Portugal containsbanking crisisInvestors keep faith withfinancial institutions, inspite ofsector’swoesPage 4

Risk ManagementFinancial Institutions

FT SPECIAL REPORT

www.ft.com/reports | @ftreportsMonday March 16 2015

Inside

Watchdogs and theletter of the lawRegulators pushbanks in a moreconservative directionPage 2

A difference ininvestment stylesTrackers gain inpopularity as investorsleave active managersPage 2

Mergers andacquisitionsWarranty and indemnitycover can help withtricky transactionsPage 2

Business remodelling,Italian-styleMediobanca’s assetsales help it live tofight another dayPage 4

Short selling’s newsultans take the stageMaverick researcherswho venture whereothers fear to treadPage 4

Social business inemerging marketsDue diligence may notend once a deal is donePage 3

F rom an earthquake destroyingthe global headquarters to arogue employee committing asophisticated fraud, some ofthe biggest threats to compa-

niescanbemitigatedwith insurance.But for many of the world’s largest

financial institutions, this most funda-mental tool of risk management isincreasinglyunavailable.

After the financial crisis and subse-quent series of scandals resulting inmultibillion dollar fines and legal settle-ments, insurance companies havegrown more nervous about providingimportant typesofcovertobigbanks.

“Insurers want to make it attractivefor buyers, but only if it’s a sustainableline of business,” says Gerard Bloom,chief underwriting officer for financialinstitutions at the New York-listedinsurerXL.

Large banks struggle to purchase pro-tection for many of their biggest opera-tional risks at sensible prices, eventhough the market for insurance inother sectors is as competitive as it hasbeeninyears.

Premiums for big areas of insurance,such as natural catastrophe reinsur-ance, are at their lowest levels in a dec-ade. A wave of capital flowing to theindustry from hedge funds and otherinvestors wanting to generate juicierreturns in the face of low interest rates,haskept themarketcompetitive.

To be sure, insofar as they present thesame risks as any other type of com-pany, banks have benefited from theplentiful supplyof insurance.

Recent scandals such as product mis-selling, benchmark manipulation andmoney laundering have had little or nobearing on some of the risks they pose.To take an obvious example, a bankbranch is no more likely to be floodedthanafactory.

In other ways, however, banks pose

bigger risks than most businessesbecause of their sheer size, the complexnature of their business and scrutiny byregulators.

Many of banks’ largest potentialexposures are uninsurable. In severalmarkets including the US, regulatorsprevent companies from buying insur-ance against fines on the basis that itcouldencouragerecklessbehaviour.

That does not stop insurers frombeing able to cover other expenses, suchas legal defence costs. Despite havingsurplus capital, however, the insuranceindustry remains sceptical aboutdeploying it tocoverbanks.

The most acute shortage is for profes-sional indemnity (PI) insurance coverfor US-exposed banks. PI, known in theUS as errors and omissions, covers com-panies for legalcostsandotherexpenseswhen a client claims it has sufferedbecause of mistakes or negligence. For abank, this could be anything from a fail-ure to execute a transaction because ofan IT failure, to a hedge gone wrongbecausedatawereentered incorrectly.

Insurers have been nervous aboutsuch coverage to US-exposed bankssince the dotcom boom, when capitalmarkets advisers were accused of artifi-cially stimulating demand for technol-ogyIPOs.

However, their concerns about PI forbanks have become even more acutesince the 2008 crisis and series of subse-quent scandals. As well as the sheer sizeof the potential exposures at individualinstitutions, the sector’s misdemean-ours have highlighted its interconnect-edness.

Siobhan O’Brien, head of financialinstitutions at insurance broker Marsh,says episodes such as foreign exchangerate rigging and the mis-selling of pay-ment protection insurance in the UKhave had a tendency to implicate sev-eralbankssimultaneously.

Insurers are cautious about coveringclosely correlated risks; they make theindustry liable for multiple claims aris-ing from the same, or similar, events.“The concern among insurers is the sys-temicrisk,”MsO’Briensays.

PI policies tend to pay out only whensufficient controls have been put inplace but not adhered to. They will gen-erally not pay out when adequate sys-tems and practices were not establishedinthefirstplace.

“We provide insurance for errors;shareholders provide insurance forbusiness risks,” as one leading financialinstitutionsunderwritersays.

Still, when a blunder or oversight at abank triggers a claim for compensation,legal costs alone can easily run into hun-dredsofmillionsofdollars.

Even though banks have been tryingto clean up their businesses since thecrisis, which should make them better

risks, insurers have been tightening pol-icy wording, increasing premiums andreducingmaximumpayout levels.

As a result large banks typically payseveral times more for PI than othersimilarly sized companies in other sec-tors. More importantly, the upper limitsmean large banks struggle to purchasecover that will indemnify them for costsabove $400m a year, even thoughunderwriters typically club together tocoveranyoneinstitution.

That is a tiny proportion of the billslarge banks are facing. In many casesthey are not even adequate to coverlegal defence costs. The situation is suchthat several large banks have decidedagainst buying any professional indem-nitycover.

“Some of them have taken the deci-sion not to,” says Mr Bloom, “becausethe big losses that they might want cov-ered can’t be covered.” He says the trendhasmovedfromUSbankstosomeof theUKandcontinentalEuropeanbanks.

Other financial institutions — smallerbanks, asset managers and stockbro-kers — are not facing the same prob-lems, since they do not present the samerisks.

Even for the largest banks, insurers

are more willing to provide other typesof cover. Ms O’Brien notes that the mar-ket for financial institution crime insur-ance is“vibrant”.

Large banks would typically pay forthefts that cost them up to $10m them-selves, but they turn to insurance for theheavier losses which can run into hun-dreds of millions of dollars from any oneincident.

Still, as armed hold-ups become athing of the past and give way to sophis-ticated cyber attacks, insurers are grow-ing wary about their exposures tobanks’ ITsystems.

Another area that insurers have beenscrutinising is directors and officersinsurance,whichcovers thecosts tosen-ior managers and board members ofbecoming embroiled personally in legalaction. Shareholder litigation has putexecutives and board members atincreasedpersonalrisk.

Risk specialists conclude that banksshould be worrying more about improv-ing controls than their ability to buyinsurance.

As one of the puts it, the key is to do“the right thing for customers ratherthan trying to minimise the financialimpact totheorganisation”.

