or repayment, or even prepayment, of the interest and principal due on the loan. This measure is also advised to guard against a change in the borrower’s tax characteristics.

Finally, as insurance against the future, investors should consider a “more favourable terms” clause, such that if the Borrower grants more favourable financing terms to another creditor, it must also offer the same terms to the Investors.

Banks are tightening their belts on high-risk assets.

Banks are tightening their belts on high-risk assets.

Are Europe’s corporate debt and equity markets really in dire straits?

The ECB Statistics Bulletin for 2015 does show some cause for concern, in that holdings of debt securities issued by euro area residents (non-government securities), fell from €1,360.9 billion in 2013 to €1,275.9 billion in 2014. That is on the listed assets side. As regards liabilities, debt securities issued fell also, from €2,586.50 billion in 2013 to €2,476.3 billion in 2014.

Equity and non-money market investment fund shares fell too, partly as a result of, and due to anticipation of, the ECB’s €1.1trillion QE programme which substantially increased the demand for government securities. Between 2013 and 2014, equity holdings fell from €792.1 billion to €768.4 billion.

At the same time, banks and other financials’ deleveraging is very much in evidence, as the level of capital and reserves rose during the same period, from €2,340 billion in 2013 to €2,466.9 billion in 2014.

This is perhaps reflected in the downward trend in loans to non-financial corporations (seasonally adjusted), a metric which includes loans issued by non-MFIs (monetary financial institutions). The total value fell from 2013 to 2014, from €4,354.1 to €4,282.1billion, slightly recovering in the first two months of 2015 to an average of €2,177.5 billion. This pattern of recovery is mirrored when you break down the loan total into 1-5 year loans, and for loans over five years.

The only increase was in short-term loans (up to 1 year), showing some appetite for low-risk corporate debt.

Hostess Entertains Illustrious PE Investors; Patton & Boggs Poaches Counsel Responsible for Financing Abu Dhabi’s $7billion Aliminium Smelting Facility

7 Feb


Hostess Brands Inc. receives triple proposal for its biggest assets

A $410m group offer from Apollo Global Management, LLC and its subsidiary Metropolous & Co. was the highest bid made for Hostess’s snack cake produce. This includes both the Hostess and Dolly Madison brands, and the vintage Twinkie brand.

Hostess Brands Chairman and Chief Executive Officer Gregory F. Rayburn said: “We are pleased to name Apollo and Metropoulos as the stalking horse bidder for these valuable and beloved brands.”

As well as delivering on Hostess’s cake products, the deal includes five bakeries and associated equipment.

Hostess requested permission from the US Bankruptcy Court, for Southern New York, to auction off the largest portion of assets from its snack cake business on March 13 – provided it received more than one qualified bid.

“Interest in these iconic brands has been intense and competitive and we expect that to continue through a robust, court-authorized auction process,” said Rayburn.

Hostess’s bread products include the following household names: Wonder®, Butternut®, Home Pride®, Merita®, Nature’s Pride®, Beefsteak®, Sweetheart®, Eddy’s®, Standish Farms® and Grandma Emilie’s® bread brands.

The proposal comes in addition to a number of other stalking horse agreements over Hostess’s bread business, which have an aggregate value of over $440m. All told, the minimum bidding floor for the assets up for sale is more than $850m.

Drake’s® snack cake business has been sold separately from the other snack cake items.


Trade and project finance legal specialist joins MENA team at Patton Boggs LLP

Former Special Counsel for the Middle East at Sullivan &Cromwell LLP, Brian J. Pierce, has now joined Patton Boggs LLP, where he will represent the Middle East and North Africa (MENA) region. His principal areas of experience are project development and finance, M&A and international corporate finance transactions.

Pierce’s outstanding contributions to project finance include advising on the $7 billion financing of an aluminum smelter complex in Abu Dhabi. He represented the Emirates Aluminum Company (EMAL).

“We particularly look forward to Brian’s ability to support the firm’s strong client base in the infrastructure and construction projects sectors,” said Susan Bastress, managing partner of the firm’s branch in Doha, Qatar. Patton Boggs has three offices outside its American practice, which specialises in government relations, also including Riyadh, Saudi Arabia, and Abu Dhabi.

Khalid Al-Thebity, managing partner of Patton Boggs’ affiliate office in Riyadh, stated: “His addition to our Middle East team… is further testament of the firm’s commitment to this region and our clients. His understanding of the business climate, having lived and worked here for many years and experience servicing it from abroad for several more, makes his addition a tremendous asset to the firm’s current and future clients.”

In the years before joining Patton Boggs, Pierce was respectively a student of Arabic in Cairo, a Fulbright Scholar at the University of Jordan, and a registered auditor at the Faculty of Law, University of Damascus. He gained his J.D. from Yale Law School and his B.A. from Dartmouth College. He was admitted to the New York Bar in 1998.

In addition to Mr. Pierce, two senior corporate associates have joined the firm’s MENA practice. Sally Soubra, based in its Abu Dhabi bureau, comes from Latham & Watkins LLP. Owen Delaney, now in the Doha practice, joins Patton Boggs from Vinson & Elkins LLP.