Originally published in the Captive Review, Guernsey Report, October 2008
Pierre Paul of Royal London tells Captive Review about managing liquidity in the credit crunch and offering reassurance in troubled times
Our liquidity management business draws on a money market pedigree which stretches back over 100 years. The business was set up by Union Discount, which was founded in 1861 to act as a liquidity conduit between the Bank of England and the commercial banks.
Over the course of those 147 years the money markets have seen many disasters and near misses, including the secondary banking crisis which came to a head in November 1973 when the London & County Bank tottered on the brink of collapse.
The then Governor of the Bank of England, Gordon Richardson, saw that more banks were becoming insolvent and that this would affect the bigger banks who had rashly over lent to the secondary banks. In the same spirit that inspired the first Baring rescue in 1890, the Bank of England called together a consortium of bankers who put up funds to support the fringe banks and see them through the crisis.
This support operation became known as 'the lifeboat', which ensured that there was no panic or runs on banks, and prevented what the Governor described as "a widening circle of collapse from the contagion of fear".
Some similarities can be drawn between the 1973 crisis and the current credit crunch, which has led to the first run on a major UK bank for 150 years and ultimately ended with the nationalisation of Northern Rock. We can only hope that the current concerns over higher energy and food costs do not create another winter of discontent with the attendant ramifications for unemployment, property prices and banks' balance sheets.
The three pillars
So, having looked at what history can teach us about current events, how do we put those lessons into practice in the day-to-day management of money? Well, in our experience, there are three pillars that support our service.
1) Biggest is best
The first pillar, 'biggest is best', refers to the concept of systemic risk, in that there are certain financial institutions which are too big to fail. The theory is that if the authorities were to let a major financial institution fail it would create so many side effects that the whole financial system would collapse precipitating a social and economic catastrophe.
The problem here is in quantifying that which is too big to fail, and while we can only speculate on where the cut-off point might be, recent evidence would suggest that the authorities will do everything in their power to prevent the outright failure of any bank or building society. This might be the case in theory, in practice, however, there is the delicate matter of dealing with the perception of risk and, most importantly for a liquidity manager; liquidity.
With risk comes reward. In chasing higher interest rates which may mean dealing with smaller institutions or lending for longer terms there is an assumption, however small, of an increase in risk. This is not necessarily the risk of financial loss but more usually the risk of a loss of liquidity; that is, the ability to get your hands on ready cash.
As a liquidity manager we achieve liquidity by investing in negotiable money market instruments called Certificates of Deposit (CDs). A CD is 'liquid' because before a CD matures it can be sold for same day value in the interbank market.
However, CDs issued by the biggest banks with the best credit ratings trade at better rates than those issued by smaller banks with lower ratings. This means that CDs issued by bigger and better rated banks are the most liquid and, naturally, a sensible liquidity manager will invest accordingly.
Second in our school of thought is that it is essential to diversify the exposure to the banks and building societies to which we lend our clients' money. We set a limit of a maximum of 10% of a client's portfolio to any one institution. This is a simple rule which, when applied to a portfolio of £10m, restricts exposure to £1m per name.
The ability to diversify without losing the ability to command market rates is difficult to achieve without significant levels of funds under management. As the Royal London liquidity management arm administers over £4bn (London and Guernsey figures as at 31 July 2008), we achieve full diversification across a broad spectrum of banking names. Additionally, our approach to diversification is that, as well as a healthy institutional spread, it is important to have a good geographical spread. Therefore, we ensure that we do not simply use UK banks but spread the exposure across the banking sectors of a number of countries, including the Netherlands, France, Germany, Spain, Sweden, Finland, Australia and the US.
3) Understand your market
Our third rule is that you should only deal in what you understand. This refers to chasing higher returns by investing in niche or hybrid securities, such as assetbacked commercial paper issued by formerly highly rated but intangible financial structures. The market in these instruments was brought to a juddering halt by the credit crunch, but 18 months ago it was possible to invest cash in all manner of asset-backed commercial paper whose assets were mortgages which had been 'sliced and diced' by investment banks on behalf of their commercial bank clients.
The value of such assets has fallen as liquidity has dried up, requiring huge write downs or, in the case of some money funds, cash injections by the parent company. We question the reason for investing in these assets in the first place. The securities were issued by structures few people had ever heard of and the returns were only marginally better than the returns achievable from CDs issued by solid dependable household names. Our view is that we would always prefer to deal with something we know and can (almost) touch, and to avoid assetbacked commercial paper like the plague.
Using these three basic rules we have managed our way through one of the worst financial crises of recent times. While it hasn't been easy there have been undoubted benefits. Firstly for our clients, who have seen their returns rise as banks compete with each other for wholesale funds, pushing interbank rates up far higher than current economic conditions would dictate. And secondly for our business, as people realise the many benefits that a dedicated liquidity manager can provide.
In conclusion, the recent episode can be likened to the effects of the rule of Gresham's Law which says that "bad money drives out good". Gresham's Law is named after Sir Thomas Gresham (1519 to 1579) an English financier in Tudor times who observed that de-based coins ('bad money') with the same face value as proper legal tender ('good money') would tend to replace good money as people would hoard all the good money leaving the bad to circulate.
The analogy with current times is that banks have had to hoard good money in the form of top quality securities which have risen in value, while shunning bad money in the form of low grade securitised bonds which have plunged in value.
History is a useful tool which is why a company like Royal London Asset Management, with a liquidity management business which can trace its roots back over 100 years, is able to provide an additional level of service; that is, reassurance in troubled times.
For more information about Guernsey's finance industry please visit http://www.guernseyfinance.com.
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