Scandals leaveinsurers waryof providingcover to banksRestrictionsmean that inmany cases lenders arechoosing not to buy policies, writesAlistair Gray

‘The big losses that somebanksmight want coveredcannot nowbe covered’

If 20 years ago, the typical hedge fundclient was an ultra-wealthy individualseeking exciting returns, today it ismore likely to be a middle class retireewho may not even know that he or shehasanyexposuretohedgefundsatall.

The super-wealthy were willing toaccept large risks to generate largereturns. Hedge funds are now increas-ingly vehicles for pension funds seekingto diversify from “traditional” holdingssuchasstocksandbonds.

Pension funds account for more thana third of assets managed by the hedgefund industry. A high proportion comesfrom politically sensitive state-run pen-sion funds that are concerned abouthow they are charged fees and how theirinvestmentsarerun.

At thesametime, ina lowinterestrateenvironment when many Europeangovernment bonds offer investors nega-tive returns on their money, pensionfunds seek less high-octane perform-ance from their hedge funds than wasonceexpectedfromtheindustry.

Predictability has replaced a desireforrisk.

“Institutional investors are now pre-pared to target lower returns from theirhedge funds, with lower volatility, thanin the past,” says Daniel Caplan, Euro-pean head of global prime finance atDeutscheBank.

In a recent Deutsche Bank survey,only 14 per cent of responding investorssaid they targeted returns of more than10 per cent in the coming year for theirhedge funds; 37 per cent had soughtdouble-digitperformance in2014.

This relatively new-found conserva-tism among investors such as pensionfunds has had an impact on how hedgefundmanagersapproachinvesting.

In the post-financial crisis years, theamount of borrowing hedge funds wereable to take on to buy investmentsshrank and investors in general werereluctant to place money with any fundthathadmisbehavedbeforethecrisis.

This has meant that the turbochargedhedge fund culture of pre-2008, wheresome funds used huge multiples of lev-erage, has been replaced by larger, farmore institutionalised hedge funds thatemphasise risk management in theirsalespitches.

Some hedge funds have significantlydeveloped their asset bases in the post-crisis years after winning the confidenceof the pension funds. Yet it mightbe argued that this incentive to accumu-late client assets, on which a lucrative

management fee can be charged, hasmeant that there are large hedge fundsthat have not delivered the investmentreturns forwhichtheyarepaid.

Alper Ince, a managing director atPaamco, a California-based fund ofhedge funds with $9.5bn of assets andwhichspecialises in investing instart-uphedge funds, sayssizecanhinderaman-ager’s ability to generate large returns for clients. As such, it is mainly whenmanagers are starting out that they areincentivised to take on the right balancebetween generating high returns fortheir clients, and making sure they donot losemoney.

“One of the reasons we are focused onsmall managers is because at the startthey are in performance-generatingmode,” says Mr Ince, contrasting thiswith managers who already have largeasset bases and are unwilling to takerisks thatcoulddamagethatposition.

“In a low-return environment, inves-tors are looking for differentiatedsources of returns. They may want a lit-tle bit more concentration instead of adiversified fund where things canceleachotherout.”

Another way in which hedge fundshave been able to allow investors to takeon more concentrated bets on particu-lar ideas is to establish so-called man-aged accounts, in which they can makeinvestments alongside specially chosenclients.

These accounts have allowed somehedge funds to offer clients chances toinvest in potentially lucrative tradesthat may take a longer time to pay off,such as bets by several managers inrecent years on the recovery of US mort-gage-backedsecurities.

But other hedge fund managers leavetheir larger employers in order to estab-lish smaller, nimbler investment groupsthat are better able to seize opportuni-tiesquickly.

“Some of the managers that are leav-ing big hedge funds to start smallerones, do so because they think they can-not take meaningful positions wherethey are currently, given the significantasset base they are working with,” saysMr Ince. “They want to run more con-centratedportfolios.”

Yet most hedge fund managersremain aware that their institutionalinvestors will probably only remainwilling to accept lower returns whileinterest rates, and returns on otherinvestments, remain low.

As soon as rates begin to rise, thedesire for the double-digit gains onceseen as the industry’s standard is likelytoreawaken.

Predictability now trumps excitementHedge funds

With their eye on lowervolatility, institutionalinvestors appear willingto target lower returns,writes Miles Johnson

Paamco managingdirector Alper Ince:‘Investors arelooking fordifferentiatedsources of returns’

The concept of stealing money from abank used to call up images of armedrobbers breaking into a building to raidtills forcash.

The reality now is that theft is largelyundertaken by sophisticated hackersbreaking into the digital channels ofbanks and their customers. As lendersopen more digital routes through whichpeople can bank, hackers have morepathways to target to siphon off moneyandstealcustomerdata.

The threat of cyber crime is perni-cious. The Financial Conduct Authority,a UK regulator, has even been warnedabout loopholes in the cyber security ofone of Britain’s largest banks, whichcould compromise the accounts of mil-lions of households and businesses. Yetpressure to cut costs pushes banks toclose branches and digitise, spurred onby consumers demanding more effi-cientbankingaccess.

Figures from the British Bankers’Association show there were 18.6m

mobile app uses a week on average in2013, more than double the amount inthepreviousyear.

The threat of cyber crime is height-ened by the increasing move to digitisa-tion, says Nicola Crawford, a boardmember of the Institute of Risk Man-agement. She notes that banks oftenhave to rely on third-party systems inorder to provide a number of their newdigital services.

She adds: “Whether it is external datafeeds, customer and staff devices orcloud services, banks find themselveshaving to adapt to relying on systemsthatareoutsidetheircontrol.”

However, while banks haveContinuedonpage3

Cyber crime thrives oncost-cutting cultureSecurity

Digitisation and consumerdemands for more efficientbanking heighten the threat,writes Emma Dunkley

Hacked off: big banks are worried

2 ★ FINANCIAL TIMES Monday 16 March 2015

RiskManagement Financial Institutions

In the past two years, the growth of pas-sive investment funds, which track themarkets and charge cheap fees, hasbeenoneof themainstories in theworldofassetmanagement.

Last year Vanguard, one of the world’sbiggest providers of passive invest-ments with $2tn in trackers and morethan $450bn in global exchange tradedfunds, was the most popular mutualfund management group globally. It hadmore net inflows, a fifth of all new busi-ness, than more than 3,000 groupstrackedbydataproviderMorningstar.

