16358 journal6 AW 6 7 04 - PwC · and hyperinflationary economic environments, structural change within the sector and the onset of competition from foreign banks. In ‘Practical

Tackling the key issues in banking and capital markets*July 2004

the journal

1

the journal • Tackling the key issues in banking and capital markets

Impact of Basel II on the EU economy: Results of thePricewaterhouseCoopers Study for the European Commission

Editor’s comments

Non-performing loan transactions – A review of what is happening in Asia and Europe

Managing security in an insecure new world – Striking the right balance

Practical difficulties of adopting the identification requirements of the EU Savings Directive

Brazil – A review of the effects of inflation on thebanking sector

Lifting the veil on global hedge funds

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Page

12

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Contents

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by

Editor’s comments

by Phil Rivett

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Phil RivettGlobal Leader, Banking and Capital Markets

Tel: 44 20 7212 4686Email: [email protected]

Welcome to the fifth edition of thePricewaterhouseCoopers banking and capital markets journal.

In Europe, there has been much debateabout the possible economic impact ofthe adoption of the new Basel and EUcapital adequacy proposals. In our firstarticle Charles Ilako, Dr Bill Robinsonand Richard Barfield review the findingsfrom a recent study carried out byPricewaterhouseCoopers for the EuropeanCommission into the effect of theseproposals on the economies of Europeand their financial services sectors.

The growth of the hedge fund industryhas been impressive and the opportunitiesit presents have become one of thefocus areas in the banking and capitalmarkets sector. In ‘Lifting the veil onglobal hedge funds’, Mark Casella,Graham Phillips and Robert Welzeldiscuss the globalisation and‘retailisation’ of the hedge fund market.They also map its progress from theexclusive domain of an elite few tobecoming an attractive alternative totraditional asset classes for both banksand their customers.

Continuing our series of articles thatfocus on different parts of the world,

Paulo Miron, Sergio Rogante and Graham Nye discuss the bankingindustry in Brazil. The past 25 years haveseen innovation in the face of significantchallenges experienced by the Brazilianbanks, including a series of inflationaryand hyperinflationary economicenvironments, structural change withinthe sector and the onset of competitionfrom foreign banks.

In ‘Practical difficulties of adopting the identification requirements of the EU Savings Directive’, Sian Herbert, Bob Harland and Laurent de La Mettrieexplain the aims and implications of theSavings Directive and explore some ofthe information and systems’ challenges(and opportunities) financial institutionsare facing in adopting this new law.

How big an issue is security? For manyfinancial services organisations, securitythreats to people, assets and operationsare on the increase. In ‘Managingsecurity in an insecure new world’ Jan Schreuder, Chris Potter and Mark Vosexplore the security issues at hand andsuggest how management shouldanalyse and address these in practiceand highlight the evolving role of theChief Security Officer.

Finally, we consider ongoingdevelopments in the non-performingloans market. Frank Janik, Michael Harrisand Henning Heuerding provide anoverview of how different territories aretackling issues arising from the highlevels of non-performing loans held in the banking sector. They also discuss theopportunities available as activity movesincreasingly towards Europe, whereslower performance in the Germaneconomy and portfolio rebalances arecreating significant interest.

I hope you find the wide range of articlesof interest. Please do continue to provideus with feedback on the topics you wouldlike to see addressed in future editions.Online copies of this, and previouseditions, are available from our website(www.pwc.com/bankingandcapitalmarkets).

Impact of Basel II on the EU economy: Results of the PricewaterhouseCoopers Study for the European Commission

4


by Charles Ilako, Dr Bill Robinson and Richard Barfield

The New Basel Capital Accord (Basel II),and the European Union’s (EU) plannedadoption of Basel II through the Risk-Based Capital Directive (CAD 3),represent a fundamental change in theregulatory framework for banks andinvestment firms, with potentially far-reaching effects on the Europeaneconomy. There has been much debatein Europe about the possible impact on the economy generally, with politicalconcern at both a ministerial andparliamentary level focusing particularlyon the impact on small- and medium-sized enterprises (SMEs). Europe ismuch more dependent on bankintermediation than, say, the UnitedStates, especially in the key small- andmedium-sized company sectors, whichaccount for 99% of all companies and66% of all employment in the EU.

The European Council of Ministers,meeting in Barcelona in March 2002,requested the Commission to assess the impact of the Basel process on ‘all sectors of the European economywith particular attention to SMEs’. The Commission responded byappointing PricewaterhouseCoopers, in partnership with the National Instituteof Economic and Social Research, to carry out this assessment.

The assessment involved three stages,beginning with an analysis of the impactof the proposals on the balance sheetsof banks and investment firms in the EU. They used the results of the thirdquantitative impact survey (QIS 3) dataas the principal source of data. The assessment then considered thepotential impact on profitability and thebehaviour of financial institutions by assessing how changes in capitalrequirements could affect banks in eachof the 15 countries which have quitedifferent market structures. Finally, at the macroeconomic level, the analysisaddressed changes in interest ratesacross all EU countries that could resultfrom Basel II and their combined impacton economic activity by:

• calculating the likely effect onborrowing costs in the economy at large under alternative scenarios in which cost changes were eitherpassed on in loan rates or absorbed in profits; and

• modelling the effect of these EU-wide interest rate changes on the macroeconomy.

The overall assessment1 was that theeffects would be positive for Europe’s

financial institutions, corporates andSMEs. Our analysis, including economicsimulations, suggested that, on balance,across the EU as a whole, the BaselII/CAD 3 proposals slightly reduce overallbank capital requirements. This could, in the longer term, have a small, butsignificant, positive effect (approximately0.1%, compounding to 1% over a period of 10 years) on GDP in the mostfavourable circumstances. Importantly,the new regime is expected tosignificantly enhance risk managementstandards and practices, which shouldlead to a better allocation of capital.

Overall change in regulatorycapital – a relatively small reduction

The Basel Committee and the EuropeanCommission, in revising the approach to regulatory capital, aimed to establisha regime which would create incentivesfor the adoption and development ofsound(er) risk management practices,whilst leaving the overall level of regulatorycapital supporting the financial systembroadly unchanged from the current(Basel I) level. The third quantitativeimpact study indicated that this aim haslargely been achieved, with an expected

5


Charles IlakoLeader, European Financial ServicesRegulatory Practice, Brussels

Tel: 32 2710 7121Email: [email protected]

Richard BarfieldDirector, Valuation & Strategy, UK


Dr Bill RobinsonHead UK Business Economist,Valuation & Strategy


1 For further details of this report, please visit www.pwc.com/basel

fall of around 5% in regulatory capitallevels in the EU (at the individual countrylevel, though, there is some variationaround this average, see Figure 1 below).This reduction, because it is accompaniedby a more sophisticated approach to riskmeasurement, should not underminefinancial stability.

