HM Treasury Discussion Paper on Building Society Capital and Related Issues March 2010
The ABI’s Response
Introduction
The ABI is the voice of the insurance and investment industry. Its members constitute over 90 per cent of the insurance market in the UK and 20 per cent across the EU. They control assets equivalent to a quarter of the UK’s capital. They are the risk managers of the UK’s economy and society. Through the ABI their voice is heard in Government and in public debate on insurance, savings, and investment matters.
ABI members, purely on account of their insurance funds, had some £750bn of fixed income assets under management at the end of 2008 (See Appendix I). As institutional investors they also manage fixed income assets on behalf of third parties. The mandates for these latter funds may vary considerably from those of insurance funds where their regulated status and matching of assets and liabilities are key criteria. Insurance portfolios hold significant funds in financial services sector assets. ABI members have been actively involved in several restructurings in the building society sector. This has included the use of the ABI special committee mechanism in the cases of Chelsea and Yorkshire Building Societies and the Newcastle Building Society.
The ABI welcomes the opportunity to respond to HM Treasury’s Discussion Paper on building society capital and related issues.
Key Points
- Our members draw a clear distinction between the action required to deal with legacy issues besetting some societies and the new environment for buildings societies once their financial structure has been normalised and access to new capital becomes a practical proposition.
- Our members believe that and would welcome participation in a wider, more holistic debate on funding that the building society sector requires. That debate should extend to a wider set of instruments than those considered in the DP, considering all forms of funding and potential innovations.
- The instruments that are the focus of the DP, Mods, PPDS and various forms of contingent capital, are not attractive to insurance funds.
- Notwithstanding the preference for mutual status expressed in the DP, the instruments considered and their equity-like characteristics and the necessary wider debate on funding indicates that the governance model requires modification. The cultural change will apply not only to the holders of new investments but also to the expectations of other stakeholders who, hitherto, may have perceived mutuality a one way upside bet.
Detailed Comments
We agree with much of the analysis set out in the paper and our comments centre on the issues raised in Section 7.
As a preface to these comments we would note the DP focus on capital, perhaps understating the issue of funding.
The question of who, if anyone, is to provide long term funding for the illiquid assets of the sector is not addressed explicitly. At one time, under the traditional conservative building society model, ABI members might have been seen as the natural long-tem investors in the sector. This is now questionable, given the authorities reassessment of solvency (both for the building society sector and insurers themselves), the corporate governance issues highlighted by developments of recent years and the unattractiveness to insurance funds of the new forms of capital presently under consideration. However, the final outcome of Solvency II may have an important bearing on insurers’ appetite for the various assets across the capital spectrum available from the sector.
Added to this uncertainty is the view of our members that, given the current structural imbalances in the sector, a return to profitability levels above the cost of capital is required before the sector will be able to raise fresh capital, in whatever form. Without positive profit levels injecting new capital would be wasteful. Consequently a clear line should be drawn between the historical situation and the new reality in which societies will operate. This will be difficult while the threat persists that existing lower-ranked capital will be subject to forced adaptation (7.1).
Turning to governance the importance of the mutuality model is highlighted (7.3). This objective conflicts, to some degree, with that of raising fresh capital in either equity-like (Mods) or debt form. It seems inevitable that for some of the forms of capital under consideration adaptation of the mutual model is required. Market participants are likely to take the view that equity-like risks require the corporate governance standards appropriate to equity. Holders of Mods would expect a degree of control commensurate to the risks they are taking i.e. not treatment on a one member one vote basis. Holders of debt might be more inclined to favour the sector if, in certain circumstances, they were afforded class voting rights. The holders of these new instruments would also expect a change in the expectation of other stakeholders recognising that mutuality also includes downside risks.
This dilemma in respect of PPDS is recognised in the DP (7.4, 7.5 and 7.7).
We agree that there is a challenge to develop instruments that “meet the needs of societies, and investors, whilst also complying with European law” (7.9). Our members are happy to participate in this debate but implications of their own regulated status would appear to preclude investment in a PPDS-type instrument. This might not apply to other less traditional fixed income investors in which case a reserve account could be a useful mechanism. However, the introduction of the concept would have to await the normalisation of the sectors’ funding position.
The suggestion in 7.10 of a nominated board member to represent institutional investors views is viewed positively. A number of practical issues will have to be resolved to achieve its effective implementation. Amongst these are the governance issues around price sensitive information within the institutional investors themselves.
A further idea for discussion could be weighted voting rights, for example an incremental vote for each £50,000 held above the (current) FSCS cover. As societies are predominantly retail funded this would modify but largely retain the principal of one member one vote.
Our members see little if any likelihood of traditional insurance funds, given their regulated status and client requirements, investing in contingent capital. ABI members do manage funds that can invest in junk-rated bonds, (into which contingent capital will fall), but such funds usually serve shorter-dated liabilities and higher-yield targets. There might be limited appetite for the Senior Contingent Notes, at an appropriate risk-adjusted return, given the greater certainty to investors that this structure can provide.
In respect of the questions raised in 7.16:
- (i) in foreseeable circumstances whereby the scope for retained profits is limited it is clear that societies require new Core Tier 1 capital instruments. As explained above this will not be forthcoming from traditional insurance funds. The DP does not consider whether a new form of hybrid Tier 1 could be developed which could partially meet regulators’ objectives: introduction of such an instrument would require less change.
1. (ii) as noted above if equity – like downside risk is involved then investors will require a corporate governance regime and risk-adjusted return appropriate to such risk. This implies a radical change in the investor base with a movement to shorter-dated funds seeking a higher-yield than traditional insurance funds.
2. whilst first reiterating the unattractiveness of PPDS to traditional insurance funds, including the lack of an exit route, modifications that might make them attractive to other investors could include:
- listing
- registered form
- reserve account
- minimum-maximum range for coupon
- write back of principal in specific circumstance.
3. again with the caveat expressed in 2 above in mind, contingent convertible instruments for new inorganic capital issuance would require a different investor base (to traditional insurance funds) such as high-yield seeking hedge funds. For traditional (non insurance) investors in building society capital the SCN is possibly the least objectionable of the new instruments outlined. Its dated form, tax deductibility in the UK and payout characteristic facilitate trading and valuation.
4-7. essentially cover the area of innovation. The DP does not cover in depth the pooled or centralised fund approaches, for raising either capital or other funding, which have been adopted in various forms by other non-listed banking groups in Europe. It would be helpful to understand Treasury’s thinking on such innovative structures, and ABI members are willing to engage actively in any debate on this topic.
Appendix 1
BRITISH GOVERNMENT SECURITIES / OTHER PUBLIC SECTOR DEBT SECURITIES / OVERSEAS GOVERNMENT, PROVINCIAL & MUNICIPAL SECURITIES / UNIT TRUSTS / DEBENTURES, LOAN STOCKS, PREFERENCE & GUARANTEED STOCKS & SHARES / LOANS SECURED ON PROPERTY / TOTAL FIXED INTEREST
INDEX LINKED / NON-INDEX LINKED / FIXED INTEREST / UK / OVERSEAS
End 2008 / 53,245 / 135,042 / 7,387 / 80,596 / 50,379 / 153,351 / 221,220 / 42,214 / 742,434
Source: ABI
Notes: Investments held on behalf of life and pensions and general insurance funds. Finds managed on behalf of third parties not included.
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