There is no big secret to the group’ssuccess. As Tim Buckley, chief invest-ment officer of Vanguard, says: “Wecharge low fees and offer value formoney. Active managers charge muchhigher fees and often still struggle tooutperformourpassive funds.”

The US mutual group levies an aver-age expense ratio on its funds in the USof 0.19 per cent and 0.23 per cent inEurope. That compares with a typicalexpense ratio on an actively managedfund of 0.75 per cent before tradingcosts.

Yet, despite what seems a successstoryforVanguardandotherbigpassiveproviders such as BlackRock and StateStreet Global Advisors, which were alsopopular with investors and attracted biginflows last year, there are questionmarks over the systemic risks theymightposetothesystem.

In short, as they track the markets,they create a herding or momentumeffect, which can exaggerate risesor falls in the stocks, bonds or

commodities that they track. If theentire market has to move in one direc-tion because investors are trading pas-sively, then the obvious problem is notknowing who is on the other side of thetrade. Who will do the buying when thepassive funds are selling and who will dothe selling when the passive funds arebuying?

Vanguard and BlackRock alone havemore than $7tn in assets under manage-ment, of which a large chunk is in passiveproducts. This means that a vast amountof money is going one way in response toeconomic announcements, externalshocks or political decisions that are con-sideredimportant for investors.

But passive investment may not yetbig enough to create the systemic riskssomemight fear.

In the US, where Vanguard launchedthe first index tracker in the 1970s, pas-sive investment accounts for 30 per centof themarket.Active investment,wheremanagers select stocks that they thinkwill beat the market, accounts for 70 percent. In Europe, the ratio is 90 per centactive management and only 10 percentpassive.

Passive is likely to make more inroadsinto active management in the UK andcontinental Europe, but it is thoughtunlikely to steal much more than 30 percent of market share in the US. Activemanagers are likely to dominate theinvestment universe, at least for theforeseeable future, say investors.

Stephanie Flanders, chief marketstrategist for UK and Europe at JPMor-gan Asset Management, says: “Themove towards passive is entirely under-standable as clients were not getting

what they paid for with some activefund managers. Passive investment islikely to grow in Europe. Active manag-ers have to make the case more rigor-ously forwhat theyarecharging.”

But she thinks active managementstill offers the best option for manyinvestors. JPMorgan Asset Manage-ment, an active house, was the thirdmost popular mutual fund manager glo-bally last year behind Vanguard andBlackRock — proof that clients are stillprepared to pay extra for an active man-ager they think can provide alpha, orbeat the market. Goldman Sachs AssetManagement, another active manager,was the fourth most popular mutualfundmanager.

Michael Dobson, chief executive ofSchroders, the active UK listed group,says: “Passive investment has a place,but we have shown that we can attractand retain clients on the basis of ourstrong products and strong perform-ance.

“You cannot beat the market everyyear, but if you can show that incremen-tally you can outperform, then clientswill choose active managers. Thatmeans over a long period you need toproduce better returns, which we haveshownwecando.”

Last year, Schroders won £24.8bn innewbusinessand78percentof itsassetsunder management outperformed overthree years. Other active Europeanhouses such as Henderson Global Inves-torshadagood2014, too.

Schrodersparticularlyhasshownthatan active management business canbeat all competition with the right fundmanagers, executives, brand and distri-bution network. It has just declaredrecordpre-taxprofits for2014.

A strong case exists, therefore, forbuying both passive and active invest-ments. As long as active managementcontinues to dominate, that shoulddamp fears that passive managersmightbecomeasystemicrisk.

Passive funds’ riseheightens fear ofshock to systemInvestment styles

Trackers gain in popularityas disappointed investorsditch active managers,writes David Oakley

Stephanie Flanders: ‘active is best’

For decades, capital markets have facili-tated corporate takeovers by providingdeal financing. But markets that helpbuyers and sellers to gain protection —or at least greater certainty from theunforeseeable following a deal — havestruggled.

This is changing. The upswing in dealactivity in recent years has been accom-panied by a rising number of insurancepolicies foreitherabuyeroraseller.

The policies, which are created withthe help of specialist brokers and under-written by large insurers such as AIG,are becoming prevalent in deal talks,practitioners say. Designed to shift lia-bilities to a third party, the presence ofso-called warranty and indemnity(W&I) insurance is aiding the comple-tionof trickydiscussions.

“In difficult negotiations over thescope of buyer protections, W&I insur-ance is increasingly being used to bridgethe gap and get deals over the line,” saysFfion Flockhart, partner at Norton RoseFulbright.

Whilemuchattention inatransactionis paid to its price and terms, less wellunderstood is the process by which buy-ers and sellers agree on the specific con-ditions regarding the asset changinghands. In a typical negotiation, a seller issupposed to provide thorough disclo-sures about the asset and makes prom-ises — warranties — about those disclo-sures,which last foraset time.

If a buyer finds any of those state-ments — that cover anything fromshares to intellectual property — werefalse, it may be entitled to seek dam-ages, even if years have passed since thedeal was struck. A seller makes certaincommitments to make good on abuyer’s future losses, known as indem-nities, in case of unforeseen circum-stances. Thus the most common formsof risk insurance are policies that coverthesewarrantiesandindemnities.

These bespoke policies are tailored tocover either a buyer or a seller in a dealfor post-closing liability. A seller, forinstance, that wants to limit its futureliabilities following a deal, may pur-chase this insurance to potentially shiftthat liability toathirdparty insurer.

That has been particularly attractivefor selling shareholders looking to retireor for companies who need to protecttheir balance sheet from potentialclaimsarisingoutofpreviousdisposals.

But the real growth has been in buyerpolicies, with private equity being a sig-nificant force in driving increaseddemand. A survey from Allen & Overyfound 17 per cent of European privateequity deals included some form of

W & I insurance. Private equity or insti-tutional sellers typically look for a cleanbreak when they sell companies, so thattheir sale proceeds can be returned totheir limitedpartners.

This is no longer acceptable for mostbuyers, who are increasingly usinginsurance policies to ensure they canrecoupanyliabilities, saysNualaRead,aLondon-based director in the M&A

practice at insurance broker Aon. Shesays: “We have seen the amount ofbuyer W&I policies increase fourfoldsince 2010, as this insurance producthas been increasingly useful for privateM&Atransactions.”