An enduring matter of contentionthroughout the development of the Basel II proposals has been the BaselCommittee’s intention to include bothexpected and unexpected loan lossesfor the purposes of regulatory capitalcalculations. Banks have argued thatexpected loan losses are alreadycovered by provisions held. Thisargument was finally recognised by

the Basel Committee through the‘Madrid Compromise’ in October 2003.The Commission’s analysis has shownthat the ‘Madrid Compromise’ couldincrease further the capital reduction to approximately an overall 10%, which is believed to constitute areduction of sufficient magnitude topotentially undermine the underlyingobjectives of capital neutrality andfinancial stability. As a consequence,recalibration efforts are now in progressto neutralise this effect.

The impact on individual financialinstitutions will depend on their businessprofiles and their chosen approaches tocalculating regulatory capital requirements.Banks lending primarily to SMEs and

retail customers should find that therelated capital requirements will fall, in some cases materially. Conversely,banks that lend primarily to sovereigns,large corporations and pure investmentbanking businesses see little or noreductions in regulatory capitalrequirements.

Impact on bank behaviour

From the viewpoint of a for-profitfinancial institution, Basel II representsan opportunity to review capital structure(the debt-equity mix) and increaseshareholder value. The more equitybanks are obliged to use, the higher thecost of capital, and hence the moreexpensive will be their loans. On theother hand, more equity means a larger‘cushion’ to insulate depositors from theconsequences of default by borrowers.Since the general thrust of bankingregulation is to impose safety marginsthat make bank failure less likely, therewas some concern that Basel II wouldpush up banks’ costs and hence theprice of loans (especially in the sensitiveSME sector).

The study indicates that the projectedoutput is likely to be quite different. The main impact of Basel II is to givebanks the opportunity to make a moresophisticated analysis of risk and therebyreduce their capital requirements.

Impact of Basel II on the EU economy continued...

6


Austria Belgium France Germany Greece Netherlands Portugal Spain UK15%

10%

5%

0%

-5%

-10%

-15%

-20%

-25%

-30%

-35%

Credit risk Operational risk Total

Figure 1: Expected change in capital requirements by country

Source: QIS3 country reports, EU Commission and PricewaterhouseCoopers analyses

They can thus reduce their overall costof funds, with beneficial effects on theirprofits and/or on their lending rates.

We estimated that a reduction of overallPillar 1 requirements could, on favourableassumptions, translate into an aggregatecapital saving of approximately €80-100 billion across the EU during theimplementation period, which wouldrepresent an increase in annual reportedprofits (post tax) of approximately €10-12 billion in the EU (see Figure 2). Whenthis benefit flows through, it may beshared with customers or retained by thebanks depending on the type of lending,market profitability, customer behaviour,industry structure and marketcompetitiveness in individual countries(see Figure 3). While these factors willvary by market, at a high level ouranalysis indicated the benefits could be shared in the following ways:

• Banks: Finland, Greece and Portugal

• Customers: Austria, France, Germany, Italy andUnited Kingdom

• Either: Belgium, Denmark, Ireland,Luxembourg, Netherlands, Spain or Sweden

7


Austria Belgium France Germany Greece Netherlands Portugal Spain UK

7

€bn

6

5

4

3

2

1

0

-1

Figure 2: Distribution of annual gross economic benefits or costs due toestimated capital changes

Source: QIS3 country reports, Bloomberg and PricewaterhouseCoopers analyses

1 However if low profitability is due to structural reasons, the industry may use Basel II as an opportunity to improve returns.

Banks likely to benefit as they maintain or increase profitability

Little impact on banks or sub-sector customers

Are Basel II capital reductions significant in any market sub-sectors of lending?

Overall, customers may benefit as banks compete for share1

Is the sub-sector profitable (ROE>COE) and the market competitive?

Overall, banks may benefit as they increase returns

Is demand strong? (How rapidly is lending growing?)

Customers may benefit (as banks compete for share or new entrants enter)

Yes

No

Yes

Yes (profitable and competitive)

(profitable but not competitive)

No

No

No

(not profitable but competitive)

Figure 3: Impact analysis

Source: EU/PwC study on the financial and macroeconomic consequences of the draft proposed new capital requirementsfor banks and investment firms in the EU.

Significant improvement inrisk management practicesand capital allocations

Behavioural changes triggered by Basel II should, however, potentially bring the most benefits. These are likely to be extensive. Regulators, market participants, analysts and ratingagencies will increase the pressure on financial institutions to improve their risk management practices. As aconsequence, financial institutions canbe expected to behave, progressively, in a more risk-sensitive way. The stepsbanks are taking to improve the designof their ratings systems, to improve the data they use in managing risk, toenhance and streamline their information

systems, and to integrate approaches tofinancial control and risk managementare significant – as are the benefits thatwill flow. One of the early effects of thereform process has been to create acommon risk language, across theindustry, initiated by larger banks andnow spreading to smaller institutions. In the long run, this will have rewardingconsequences for the economy, leadingto a more efficient allocation of capital.

A beneficial outcome formost SMEs

The study found little evidence to suggestthat the availability, or cost, of bankfinance will be much affected by the newcapital regime, though there could be

some sectors, at the margins, whichexperience adverse transitional effects.

Overall, SMEs are, however, expected to benefit as their lower risk profilebecomes more transparent to externalmarkets and lenders (see Figure 4). There is no indication that the riskappetite of EU banks and financialinstitutions will be diminished by thereform of the capital framework. After all, risk sensitivity does notnecessarily mean risk aversion – althoughrisk appetite may be better directed.

Banks will need to know more abouttheir counterparties. Borrowers andpotential borrowers are likely to be asked to provide more and more timely information about their financialposition. Consequently, there could be some incremental accounting andadministrative costs to achieve this(though these could be minimised byprocess automation and standardisationand the adoption of internet reportinglanguages such as XBRL). Many SMEsshould, however, experience littledifference, as lending decisions in manyjurisdictions already tend to be based onrating or scorecard-based approachesthat require customers to provide key information.


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2004 2005 2006 2007 2008 2009 2010 2011

Basel I capital level

Regulatory dampening

Improved communication

Improved risk management

Improved capitalefficiency

Basel II capital level

Figure 4: Basel II – Benefit profile

Source: PricewaterhouseCoopers analysis

Competitive impact on EU financial firms –coordinated nationalimplementation is essential

With one or two possible exceptions, the study did not find evidence tosuggest that EU financial firms will be at a significant competitive disadvantageas a result of the EU applying the newcapital requirements to all banks andinvestment firms. Similarly, the decisionof the US authorities to limit theapplication of Basel II to some 20 institutions is unlikely to be asignificant competitive factor: the vastmajority of US banks are local.

Most competition still takes place withinindividual EU territories – and mostfinancial markets remain defined innational terms – as the full integration ofEurope’s financial services market hasnot yet been achieved. This said, it will be important to have a consistentapplication of the new proposals acrossthe EU. Consequently, it will be importantto ensure safeguards to prevent the manyoptions and areas of supervisorydiscretion included with the Basel IIproposals becoming a source ofcompetitive advantage for rival firms in the EU. The multiple options anddiscretions may have been necessary to accommodate structural differencesbetween countries and to reach

international agreement, but they couldmake the creation of a genuinely levelplaying field in the EU much more difficult.