Marsh, another broker, says the use ofinsurance policies around deals is grow-ing. In2014, itplaced limitsof$7.7bn,up51 per cent from a year earlier. DanielMax, a managing director of privateequity and M&A at Marsh, says the poli-cies are filling the void where capitalmarkets struggle to understand contin-gentdeal-specific liability.

He says insurance companies are gen-erally bad at working with single issuecredit risk “so what we are doing isexploiting the arbitrage where aninsurer is well positioned to providesome deal certainty by ringfencingknownrisk issues”.

So why has the market for these poli-cies grown so quickly in recent years?Mary Duffy, head of M&A at AIG, saysshe has been working on the productsince its infancy in the late 1990s, whenacquirers complained that the insur-ance was too expensive to be used: “Oneof the main reasons we are seeingincreased adoption of insurance isbecausepricinghascomedown.

“Also, we have hit the critical pointwhere it has gained enough credibilityso that dealmakers have used the prod-uct successfully and are becoming morecomfortablewith it,”MsDuffyadds.

Underwriters say they have compiledsufficient data to study loss trends overtime,allowingthemtoreducethecostofpolicies.

There are risks, however. The insur-ance is designed to cover unexpectedissues after a deal, but relies on a buyerdoing thorough diligence of the assetand the seller providing full disclosuresabout it.

“Our biggest risk is that adoption ofthe insurance will change the behav-iours of parties in negotiations and duediligence. So we look closely to see thatthere has been a balanced, negotiatedagreement and that due diligence hasbeenrobust,”saysMsDuffy.

Nonetheless, “there seems to be noslowing down” in demand, adds Aon’sMs Read. “It is a very exciting time fortheM&Ainsuranceworld.”

Transactions insurance gains inprominence as deal activity picks upMergers and acquisitions

Warranty and indemnitycover can aid the completionof some tricky discussions,writes Arash Massoudi

W&I: liabilities shift to third parties

‘Activemanagers have tomake the case rigorouslyfor what they are charging’

T he public debate on banks’capital ratios has longfocused on the “top”number, namely homing inon the billions in capital

that banks have and how they can goabout increasing it to satisfy regulators’demandsforeverhighercapital ratios.

A far more interesting debate hasbeen bubbling under the surface, focus-ing on the “bottom” number, the yard-stick against which banks measure theircapital to get that all-important ratio.Andit isabout tocometoahead.

That yardstick in the line of fire is“risk-weighted assets”, or RWAs, whichareanexpressionofhowriskyanasset isconsideredtobe.

A $100,000 mortgage could have arisk weight of 30pc, so its RWA figure is$30,000. You need $3,000 of capital tohave a 10 per cent capital ratio againstthe $30,000; but if the risk weightingwere 40 per cent, you would need$4,000.

As things stand, banks can calculatetheir RWAs using “standardised” riskweights set by the international regula-tors, or they can choose to create theirownmodelsandusethose instead.

Those internal models spit out strik-ingly different results, a fact that has notgone unnoticed by regulators, includingthe Bank of England and the globalbanking watchdog, the Basel Commit-tee.

Pressure to reduce those discrepan-

cies — which can make the differencebetween a bank being able to pay a divi-dend and having to raise extra capital —ismountingonmultiple fronts.

Regulators across the globe, who werealways responsible for reviewing banks’internal models, have become increas-inglyvigilant in thepastyear,and indus-try insiders say some banks have takena more “conservative” approach tomodelling.

“Tolerance has gone down,” saysStephen Hall, a London-based partnerat KPMG. “Regulators are much morekeen to see if the organisation is apply-ingthe letterof the law.”

The European Central Bank, newlyempowered as the eurozone’s pre-eminent banking supervisor, has sent ashiver down banks’ spines by embark-ing on a review of RWA calculationsacrossallbanksunder its supervision.

The review follows hard on the heelsof the ECB’s Comprehensive Assess-ment on whether banks were valuingtheir assets properly and were strongenough to cope with another financialcrisis. Some 25 of the 130 banks exam-inedfailedtheassessment.

“European banks generally acknowl-edgethatRWAswill riseasaresultof thereview,” says Jon Peace, bank analyst atNomura. “The ECB is very keen to seesomeharmonisation.”

At the global level, the Basel Commit-teehasputoutaconsultationpaperpro-posing to make standardised risk

weightings more nuanced, and suggest-ing“floors” forbanks’ownmodels.

If floors were introduced, regulatorscould declare that modelled RWA expo-sure cannot be less than, say, 75 per centof thestandardisedresult.

Analysts from Barclays wrote in anote on March 2: “These proposals arequite radical and could have a profoundimpact on capital adequacy, dividendpayouts and the earnings power of dif-ferentbusinessmodels.”

They believe banks’ common equitytier one (CET1) ratios — their key capi-tal target — could fall by as much as 1.4to 2.7 percentage points, depending ontheBaselCommittee’s findings.

International rules require banks tohave a CET1 ratio of at least 4.5 per cent.Regional and national regulators can sethigher thresholds, and banks usuallylike to have a CET1 ratio of about 10 percent so they can assure investors theyare“wellcapitalised”.

In their research, the Barclays ana-lysts focused on RWAs for credit risk, acategory that covers the loans and othercredit commitments that make up 81per cent of the total RWAs across thebanksstudied.

Mr Peace says the impact of the inter-national review will probably be mostpronounced for investment banking,which relies more heavily on internalmodels than retail and commercialbanks.

Calculations from investment

banking research firm Tricumen showhow greatly RWAs in investment bank-ing vary. Tricumen looked at the rela-tionship between RWAs and revenueacross eight key business lines for the topnineglobal investmentbanks.

In the cash equities business, it foundthat one bank had RWAs equal to 16 percent of revenue. At the opposite end ofthe scale, another bank had RWAs equalto5percentofrevenue.

In foreign exchange, the discrepan-cies were more modest, with one of thelowest RWAs at 2 per cent of assets andthe highest at 5 per cent, across thebanksTricumenanalysed.

“Banks are definitely optimisingRWAs and we certainly see differenttreatments,” says Seb Walker of Tricu-men, adding that banks’ results couldalso vary depending on which assetstheyput intheir tradingbookandwhichthey held in their banking book. Trad-ing and banking books attract differentRWAtreatments.