This concern is strongest with regard to the Pillar 2 elements of the newframework involving supervisoryoversight where there is, as yet, relativelylittle public guidance as to what will berequired of firms. Many institutions worrythat EU regulators may take differentdirections. Discussions with regulatorsduring the course of the study, however,suggested there is keen awareness ofthe issue of competitive equality andmuch effort is being devoted to clarifyingrequirements and to co-ordinating theviews of national supervisors – at theBasel level through the AccordImplementation Group (AIG) and at anEU level through the Groupe de Contact(GdC) and the Committee of EuropeanBanking Supervisors (CEBS).

Procyclicality – unlikely to be a major problem butneeds to be monitored

The issue of procyclicality, or the extent to which risk-sensitive capitalrequirements will exacerbate economiccycles by ramping up capitalrequirements as credit quality worsens,has engendered considerable debate. We believe sufficient steps have beentaken to mitigate the effects of

procyclicality in the current proposals-whether by encouraging stress testing or by flattening risk curves, so thatchanges in creditworthiness do notproduce inordinately large changes incapital requirements.

Basel II should, on balance, reduce herdbehaviour, both in granting and abruptlywithdrawing credit. This has so oftenresulted in lending sprees and creditcrunches. In effect, enhanced riskawareness by the lending institutions,and a more forward-looking approach to granting credit, will be the greatestdefence against procyclicality. Moreformal and well-constructed lending andrisk management processes, togetherwith greater emphasis on the use of fairvalue measures, are less likely to result in abrupt reversals of lending decisions.Prompt correction is more likely to avoidthe need for drastic action at a laterdate. Anecdotal evidence in somecountries indicates that the increaseduse of more formal lending processeshas already led to a dampening of the typical cyclical pattern of bank credit availability.

The Commission and national authoritieswill need to keep this issue under review,during both the initial transition stageand the medium term, and stand readyto amend the framework should thisassessment prove too optimistic.

9


Significant cost and resource requirements

Banks are already spending considerablesums on devising systems in order to comply with the requirements of the new capital regime. Based onPricewaterhouseCoopers’ experienceand on published external surveys, the estimate of the total cost in the EU is between €20 billion and €30 billionduring the period 2002 to 2006 (seeFigure 5). Large banks are forecast tospend some €80-150 million each, while smaller banks are expected toinvest significantly less.

These estimates clearly include elementsof systems development that would have

occurred irrespective of Basel II. It ishard to isolate the element of costs that represents a ‘pure’ regulatory cost,though anecdotal evidence suggests it could be relatively small. It is clear that Basel II has accelerated thedevelopment of more enhanced systemsand processes. Policymakers, however,will need to be mindful of the context inwhich the reform is being implementedas it is one of many competing demandson management time (including theimplementation of International FinancialReporting Standards and meetingincreased corporate governancerequirements, e.g. the Sarbanes-Oxleyprovisions), in an environment wherebank margins in most markets are under pressure.

In addition to financial institutions, the implementation of the new capitalframework will place very significantresource demands on nationalsupervisors. They will have to investsignificant sums on systems, training andrecruitment and in mobilising both thestaff numbers and the technical skills to meet the implementation challenge.Significant concerns exist within theindustry that national supervisors will notbe able to cope with the demands thatBasel will place upon them in terms ofvalidating banks’ internal approaches torisk assessment and quantification andquality and in terms of Pillar 2 supervision.

At the same time, there are concerns in the supervisory community that banksmay be less advanced and less able tomeet supervisors’ requirements than banksthemselves believe. There are differingperceptions of what is ‘fit for purpose’that could be difficult to reconcile.

Overall conclusion – Basel IIand CAD 3 should on balancebe positive for the EUmacroeconomy andprudential structures

From a macroeconomic perspective, the encouragement of risk-sensitivecapital and approaches to supervisionshould impact positively on thebehaviour of financial firms and enhance


10


2003 2004 2005 2006 2007 2008 2009 20102002

Implementation costs/accelerated costs

Basel IIGo live date

€

Maintenance costs

Communication costs

Figure 5: Basel II – Cost profile

Source: PricewaterhouseCoopers analysis

financial stability. More efficientallocation of capital in the economyshould exist without undue adversecompetitive effects or, as far as it ispossible to tell at this stage, excessiveprocyclical effects. The effect on themacroeconomic aggregates and, inparticular, on output, is mildly beneficial.

There are still many unknowns. A numberof key decisions about the final shape of the capital adequacy framework remainto be taken. Much will also depend on the manner in which the framework isimplemented and the extent to whichimplementation is coordinated on an EU-wide basis. Much of the detail of the EU framework will be filled in andcoordinated by the recently constitutedCommittee of European BankingSupervisors, which represents the 15 EU member states.

Overall, however, the analysis of theavailable evidence concludes that, from a macroeconomic perspective,Basel II and CAD 3 should be positive for the EU and for prudential regulationwithin the EU.

11



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by Mark Casella, Graham Phillips and Robert Welzel

A former backwater of investmentmanagement, hedge funds have becomeone of the most important growth areasin financial services. Growth in businessfor the industry from banks, brokers,derivatives, prime brokerage and custodyand settlement arms is also now beingmirrored by the creation of ‘in house’funds and greater levels of investment of institutions’ own capital into this assetclass. Hedge funds have historicallybeen restricted to the privateparticipation of an elite few. In absolutedollar terms, hedge funds lag behindtraditional mutual funds by a significantamount. However, they are becomingever more mainstream, as institutionalinvestors recognise them as an attractivealternative to traditional asset classes.Increasing awareness of hedge funds’unique attributes and appeal is embodiedby the substantial increase in both thenumber and total value of hedge funds’assets under management. Several yearsof impressive growth have liftedworldwide assets in hedge funds to morethan $750 billion. This has been led bydemand from institutional investors andfavourable regulatory and tax provisionsthat are opening up new markets acrossEurope and Asia as well as relaxingregulatory constraints on investment.

Until recently, regulatory attitude hasbeen ‘buyer beware or touch at yourown risk’. Now squarely out of theshadows and under the microscope ofinvestor interest, hedge funds and otheralternative investments are receivinggreater regulatory attention than everbefore, focusing on their management,reporting and distribution. This attentioncomes not only from regulators and rulemakers such as the Securities andExchange Commission (SEC) in theUnited States and the Financial ServicesAuthority (FSA) in the United Kingdom,where hedge fund markets are welldeveloped, but also from nationalgovernments across Continental Europeand Asia, where the hedge fund marketis now poised for explosive growth.

Banks, insurers, pension funds and other institutional investors continue to increase allocations to alternativeinvestments with expectations of findinginfrastructures capable of satisfying theirrisk and return needs. These participantswill become more important as standard-setters for hedge funds and their internalpractices. Capital markets participants,now seeking to enter what hastraditionally been an industry dominatedby boutiques, will forever change thedynamics between hedge funds and

their investors. Greater transparency and accountability will be demanded offund managers, who will find themselvesanswering to a newer constituency thanthey have been accustomed.

Regulatory attention in the US hasrecently been diverted by the tradingscandals afflicting the mutual fundindustry. However, there will becontinued and intensified interest from global regulators and rule makers in hedge fund structures, reportingpractices and tax issues throughout2004. While financial centres in the US and UK are two of the largest andmost experienced hedge fund markets –setting operational and regulatoryprecedents and best practices,developing regulatory and taxationstructures, and influencing the cross-border flows of global capital – we willalso highlight developments in marketsacross Europe and Asia and theimplications of hedge fund investmentsfor capital markets.

The state of the hedge fund market

In recent years, hedge funds haveceased to be the exclusive domain of the ultra-wealthy and have become

13


Mark CasellaPartner, US Capital Markets


Robert WelzelSenior Manager, Capital Markets andInvestment Management, Germany


Graham PhillipsEuropean Hedge Fund Practice Leader, UK


more accessible to a wider audience of investors. Many institutions are nowoffering hedge fund pools or funds-ofhedge-funds1. The entry of assetmanagement companies into theformerly closed world of hedge funds is having a profound effect on practices.This relaxation of access has led todiscussions about registration anddisclosure requirements, a move thatmany have expected for years, especiallyin the highly publicised wake of recenthedge fund meltdowns. In May 2003, the SEC met representatives from thehedge fund industry to determine whatchanges and amendments were neededto existing regulations to make hedgefund investing ‘safer’ for mainstreaminvestors. In the UK, the FSA hasundertaken studies of the hedge fundindustry and short selling2, although nosignificant changes have been proposedto current regulations for the monitoringof hedge fund managers or of thedistribution of hedge fund products.

The hedge fund market has gained evergreater credibility and reach amonginstitutional investors during the past five years. As an increasing number ofinstitutions enter the market, they arechallenged on a number of fronts. At one level, there is the challenge ofretaining top talent, those who used thedownsizing of the sector during the bear

market to strike out on their own and set up funds. Investment professionalsfrustrated by the limitations of ‘long-only’strategies and institutional compliancerequirements were easily wooed by themore dynamic and potentially personallylucrative world of small, private hedgefund management firms. Institutionswhich are adding alternative investmentopportunities to their offerings are beingchallenged by the regulatory/reportingdisconnect between their historicalpractices and the unique operatingenvironment of typical hedge funds.Conflicts between product strategies,going short in one fund while being longin another, will make this institutionalmove into alternative investments farfrom a simple proposition.

The ‘blessing’ of the asset class byincreasing numbers of regulators hasopened the door to a flood of newproducts and opportunities for institutionaland high net worth individuals. The trendin Europe is also one of bringing funds‘onshore’, domiciling them in the countrieswhere they will be distributed andmanaged. This move is largely due toefforts by the European Parliament topass proposals designed to encouragefund managers to base their funds inregulated markets under a EuropeanUnion-wide regulatory regime. Fundmanagers and administrators, however,

should not be beguiled by the vision of a pan-European financial market. The fact remains that there are 25distinct and separate national regulatoryregimes in Europe. This creates complexregulatory difficulties that continue to be a significant barrier in the Europeanmarket. The increasing popularity ofhedge fund investments, however, isforcing national regulators to review thissituation and legislative changes areoccurring in many European territories.

Lifting the veil on global hedge funds continued...

14


For more details about the hedge

fund market in Europe, please see

‘The regulation and distribution of hedge

funds in Europe – Changes and challenges’

at www.pwc.com/hedgefunds

1 A hedge fund with a strategy of investing in multiple other funds to diversify performance risk.2 The sale of shares that are not yet owned in anticipation that they will fall in value before settlement occurs, thus making a profit.

The globalisation of thehedge fund market

European institutional investors havebeen historically risk averse but they are increasingly allocating more of theirportfolios to alternative strategies,including hedge funds, as riskdiversification becomes betterappreciated. For one thing, the euroeliminated many of the diversificationbenefits of cross-border bond investing.In Europe, French and Swiss investorshave been more inclined to invest inhedge funds, though demand fromGerman, Italian, Danish, Dutch and UK investors is now gaining momentum.

Perhaps the greatest immediateopportunity for hedge fund industrygrowth lies in Germany. As of 1 January2004, the German InvestmentModernisation Act permitted assetmanagers to offer hedge funds toinstitutional and high net worth clients inGermany. The pent up demand for theseproducts, which have only been madeavailable to German investors in the pastthrough complicated offshore structures,is expected to spark a rush of interestfrom investment institutions seeking atoehold in the German market. Someexperts predict that German hedge fundinvestments could top the €50 billionmark within five years. Unlike the US,where distribution is restricted to

qualified individual investors, there areno such restrictions written into Germanlaw. These differences in territorial legaland regulatory frameworks furthercomplicate the distribution landscape forfunds seeking to enter the new market.Still an increasing number of institutions,such as DWS, Deutsche Bank, Dresdnerand DIT, are among the German financialinstitutions now offering or planning tooffer hedge fund investments to theircustomers in the near term. It isinteresting to note that, in Germany,individual foreign funds may only bedistributed through private placements,however, funds-of-hedge-funds may bepublicly distributed. In addition, there areno restrictions or minimum thresholdsthat define a ‘qualified’ hedge fundinvestor, opening the way for someinteresting true retail strategies for funds-of-hedge-funds.

Elsewhere in Europe there continues tobe a great deal of hedge fund activity,particularly in London, where many USfunds have established beachheads toaccess better local research and toimprove the reach of their distributionefforts. With a burgeoning infrastructureof specialist accountants, lawyers and prime brokers supporting them,London-based hedge fund managers are well positioned to take advantage of changes by national regulators inEurope. With institutional allocations to

hedge funds nearly doubling in the pastyear, it is widely believed that hedgefund managers with strong infrastructurefor reporting results, managing operationalrisk and satisfying the rigorousrequirements of institutional investors, will benefit the most.

In Italy, institutional hedge fund assetsare expected to triple by 2005, accordingto Hedge Invest, an Italian fund-of-hedge-funds manager. Their assetsunder management grew from €2.2 billionin 2002 to €6.2 billion in 2003 and areexpected to rise to €18 billion by theend of 2005. Recent legislation in Italy dropped the minimum investmentin the class from €1 million to €500,000,providing access to a wider class ofpotential investors.

In Asia, the market is geographicallyfocused on Tokyo, where a number of US and European funds and funds of funds have established a presence to serve the burgeoning market foralternative investment products in theregion. In the Asian markets, there is lessinstitutional investment in hedge fundsthan in the US or Europe but as moreglobal players move into the region andbegin to offer products, this will change.Official reservations against hedge funds,stemming from charges that hedge fundsprofited from and exacerbated theregional currency crisis of 1998, appear

15


to be abating. According to estimatespublished by Eurekahedge, a Singaporeconsulting firm, Asian hedge fund assetsunder management have swelled from $11 billion to $35 billion over the pastfour years.