Mr Walker says a gap is developingbetween those banks that had investedin group-wide risk systems and thosethat had not. Banks with sophisticatedgroup-wide models are better placed tocreatemodels thatwill reduceRWAs.

While banks have done a lot toimprove their models and achieve lowerrisk-weighted assets in the past, mostexperts saybanksareno longer focusingattention on this area, and are insteadpreparingforamoreconstrainedworld.

“There’s a general acceptance thatbanks will have to use the standardisedapproach with floors, but not for a fewyears,”saysMrHall.

Banks are not expecting to see theBasel Committee’s final proposals untilthe fourth quarter of 2015. They arelikely to be given several years to imple-mentanynewrequirements.

The timing of the ECB review isunclear and some banks think it couldtake years to carry out comprehen-sively. They also face another constraintthat means the gains from low RWAs arenot what they once were. Regulatorsacross the globe are introducing a newmeasure, dubbed the leverage ratio,which restricts banks’ abilities to usemodels that reduce the amount of capi-tal theyarerequiredtohold.

The leverage ratio means banks holda set amount of capital relative to totalassets, regardless of how risky thoseassets are. Regulators say they still likethe theoretical basis of using RWAs tocalculate capital ratios as they wereintroduced to reflect that differentbanking assets have different risk pro-filesanddifferent levelof likely losses.

Mr Hall says the UK authorities arestill approving new models and not justforbigbanks.PrincipalityBuildingSoci-ety, a UK deposit taker with a balancesheet of £7bn, had an internal modelapproved in late 2013. “There’s norestriction. The regulator will still allowmodelledapproaches,”saysMrHall.

Regulators pushbanks hard oncapital ratioflexibility

Weighted assetsWatchdogs appear increasinglykeen on the letter of the law, writes Laura Noonan

Basel’s world:consultationsuggests ‘floors’for banks’ ownmodelsDreamstime

‘There couldbe profoundimpact onthe earningspower ofdifferentbusinessmodels’

‘Dealmakers have used theproduct and are becomingmore comfortable with it’

Monday 16 March 2015 ★ FINANCIAL TIMES 3

RiskManagement Financial Institutions

ContributorsAlistair GrayInsurance correspondent

Miles JohnsonHedge fund correspondent

Emma DunkleyRetail banking correspondent

Laura NoonanInvestment banking correspondent

David OakleyInvestment correspondent

Arash MassoudiM&A correspondent

Joseph CotterillPrivate equity correspondent

Rachel SandersonMilan correspondent

Peter WiseLisbon correspondent

Steven BirdDesignerAndy MearsPicture EditorPeter ChapmanCommissioning editor

For advertising details, contact:Peter Cammidge, +44 (0)20 7775 6321or peter.cammidge@ft.com, or your usualFT representative.

Our advertisers have no influence over orprior sight of the articles.

used on specific areas susceptible tocyber attack, Ms Crawford says thatmultiple systems and processes runningin parallel are under threat, which couldcause“widespreadharm”.

Online and mobile payment servicesform one area where banks are seekingto innovate, while implementing newtypes of authentication to bolster secu-rity.

Royal Bank of Scotland recentlyunveiled “Touch ID”, which allows peo-ple to log in to their mobile banking appusingtheir fingerprint.

Thomas Bostrøm Jørgensen, chiefexecutive of Encap, an authenticationsoftware provider for banks, says thisdevelopment marks a “watershedmoment” forbiometrics inbanking.

Buthe iscautiousaboutraisingexpec-tations at a time when “banks are beingassaultedbyhackersandfraudsters”.

“Sure, it’s trickier to subvert a finger-print than a password, but it’s notimpossible. Touch-ID was ‘hacked’ lessthanamonthafter introduction.

“One hacker has claimed to be able to

recreate fingerprints from high-resolu-tion photos. And while you can issue anew Pin or password, you can’t issue anew fingerprint — not without it beingvery messy. A single factor will alwaysbevulnerable toattack.”

He notes how US technology giantApple suffered reputational damagefromarecent iCloudbreach.

Large banks in particular face chal-lenges in having to grapple with archaicIT systems. Jonathan Wyatt and RyanRubin of Protiviti, a global consultingfirm, believe these systems are often soold that parts are no longer manufac-tured and trained technicians havemovedonorretired.

Such banks have been “bolting” onsoftwareontopofcoresystemsforyearsand continue to use platforms that “can-notbesecured”,MrWyattsays.

He adds that there is a realisation inthe industry that large banks need to be

Continued frompage1

doing more: “Attacks will become moresophisticated.”

Banks are acknowledging the issue.“The number of security programmesthat bankers are running is a strongindicator that they are battling with[cyberrisk]asaproblem,”hesays.

Cyber security is on the board’s to-dolistasatop10riskthat is rapidlymovingup the agenda, he says. Large banks areallextremelyconcerned.

Aside from cash, hackers might stealcustomers’ data which can be mone-tised. “There is a value to having infor-mation on people’s identities, to havingcredit card details which can be sold ontheblackmarket,”MrWyattadds.

“We have also seen instances whererogue employees may be manipulatingprogrammestoperpetrate fraud”andoffraudsters using IT to take advantage ofthewaysoftware iswritten.

Newer “challenger” banks, unencum-bered by old IT systems, might appearmore nimble as they have fewer layersof software. But, according to StephenBonner at accountants KPMG, not allchallengers are using third-party soft-ware.

“Quite a few are running off the sameback-end systems as the big banks,” hesays. TSB, for example, was spun out ofLloyds Banking Group and is reliant onits IT infrastructure.

The regulator has even suggested thatsmaller banks are more exposed tocybercrime.

Anthony Rawlins, senior manager atMoore Stephens, a consultancy firm,says: “The FCA has, quite rightly, con-centrated on the increased sophistica-tion of criminals using banks to laundermoney and move illegal funds interna-tionally.

“Unfortunately, smaller banks docarry higher risks in this regard, simplybecause of the sophisticated nature ofthe criminals involved and their smallerinternalresources.

“However, much of the preventiveaction that can be taken is culturaland, if senior management engage,many of the risks can be mitigated andavoided.”