‘Retailisation’ of the hedgefund market

The creation of more funds-of-hedge-funds, with vastly reduced minimuminvestment levels from the traditionalhedge fund minimum of $1 million in net worth or $200,000 in annual income,is the best indicator of retail investorsgaining access to the potentiallybeneficial attributes of hedge fundinvestments. Retail investors are notablyattracted by the ability to protect capitalin bear markets, a capability accentuatedby the relatively poor performance oflong-only funds recently. Investors alsowant the downside protection that hedgefunds purport to offer.

Mutual fund companies, in particular, aredrawn to these investments. An increasein the number of mutual fund companiesentering the hedge fund market, eitherthrough direct management of hedgefunds or the creation of funds-of-hedge-funds, has profound implications for further regulator involvement,changes in reporting structures and fund governance.

The American mutual fund industry ispressuring the SEC to look more closelyat the practices of the alternativeinvestment world, partially because theirown investments are so closely regulatedand scrutinised, and because they wishto adopt some alternative investmentbest practices. With competition alwayskeen for investment dollars, the mutualfund industry wants to remaincompetitive with the alternativeinvestment world. For example, in theUS, the SEC is focusing on the reportingof the fee structures of the underlyingfunds in funds-of-hedge-funds, and theappointment of an independent board to oversee operations and compliance.Some critics have warned that this willmean a diversion of SEC resources fromthe most popular retail investmentvehicle, mutual funds, to one that is not as significant an asset class astraditional funds, although they receive a great deal of press.

As more investment companies enter thefunds-of-hedge-funds business, one canalso expect some questioning ofmanagers’ conflicts in managing bothlong only and leveraged short funds.Recent SEC recommendations haveattempted to head off these concerns;however, there will be further uncertainty.Discussion is expected to continuethroughout this year.

The marketing of alternative investmentsis an especially sensitive area.Traditionally, hedge funds have not soldtheir investments in any overt way, atleast not on the retail scale that a mutualfund would. Marketing creates claimsand disclaimers. There is currentlysignificant focus on marketing practicesand disclosure standards for ‘retail’hedge funds and funds-of-hedge-funds. The SEC has issued recommendationsfor the presentation of hedge fundbrochures and has asked fund advisersto register with them and then to sendinvestors a statement disclosing conflictsof interest, risk management measuresdeployed by the fund, valuationprocedures used for the securities heldby the fund, and all applicable lock-upperiods for investors. Such a brochure or statement would need to be updatedregularly and made available to investorson an ongoing basis.

While the US hedge fund industry maylead the world in numbers, and arguablyregulatory oversight, the expectation thatother regions will import a US model ismisguided. The notion of establishing a common pan-European regulatoryregime for hedge funds is simply not apriority, and individual funds seeking tooperate and distribute their productsacross the region will have to navigatesome fairly complex issues during theyears to come.


16


Growing in ContinentialEurope too

In the case of Germany, where the mostsignificant changes have recentlyoccurred in the global hedge fundlandscape, participants in the widercapital markets there are confronted with some extremely interesting changes. For instance, insurance companies are now authorised to commit up to 5% of their portfolios into Europeandomiciled hedge fund investments – notoffshore funds. There is likely to becontinued caution shown by institutionsas they dip their toes into alternativeinvestments and expect to see somefunds-of-hedge-funds take great stepsto prove their worthiness as credibleinvestments for historically conservativeinvestment pools.

Another substantial change is the way in which German tax law treatsdistributions of profits earned fromderivatives. For a private investor, anycapital gains from derivatives held by a hedge fund are tax free, whereas aprivate investment directly in a derivativeis taxed. For institutional investors, the tax-free treatment applies only aslong as the gains are not distributed, and as many hedge funds onlyaccumulate and rarely distribute gains,an institutional investor can achievedeferred tax assets by investing in a fund

which is highly invested in derivatives.The implications are that if interest issynthesised through a derivativecontract, it is tax-free for individuals andfor institutions, if it is not distributed.This will be an additional market driverfor investment in credit derivatives, forexample, outside the banking industry,transferring credit risk to non-bankseither through funds and/or theinsurance industry. This general trend ofrisk spreading will be an additional driverof the German fund industry from thetaxation strategy point of view.

Funds-of-hedge-funds

The funds-of-hedge-funds industry ispoised for explosive growth in all majormarkets. As it gains in popularity and asa main vehicle for ‘retailisation’, one canexpect much more scrutiny on how afunds-of-hedge-funds structure affectsthe transparency of the underlyingindividual hedge funds.

In October 2003, the SEC proposedthree new rules under the InvestmentCompany Act of 1940 regarding theability of an investment company toacquire shares of another investmentcompany. The proposal would broadenthe ability of a fund to invest in otherfunds, but the most notable impact maybe the requirement that the expenses ofthe component funds be aggregated and

shown as an additional expense in thefee table of the funds-of-hedge-funds.The pass-through effect of a funds-of-hedge-funds structure on fees, and thelight that is cast on formerly privaterelationships between fund advisers,prime brokers, solicitors and consultants,will cascade down and have a reformingeffect on individual fund practices. This may prove unsettling for many fundmanagers accustomed to working ‘in thedark,’ yet should, in most cases, beoffset by the infusion of new investorsinto their funds.

Returns alone will not be sufficient for an individual hedge fund, or even anestablished fund-of-hedge-funds todistinguish themselves from among a very crowded market of offerings. While returns may have led the charge in terms of attracting assets away fromequities during the market corrections of2000 through to 2002, we believe it willbe the quality of the hedge fundmanager’s reporting, back office, overallinfrastructure, communications andoperational risk management capabilitiesthat will distinguish it from its peers andattract additional institutional interest.

Ongoing due diligence and oversight by investors are becoming increasinglyimportant. With ever stricter requirementson management to show how itdischarges its reporting responsibilities,

17


we would expect controls reporting andcertification arrangements (similar toSAS70 reports in the US or FRAG 21reports in the UK) to be used increasinglyby fund managers.

The effect of funds-of-hedge-funds onindividual fund practices will come intosharp focus as they seek to populatetheir offerings with individual funds that

comply with the mandates of territoryspecific regulations. For example, fundsthat do not comply with Germanregulations stand the risk of beingdesignated ineligible for inclusion in aGerman fund of funds offering. A greatdeal of activity among hedge fundadministrators to identify compliant taxreporting modules for their platforms toreach the chosen markets is occurring.

US funds in a global market – It’s not just Wall Street anymore

As the hedge fund industry continues toexpand in Europe and Asia, many USmanagers are seeking distribution tonon-US investors. This cross-borderfocus raises a number of significanttaxation and regulatory issues.