Cyber crimethrives oncost-cuttingculture

O nce upon a time in SouthAfrica, being HIV-positiveeffectively meant you wereuninsurable. That wasuntil 10 years ago, when

one life insurer began to offer regularmedical testsalongside itspolicies.

In doing so, AllLife became theworld’s first company to sell whole-lifeinsurance cover to people on lowincomes with HIV. Its “continuousunderwriting” has since helped its cli-ents measure and manage their healthaswellashelping it toprice itsproducts.

This makes AllLife a success story forinvestment by private equity in emerg-ing markets as much as being clever riskmanagement. The company is one ofthe holdings of LeapFrog, a fund thathas backed fast-growing African andAsian financial services since 2008.Bima, another of its companies, workswith network operators to sell microin-surancethroughmobilephones.

However, it may be the clever risk

management — including LeapFrog’swider approach to monitoring govern-ance in its portfolio companies — thatmost interestsotherprivateequitycom-panies also looking at buying unlistedassets inemergingmarkets.

The best forms of due diligence maybe those that do not end when a deal issigned and which are as diligent sociallyas they are financially. It might also helpraise returns, as private equity firms sellcompanies to corporate buyers whoincreasingly value governance inemergingmarkets.

LeapFrog, which raised its latest,$400m fund last year, may admittedlyhavearareperspective in its industry.

It invests its backers’ money for“profit with a purpose”, delivering highreturns while aiming to bringeffective, affordable insurance tomillions of low-income consumers forthe first time. The company says its2008 target of reaching 25m people in adecade has already been achievedthanks to measuring the impact of port-folio companies on financial inclusionthroughthecourseof the investment.

“Our approach is ESG [environmen-tal, social and governance] plus plus, inthat sense,” says Sam Duncan Leap-Frog’sheadof impact,.

Such ESG factors are being increas-ingly demanded by investors in stand-ard private equity funds, from pensionfunds to university endowments, ashallmarksofagoodinvestment.

Also, the weight of private equity cap-ital that has been raised to find returnshigher than those in developed marketsmay mean far greater care will beneeded putting it to work. Of $22bnraised by private equity funds to invest

in Africa between 2007 and 2014, morethan $8bn was raised last year, accord-ing to the African Private Equity andVenture Capital Association. Mean-while, in Asia, the amount of “dry pow-der” — capital yet to be committed todeals—iswellabove$129bn.

Many new firms deploying capital arealso private equity houses with globalfranchises underpinning listed entitieswith billions of dollars under manage-

ment. Last year KKR, a US-based globalfirm,madeits firstAfricanforaybybuy-ingastake inanEthiopianrose farmer.

Meanwhile, Washington DC-basedCarlyle’s sub-Saharan fund made itsmaiden investments in Nigeria andSouth Africa, respectively stakes in apublicly listedbankandatyreretailer.

The need to protect global brands is atwist on an old problem for investorscarrying out due diligence in emergingmarkets.Politicalandreputational risksarevery importantbuthardtogauge.

Onecommonpracticewhenconsider-ing investing in Nigerian companies forinstance is to check ties to previousadministrations, not just the rulinggovernment, given the perseverance ofpoliticalnetworks.

A more pressing due diligence chal-lenge may be that many of these buy-outs are bets on the rise of emergingconsumers. Diligence on a business planmay have to assure companies cannotonly expand to reach millions of cus-tomers,butalsoretaintheir loyalty.

That is where LeapFrog’s specialism— combining financial and social duediligence in insurance, an industrywhere consumer protection is para-mount—mayprovecrucial.

Ms Duncan says: “Unless the

customer understands your product,the long-term value proposition for thatcustomer iscompromised.”

So due diligence may involve lookingat tell-tale signs that go beyond financialperformance: for a business sellinginsurance, a healthy — and, dependingon the product and maturity, not toolow — number of claims is “a key opera-tional indicator, but also shows strongvalueforcustomers”,MsDuncanadds.

Renewal rates “are a key leading indi-cator from a customer retention view-point, but if a low-income customer[renews] year after year, it’s also strongsignofsocialperformance”.

The benefit of measuring this per-formance throughout the life of aninvestment may, after all, mean that itfetches a higher price when sold to otherinvestors in emerging markets, whichare lookingfordataandtransparency.

Apollo, a LeapFrog investment thattailors livestock insurance policies forKenyan farmers and others, was sold toSwissRe lastyear, forexample.

Ms Duncan says: “Due diligence iscentral, but integrated measurement isthe key piece. That’s [what is impor-tant] in valuations, in being able tomeasure both financial and social per-formance.”

Clever LeapFrog keeps portfolio one jump aheadEmergingmarkets Bestdue diligencemay notendwhen deal is signed,reports Joseph Cotterill

Profit with purpose: aim is to bring insurance to low-income consumers— Reuters

‘We have seen instanceswhere employeesmay bemanipulating programmesto perpetrate fraud’

Fingerprint ID: a ‘watershed moment’

Contributors

4 ★ FINANCIAL TIMES Monday 16 March 2015

In comic books, the masked vigilantecarries a double-edged sword as far asthe authorities are concerned. The mys-terious hero sorts out baddies but oper-ates outside of official control and mightevenriskbreakingthe lawhimself.

The rise of the independent short sell-ing research analyst has created a simi-lar dilemma for regulators and inves-tors. These outfits, often run by anony-mous lone wolves, have become inrecent years influential voices acrossgeographically diverse stock markets,fromLondontoHongKong.

While traditional short sellers —investors who bet against companyshare prices — have been large hedgefunds risking their own capital, themotivations of the research groups canbemorediverse.

Some serve as guns for hire, taking oncommissions fromclientsandlaterpub-lishing their research online. Othersinvest their own money into their ideas,just on a smaller scale than conven-tional hedge funds. Others claim amoral imperative for their work, sayingthey are rooting out corporate fraudconventional investment bank analystsaretooconflictedor lazytoseekout.

For traditional fund managers, whohave been used to relying on the opin-ions of investment banks, the ability of anew breed of talented analysts to wipemillions from the value of their holdingsarmed with only an internet connectionandbloghascomeasashock.

“This is a new type of risk we need toconsider when we invest,” says one UK-based fund manager. “The nature offinancial markets is changing and theway information and opinions about acompany spread is very different tobefore.”