The impact of the USA Patriot Act and thegeneral security climate in the US hasplaced a large burden of Know-Your-Client(KYC) and anti-money laundering (AML)compliance on hedge fund managers.These strict requirements add to theoverall back office compliance cost andhave had a chilling effect on overseasinvestor solicitation efforts. While US fundmanagers will seek cross-borderinvestors, many will avoid them and becontent to only accept US-domiciledinstitutions and individuals. As registeredinvestment companies enter the market

for funds-of-hedge-funds, with KYC andAML compliance procedures wellestablished it is likely that overseasbusiness will gravitate towards thosecompanies for whom the incrementalcompliance complexity and costs arelowest. While efforts are well underwayto develop a global GAAP, withencouraging progress on IFRS, there canbe a dilemma for US funds trying tocome to grips with local accountingstandards in addition to regulationsduring the transition phase.

US experience with rigorous reportingstandards places those funds in a good position for compliance with new tax regimes, such as thosedeveloping in Germany. Because taxreporting is complicated in the US, it appears that those fund managersshould be able to capture the necessarydata for German tax reporting and, in the end, with some adaptations, maketheir administered funds capable ofreaching the German market.

London has emerged as the beachheadfor US funds seeking a presence inEurope and to capture funds invested intraditional products. While Americanfirms seeking to broaden their cross-border distribution capabilities may havedriven activity in the hedge fund marketin London, a large number of newEuropean hedge fund managers have


18


An article entitled ‘Lifting the veil on

American hedge funds’ appeared in

Investment Management Perspectives,

March 2004 (page 47).

For further details, please visit

www.pwc.com/investmentmanagement

been formed. London has become theepicentre of the alternative investmentbusiness in Europe. Tax advantagesmean Dublin, Jersey and Luxembourghave also seen increasing popularity ashedge fund administration centres.However, we expect to see more localtax authorities reform their treatment ofalternative investments to lure fundsonshore, where they can be more easily regulated.

Conclusion

With financial regulatory reform and the general issue of transparency high onthe agenda, no one should be surprised if hedge funds and the universe ofalternative investments come undercontinuing scrutiny from regulators andlegislators worldwide.

Scrutiny does not mean the hedge fundbusiness is going to wither. This is agrowth industry, with a trend towards‘mainstreaming’ hedge funds into theflow of the traditional financial sector.Funds-of-hedge-funds structures willcontinue to be adopted by banks,insurers and other capital marketsparticipants which seek to offer hedgefund attributes to the retail investor.Institutional investors will continue toembrace asset allocation to hedgefunds, particularly as compliance andrisk management controls become more

transparent and acceptable to their investment committees and theavailability of structured productsenabling leveraged or downsideprotected exposure to hedge fundreturns widens.

The hedge fund industry has an excellentopportunity to adopt control, risk andreporting best practices and self-monitorits operations. The adoption ofcompliance measures will place aburden on smaller funds, which in turnwill rely more heavily on broker-dealersand administrators to assist them inmanaging their back office operations.Larger fund complexes will have anadvantage in satisfying regulatoryrequirements and the compliance burdencould result in pressure on smallerindependent fund managers, with fundsbanding together to share common back office services to gain economiesof scale.

One cannot underestimate the influentialrole of the traditional mutual fundsindustry with regards to how the hedgefund industry will evolve and beregulated. The sharp dichotomy betweenthe transparent and opaque world ofpublic and private funds has increasedpressure on regulators and rule makersto level the playing field. The veil is lifting. As it does, a new era ininvestment management will begin.

The entrance of large players from thecapital markets into hedge funds andother alternative investments willcertainly change the face of hedge fundinvesting forever, removing it from the‘rogue’ category it has laboured underover the past fifty years. It will become a far more mainstream, standardisedinvestment vehicle, one as regulated andcodified as any in the past.

19


Brazil – A review of the effects of inflationon the banking sector

20


by Paulo Miron, Sergio Rogante and Graham Nye

Over the past 25 years, the Brazilianfinancial system has faced the challenge of functioning in an economicenvironment that became inflationary,hyperinflationary and subsequentlyreturned to relatively stable prices. The adaptation of the banking sector to these scenarios introduced peculiarcharacteristics that set the Brazilianfinancial services sector apart from that found in developing nations. These, and the economic changes thatbrought them about, are explored in this article.

Like most, the Brazilian financial systemis based on two subsystems, regulatoryand operating. In Brazil, they areintegrated and interact effectively. The bodies that make up the regulatorysubsystem include the NationalMonetary Council, the Central Bank of Brazil, the Brazilian SecuritiesCommission, the Superintendency forPrivate Insurance and the Secretariat forComplementary Pensions. These bodiesof the Federal Government areresponsible for formulating monetarypolicy, directing the functioning of thesystem within the macroeconomicguidelines and regulating the activities ofinstitutions in the operating subsystem.These bodies are assisted in specific

situations by others, which, whileoperating in nature, also takeresponsibility for specific regulatoryguidelines, such as Banco do Brasil(farm credit), the National Bank forEconomic and Social Development (long-term development) and the Federal Savings Bank (home financing).

The operating subsystem is made up of full-service (bancos múltiplos),commercial and investment banks,savings and loans, leasing companies,securities distributors and brokers,among others. The custody andsettlement of almost all transactions in the banking sector are processed by specialised independent entities; and the agility and dependability withwhich transactions are processed in this operating subsystem deserves note. This environment was further enhancedafter implementation in 2002 of thenational Brazilian Payment System(SPB), resulting in the processing ofsettlements on a virtually real-time basisthus permitting better management ofsystemic risk in the financial system.Given the size of Brazil, in bothgeographic and population terms and the scale of technology applied, the new national payment system is remarkable.

Although the regulatory environment iscomplex, guidelines for the functioningof each of the regulatory units are welldefined. Supervisory procedures andregulations have also improved, reflectingthe strengthening of expertise locally,largely as a result of the application ofbest regulatory practices from abroad.

The beginnings of inflation

Inflation in the Brazilian economy veeredout of control at the start of the 1980s.Inflation indices reached annual levels of nearly 100% and by the mid 1980sreached levels in excess of 200%. At thetime, the economy did not benefit fullyfrom mechanisms that were capable ofreducing the risks inherent in suchcircumstances. Although thesemechanisms (such as the application ofmonetary correction to transactions andthe existence of a significant overnightmarket) already existed, they were notaccessible by all bank customers,especially the less sophisticated. The first consequences of adapting tothis enviroment included a reduction inthe provision of long-term credit bybanks and the collapse of homefinancing, since the maturity of availablefunding was shorter than maturitiestypically required for home loans.

21


Paulo MironPartner, Banking and CapitalMarkets, Brazil


Graham NyePartner, Banking and CapitalMarkets, Brazil


Sergio RoganteSenior Manager, Banking andCapital Markets, Brazil


The Brazilian banking system wasdivided among four broad groups at the start of the 1980s: federally-ownedbanks, state-owned banks, privateBrazilian-controlled banks and foreign-controlled banks. These groups eachhad separate and diverse interests anddeveloped business strategies that werequite different from one another.

Federally-owned banks for the most part focused on developing andimplementing specific credit policiessuch as farm credit, urban and regionaldevelopment, among others. Banco doBrasil and Caixa Econômica Federal,both large federally-owned banks,developed extensive branch networksthat competed directly with other retailbanks and covered regions andcustomers that were not always of

interest to private sector financialinstitutions. The administrative structuresof these banks were not very efficientbecause employees received employmentbenefits only available in the publicsector, such as tenured positions anddifferentiated retirement schemes.