One of the most successful andrespected of the short selling researchgroups is Gotham City Research, namedwith a nod to the home town of thearchetypal masked vigilante, Batman.Gotham, which is run by the researchanalyst Daniel Yu, has quickly built areputation for uncovering irregularitiesat thecompanies it targets.

Few institutional investors had heardof it until it published a strongly wordedreport questioning the accounts ofQuindell, a UK-listed legal and insur-ance company. Quindell later won anuncontested libel action againstGotham but the impact of the report onitssharepricewasdevastating.

Having been one of the UK’s best-per-forming shares over the previous year,

helping Quindell grow to become one ofthe most valuable companies on theAim market, the shares slumped asinvestors took fright at Gotham’s assess-ment.

While Quindell denied there was anytruth to the Gotham report, its founderand chairman Robert Terry later wasforced to resign over misreporting ashare transaction and Gotham was ableclaimanelementofvictory.

Some of the world’s largest hedgefunds profited from selling Quindellshares short, while bullish investors,including M&G, the investment arm ofthe Prudential insurance company, andthe hedge fund Algebris, were leftembarrassed.

Gotham followed up with an investi-gation into Gowex, a Spanish wirelessinternet provider that had grown intothe largest company on Madrid’s smallcompany exchange. Less than a weekafter Gotham questioned Gowex’saccounting, the latter’s founder andexecutive chairman Jenaro Garciaadmitted the company had fabricatedits earnings and shares were suspendedfromtrading.

Another group claiming success isMuddy Waters Research, run by CarsonBlock, which came to fame for allegingaccounting fraud at a Canadian-listedChinese forestry company that filed forbankruptcyprotection in2012.

Some critics argue, however, thatsuch analysts can spread dangerousmisinformation. “These guys can sayanything they want and destroy thevalue of companies without facing anyconsequences,” says one executive froma large hedge fund. “If one of myemployees were to do what they do wewould be called up by the financial regu-lator in fiveminutes.”

Companies that have been targetedby short selling research groups havebecome more co-ordinated and robustin their responses. This year NobleGroup, Asia’s largest commodities trad-ing house, issued a long and detailedrebuttal to allegations about its balancesheet by Iceberg Research, a group thatpublishes its notes on its blog and onTwitter.

But the vigilantes are unlikely to dis-appear soon. Company executives andinvestors may well just have to becomeaccustomed to opinions from a broaderrangeofsources thanbefore.

And anyone contemplating commit-ting financial fraud at a listed companymust now be fearful in case the capedcrusaders of the financial markets mayswing intheirdirection.

Vigilante researcherswield their swords

Short selling

A new breed of analyst iscutting a swath through theold research hierarchy,writes Miles Johnson

RiskManagement Financial Institutions

I n journalist’s lore, the only way toknow when a deal was done atinvestment bank Mediobanca 20years ago was to stand outside andwait for the sound of champagne

corks popping. Such corporate colourhas been consigned to history thanks totheeurozonecrisis.

The once very powerful and secretiveMilanese bank, which presided over anetwork of cross-shareholdings makingit the top table for Italy’s most influen-tial bankers, businessmen and finan-ciers,hasbeenradically transformed.

When the eurozone crisis saw thebank’s shares value fall 90 per cent itdiscovered risk was not outside butinside: the cross-holdings were the veinsthroughwhichcontagioncouldspread.

The response of Mediobanca underAlberto Nagel, its chief executive, hasmade it a case study of how to changethe risk profile of a business modelwhenthemarketdemands.

In 2012 the price of its shares fell to€2.5 each. Having shed many cross-shareholdings and diversified frombeinganall-Italian investmentbanktoapan-European boutique, Mediobanca’sstocknowstandsat€8.4pershare.

“In recent years both the regulatoryand market settings have changed pro-foundly,” says Mr Nagel, who started hiscareer at Mediobanca more than 20years ago. He is now as likely to be foundat its recently expanded 100-personstrong base in London’s Grosvenor Placeas in itsMilan’sheadquarters.

Mr Nagel has also hired senior bank-ers toexpanditspresence inMadridand

Paris.Hearguesthattoday,being“aspe-cialised bank allows you to have higherand more stable profitability and betterproximity to customers than universalbanks. Mediobanca’s strategy fits thiscontextof increasingspecialisation.”

Its latest quarterly results support thechanges. It reported an 8 per cent jumpin revenues to €489m and operatingprofits of €282m helped by gains onequity disposals. Its fully phased com-mon equity tier 1 ratio — a bank’s coreequity capital compared with its totalrisk-weightedassets—was12.7percent.

UBS analyst Matteo Ramenghi saysthe profits were well above expecta-tions. He says the bank’s managementhas taken “a proactive stance, managingthe balance sheet in the new interestrate environment by reducing excessliquidity and bond investments to leaveroom for loans expansion, and thereforeimprovingassetspreads”.

Marco Sallustio, analyst at ICBPI,believes “ongoing recapitalisation of EUbanks, the pick of M&A in the banking,telecomandutilities sector,andthe flowof new IPOs are expected to provide adecisive contribution to the group’searnings in2015”.

Yet building a pan-European bou-tique investment bank to compete withthe likes of Lazard and Rothschild as itseeks to be “more bank and less holdingcompany”, in Mr Nagel’s words, has notbeenwithoutpain.

From 2008 to 2013, Mediobancamade €1bn in writedowns. Havingraised €3.3bn from selling holdings incompanies such as Fiat and Ferrari, in

June 2013 Mr Nagel announced plans tosell another €1.6bn in stakes, a movethat would effectively cut its links tomany Italian companies. He and histeam have since realised €840m withsales of shares in Gemina, Intesa San-paoloandothers.

It still has a few holdings in industriesrelated to some of Italy’s top power bro-kers, tyremaker Pirelli and cementgroupItalmobiliareamongthem.

In terms of historic significance andvalue, its bigger share sales will comelater this year, when Mr Nagel has saidhe will exitRCS Mediagroup, whichowns newspaper Corriere della Sera — atraditional hub of business, financialand political power — and Telco, theholding company of Telecom Italia, byJune. Both RCS and Telco had becomeliabilities with their fortunes tied toweakeningconsumerdemand.

Mr Nagel also plans to sell down 3 percent of its stake in Generalito take it to10 per cent to raise funds, possibly tobuy a banking business in the UK orItaly. The General i stake isMediobanca’s most precious — and con-troversial — asset: about 70 per cent ofits quarterly profits came from theinsurance multinational. Selling threeper cent now would give Mr Nagelnearly€900mtoplaywith.

Analysts say the jury is still out on thedestination of Mediobanca’s transition.They speculate it may ultimatelybecome a takeover target. But, in thewreckage of the eurozone crisis thatdestroyed many of Italy’s old certain-ties,Mediobancawill fightanotherday.

Mediobanca’sasset saleshelp it to fightanother dayBusiness remodellingThe once powerfulMilanesebank has been transformed, saysRachel Sanderson

Angrygroupsofmiddle-aged,middle-classdemonstratorshaverecentlybeenswoopingonindividualbankbranches inPortugal,occupyingthepremises,wavingplacardsandshouting:“Wewantourmoneyback!”

Theprotestersarevictimsof thecollapseofBancoEspíritoSanto,oneofthecountry’sbiggestandmostrespected lendersuntil itunravelled lastsummerinoneofEurope’s largestfinancial failures. Individuals telldistressingstoriesof losingtheir lifesavings,beingforcedtoclosesmallbusinessesandstrugglingtosupportelderlyrelatives.

TheprotestershaveaccusedaccountmanagersatBESof trickingthemintobuyingcommercialpaper issuedbydisintegratingEspíritoSantogroupcompaniesby leadingthemtobelievetheywereputtingtheirmoneyintosafeinvestments.Regulators,meanwhile,arewranglingoverhowtocompensatemorethan2,500savers inthissituationfor losses inexcessof€550m.

ThedemonstrationsatbranchesofNovoBanco, theso-called“goodbank”

createdfromhealthyassetssalvagedfromtheruinsofBES,mayseemtosuggestariskandassetmanagementsector incrisis.

ButoverallPortugalhasweatheredthestormof its three-year internationalbailoutanddeeprecessionwell.DespitethefallofBES,Portugueseretailinvestorshavekept faithwiththeirbanksandtheirassetmanagers.

“Unlike inGreece,Spainor Ireland,confidence inPortuguesebankshasneverseriouslybeenundermined,”saysLuísSaraivaMartins,aboardmemberatCaixagest, thecountry’s largestassetmanager.“ThecrisisofconfidencecausedbythecollapseofBESwaslimitedtothebankitselfandhasnotspreadtoother lenders.”

Aspartofstate-ownedCaixaGeraldeDepósitos,Portugal’s largestbankinggroup,Caixagestwasabeneficiaryofahugeoutflowof fundsfromtheBESgroupandNovoBanco. Itargues,however, that ithasresistedaggressivelyhuntingfor thebusinessofworriedsavers.

“Wedeliberatelyheldbackandmovedslowly,”saysMrSaraivaMartins.“Wewantedtocapturenewfunds,but itwasequally important toensurethatadegreeofbalancewasmaintainedbetweenthedifferentplayers,especially inacountrywherethetopfivebanksaccount forabout80percentof totalbankdeposits.”

Domesticbanksdominateassetmanagement inPortugal. “ThePortuguesetypicallychannel their

investments throughbanksbywayofdiscretionarymandates,”saysCarlosCostaAndradeof theLisbonofficeofUríaMenéndez,aSpanish lawfirm.“Asaresult, commercialbanksarethemarket leadersandalargeproportionoffundsareallocatedtodiscretionarymandatesratherthandirectly investedinfunds.”

Caixagest isbyfar thebiggestplayerwithassetsundermanagementtotalling€28.2bnat theendof2014andamarketshare inPortugal inmutual fundsof31.8percent,upfrom24.1percent in2007andalmostdoubletheshareof thenextlargestmutual fundmanager,BancoBPI.At theotherendof thescalearesmallbankssuchasBancoCarregosa,

whichbeganprivatebanking in2009with€10mundermanagementandnowmanagesatotalof€200m.

“Weexpect togrowourassetsundermanagementatanaverageratewayabovethemarket,”says JoãoPereiraLeite,headof investmentatCarregosa.“Wearegrowingfromalowerbasewhichmakes iteasier. If therearenomajorsetbacks inthemarket,wehopetogrowatanaveragerateofmorethan€100monayearlybasis.”

Inthewakeof the2008globalcrisis,

assetmanagementvolumesandreturnsfell sharply from2009untila turnroundinthefirsthalfof2013, saysMiguelStokesofUríaMenéndez.“Theupwardtrendisexpectedtobemaintainedin2015and2016,”hesays.

Intermsof investoroptions,moneymarket fundshavegrownfromabout24percent tomorethan30percentof themutual fundmarketbetween2007andtheendof2014.Balancedfundsrosefrom22.3percent to30percent.

Direct investment infunds,asopposedtodiscretionarymandatesgiventobanks,hasbeenincreasingsince2014,saysMrCostaAndrade.“Inparallel,discretionarymanagersaresearchingforhigheryield instruments,”hesays.“As intherestof theeurozone,higher-yield investments, inbothdebtandequity,areexpectedto increaseunderthequantitativeeasingpolicyannouncedbytheEuropeanCentralBankinFebruary.”

MrPereiraLeiteadds:“Thetraditional trustplacedinbankingsystemsacross theworldhasbeenhugelydamagedinrecentyears.”

But inPortugal,unlike insomecrisis-hitperipheraleurozonecountries,“theconfidenceofhouseholds inthefinancial systemhasalwaysbeenthere”,saysSofiaTorresofCaixagest. “Therehasbeennoflightofdepositsabroad.”

Intoday’sdifficult low-growth, low-interestrateenvironment, sheadds,this trustrepresentsachancefor theriskandassetmanagementsector“toshowwhat itcando”.

Carson Block,founder of MuddyWaters Research,came to fameover an allegedforestry scam

Lisbonmaintains degree of balanceKeeping the faith: protests against austerity reached something of a peak in 2013 (above) but overall Portugal has weathered the stormwell— AFP

Out in the open:Mediobanca isnot the secretiveinstitution itonce wasBloomberg

‘In recentyears, theregulatoryandmarketsettingshavechangedprofoundly’

‘Portuguese households’confidence in the systemhas always been there’

Profile Portugal

Unlike some peripheraleurozone countries, thecrisis of confidence appearsto have been well contained,reports Peter Wise