State-owned banks also developed retailnetworks but these were mostly limitedto their state of origin. They implementedcredit policies that complemented thepolitical interests of the governors ofthese states. Their administrativestructures were generally similar to thoseof federally-owned banks.

Domestically-controlled private banksduring this time comprised of two distinctgroups. The first operated nationwide aspart of a financial conglomerate with a

large national branch network and with a broad range of products and services.The second operated in a more regionalform and served a specific market niche.

Foreign-controlled banks had historicallyheld a relatively small market share in the Brazilian financial market. For themost part, they were organised asrepresentative offices of traditionalinternational institutions that managedlines of financing offered to Braziliancompanies, usually focusing oninternational trade finance. A select few had a retail presence; this waslimited to large urban centres focusingon high net worth individuals, large local corporates and employees ofinternational organisations’ global clients.

Hyperinflation and initialefforts to rationalise costs

In 1986, the implementation of a plan by the government (the Plano Cruzado)to halt the inflationary spiral then incourse put the financial system and the economy as a whole to the test. The main objective of this economic plan was to reduce inflation by anartificial control of prices. The shortperiod of relative stability during 1986,following its implementation, exposedthe fragility of the financial system in an environment with controlled prices. This fragility was attributable to the

Brazil – A review of the effects of inflation on the banking sector continued...

22


0

50

100

150

200

250

1978

40.80%

77.20%

110.30%

95.20% 99.70%

211.00% 223.80%

235.10%

65.00%

1979

%

1980 1981 1982 1983 1984 1985 1986

Domestic General Price Index

Figure 1: Brazilian inflation – Inflationary period

Source: Getulio Vargas Fundation

adaptation of the system to the inflationaryenvironment. Banks had become overlydependent on ‘float’ revenues, that is, theinflationary gains made on the distortedspreads between the interest andindexation on assets, and the cost of theirnon-indexed and non-interest or lowinterest bearing funds. This income grewto as much as 70% of the operatingmargins of banks during the inflationaryperiod that preceded the Plano Cruzado.Without the gains, banks with excessivecost bases – there had been little pressureto control these, since the largest,remuneration of staff, had not beensubject to the levels of indexation thatbanks’ assets had benefited from – had torestructure quickly. Two large banksbecame insolvent due to the loss of theseinflationary gains and were subsequentlyliquidated by the government.

The hyperinflationary period thatfollowed the Plano Cruzado from 1987reduced the banks’ ability to generatedirect float revenues as depositors wereforced to protect themselves againstconstant daily inflation and manage theirliquid funds more effectively by usinginstruments available in the overnightmarket. However, during this period, realinterest rates and spreads increased(compensating the banks for loss of floatrevenues), which further focused banks’activities on lending and deposit takingoperations as an easy source of income.

It became evident that the system wouldface many problems in a stableeconomic environment given banks’dependency on float revenues generatedduring periods of high and hyperinflation(see Figure 2).

One of the side-effects of the inflationaryperiod is that the financial system wasforced to, and had the resourcesavailable to, modernise by developinghigh quality technology-intensiveprocesses. Brazilian banks havedeveloped a reputation for theirtechnological astuteness and many of them use integrated and real-timesystems, especially in their retail andrelated treasury operations. Conversely,the exceptional float revenues alsopermitted the survival of institutions that

had a scale of operations which wasbelow their natural breakeven point andcosts that exceeded accepted levels. As noted earlier, cost control had notbeen a major concern during theinflationary periods due to the distortedlevels of float income.

One of the most significant stepstowards rationalisation of costs in theBrazilian financial sector involved theimplementation of the banco múltiplo or commercial bank concept in 1988.Before this, financial conglomerates wererequired to organise their activities indifferent financial areas using separatelegal entities. The banco múltiploconcept allowed these different activitiesto be grouped in a single business entity, thus reducing operating costs.

23


0

500

1000

1500

2000

2500

3000

1987

415.83%

1037.60%

1782.90%

1476.60%

480.18%

1157.95%

2708.60%

1093.84%

1988

%

1989 1990 1991 1992 1993 1994


Figure 2: Brazilian inflation – Hyperinflationary period


The challenges of stability

It is only since the implementation of thePlano Real in 1994 that relative long-term stability has become a reality forthe Brazilian economy. However, thestructural problems of the financialsystem began to become evident afterthe Plano Real. Federal and stategovernment-owned banks began to findit difficult to support their administrativestructures. Banks, in general, began toface further challenges in maintainingearnings without the float income tooffset the inefficient cost structureswhich had been ignored during theinflationary periods. Their scale ofoperations was insufficient and bankshad not developed the practice ofcharging for services while the focus of

attention was to attract deposits togenerate float income. Furthermore,problems emerged within the creditportfolios as the corporate sectoradapted to the lower inflation rates (see Figure 3).

Three programs were introduced to assist with the restructuring of thefinancial system:

(i) the Program to Stimulate theRestructuring and Strengthening of theNational Financial System (PROER),designed to recapitalise private banks;

(ii) the Program to Stimulate theReduction of the Banking Activities ofState Governments (PROES), in orderto clean up and subsequentlyprivatise state-owned banks; and

(iii) the Program to Strengthen FederalFinancial Institutions (PROEF) to clean up and recapitalise banks controlled by the Federal Government.

These programs were considered tohave produced satisfactory results inrelation to their intended objectives andrepresented a relatively low cost to thetax payer when compared with similarprograms implemented in other countries(see Figure 4).

PROER was implemented in the middleof a crisis provoked by the insolvency ofthree banks ranked among the tenlargest private sector banks in Brazil.Simply liquidating these banks couldhave undermined confidence in thefinancial system. The monetaryauthorities intervened and immediatelyassigned the good operating assets andliabilities to other financial institutions,while continuing to manage those assetsfor which realisation was uncertain. In addition, a policy of early repaymentof federal liabilities was adopted to injectadditional liquidity into the system, thus maintaining its solvency.

The objective of PROES was not only toclean up state-owned banks but also toprepare them, when possible, forprivatisation. In addition to havingadministrative costs that exceeded those


24


0

5

10

15

20

25

30

1995

14.78%

9.34%7.48%

1.70%

19.98%

9.87%10.40%

26.41%

7.67%

1996

%

1997 1998 1999 2000 2001 2002 2003


Figure 3: Brazilian inflation – Period of stability


of private sector institutions, these bankswere also used by state governments tofinance their debt and for other politicalpurposes. Accordingly, loan delinquencyratios were higher than the average in the Brazilian market. The PROESstimulated the ‘federalisation’ of thesebanks, that is, majority ownership wastransferred to the federal government. A process that included restructuringand recapitalisation was then initiated,ready for privatisation.

PROEF was instituted to clean up andcapitalise the four main federallycontrolled banks: Banco do Brasil, CaixaEconômica Federal, Banco do Nordeste,

and Banco da Amazônia. These banksheld a significant volume of loans thatwere unlikely to be realised or for whichreturns were insufficient as a result of thedevelopment policies of the federalgovernment. The approach in this caseinvolved the transfer of these credits tothe National Treasury, as well as theexchange of other non-liquid assets forones with more liquidity and returnscompatible with market levels.

Facing international crises

The Asian Crisis in 1997 presented anotherchallenge for the Brazilian financial system.Immediately prior to the crisis, the domesticeconomy was being prepared for a gradualreduction in basic interest rates, while thebanking system developed new service-related business strategies. Some privatesector banks, especially those with smallerscale operations, began to borrow payingfloating rates, while lending these samefunds at fixed rates. However, the AsianCrisis resulted in local interest ratesincreasing significantly and unexpectedly.The Central Bank of Brazil acted byidentifying institutions with problems andrequiring action from shareholders orfacilitating the transfer of control to thestate before the situation worsened.

This facilitated the entry of new players –international banks – into the Brazilianbanking system. These institutions, whichhad previously limited interests in Brazil,entered the Brazilian banking system bytaking part in privatisation processes oracquiring medium-sized private sectorbanks caught up in the after-effects of theAsian crisis. Accordingly, of the eighteenlargest deals involving acquisitions,associations or privatisations in theBrazilian banking market between 1997and 2002, nine involved an internationalfinancial institution as buyer (see Figures5 and 6 overleaf).

25


Figure 4: Comparison between countries

Source: Rojas-Suarez, Liliana, and Weisbroad, Steven R, ‘Banking Crises in Latin America: Experience and Issues’ BID (1995);Brazil: Central Bank of Brazil

Year Country Fiscal cost/GDP

1982 Argentina 13.00%

1985 Chile 19.60%

1985 Colombia 6.00%

1988 – 1992 Norway 4.50%

1991 – 1993 Finland 8.20%

1991 – 1993 Sweden 4.50%

1991 United States 5.10%

1994 Venezuela 13.00%

1995 – 1997 Brazil 1.40%

Brazil then faced the so-called ‘BrazilianCrisis’ during 1999. The practical effect of this attack on its currency, the Real, resulted in its devaluation byapproximately 70% during the month of January 1999. This did not, however,result in serious consequences for thebanking sector, because many of thelarger banks had anticipated thedevaluation and entered into appropriatehedging arrangements. The CentralBank of Brazil provided the liquidity tothe market while attempting to preservethe value of Brazil’s currency throughintervention in the derivatives marketsselling dollars. Only two small bankscollapsed in this period as a result of thesuccess of the initiative.

Consolidation andperspectives

The profile of the Brazilian banking sectoris currently concentrated (the 20 largestbanks hold approximately 80% of totalassets in the system). The dominantbanks include the two largest federally-owned banks and the three largestdomestic private sector banks (whichoccupy the first five positions by assets)and five large international banks. In theshort term, there is no expectation ofsignificant change to this position.


26


Private sector banks 41%

International banks8%

Government-owned banks51%

Figure 5: Market shares in the Brazilian financial system – 1993

Source: Central Bank of Brazil

Private sector banks 37%

International banks27%

Government-owned banks36%

Figure 6: Market shares in the Brazilian financial system – 2002


Although the sector has become moreconcentrated, some institutions withinthe largest 20 have not yet acquired thescale of business necessary to achievethe sector’s average level of profitability.In addition, the macroeconomicenvironment still holds challenges thathave yet to be dealt with by the sector.Brazil still has the second highest realinterest rate in the world after Turkey.Lowering the basic interest rate is aparticularly difficult challenge in Brazil,due to the fact that decreases in rates,while benefiting the government from acost perspective, seriously increase therisk of hot money exiting the economyand downward pressure on the value ofthe Real. The Government’s economistshave nevertheless indicated that interestrates should fall gradually over 2004. Infact, the Brazilian economy’s inter-bankinterest rate has already fallenapproximately 10 percentage pointssince July 2003 to its present level of16.0% per annum. Furthermore,competition for banks and other lendersremains intense since, outside of theGovernment, there are relatively fewcorporates and other borrowersconsidered sound enough from a creditperspective and the consumer financemarket is in its infancy (in relative terms).These factors point to a continuedsqueeze of bank spreads.

One of the alternatives for banks foreseenby the industry is the redirecting of fundsthat are presently invested in the moneymarket, mainly in federal governmentsecurities, to corporate and consumerloan portfolios that provide higherreturns. The share of loan portfolios intotal financial assets in Brazil is still small(approximately 25% as of December2003) and the capital ratios of Brazilianbanks would allow this realignment (theaverage capital adequacy ratio of the 20 largest Brazilian banks is around 21% measured by reference to the Basel Accord (see Figure 7 overleaf)).Large banks have, therefore, begun toplace more emphasis on their consumerloan businesses and the generation of commission business from services.This segment was previously served bysmaller financial institutions. By focusinggrowth on their consumer loan business, the larger banks are also targeting thelarge number of individuals who havetraditionally not done business withbanks. Lower inflation rates havebenefited the country’s huge segment of society which has operated in a cash-only economy: banks are now targetingthis sector as the poor become morebankable and in their search for greaterbusiness volume and market share.

27


Highlights of Brazil: 2003-2004

For more details of our annualpublication, please visitwww.pwc.com/soacat or [email protected] [email protected]


28


Figure 7: Top 20 banks in Brazil by total assets (US$)


Bank Capital Total assets Deposits Equity Number of Number of (Capital(in thousands (in thousands (in thousands branches employees ratio)

of dollars) of dollars) of dollars)

1 Banco do Brasil Brazil – Public 79.635 38.067 4.212 3.296 97.258 13.65%

2 Caixa Econômica Federal Brazil – Public 52.074 28.036 1.997 2.046 100.498 19.24%

3 Bradesco Brazil – Private 50.922 20.157 4.691 3.060 70.716 19.85%

4 Itaú Brazil – Private 38.048 12.963 4.426 2.258 49.487 20.22%

5 Unibanco Brazil – Private 22.018 9.021 2.545 912 24.096 18.60%

6 Santander Spain 19.737 6.305 2.663 1.026 21.458 18.08%

7 ABN Amro Real The Netherlands 18.842 9.258 2.908 1.145 29.750 19.55%

8 Safra Brazil – Private 11.772 3.003 1.085 82 4.344 15.59%

9 Nossa Caixa Brazil – Public 9.528 6.571 631 505 13.822 28.67%

10 HSBC United Kingdom 9.088 5.236 657 928 20.792 14.39%

11 Votorantim Brazil – Private 8.638 3.046 825 4 320 22.12%

12 Citibank USA 7.042 426 1.138 45 2.099 20.85%

13 BankBoston USA 6.733 1.142 883 60 3.837 21.33%

14 BNB Brazil – Public 4.414 957 455 175 6.472 22.55%

15 Banrisul Brazil – Public 4.083 2.653 277 380 8.648 16.69%

16 Credit Suisse Switzerland 3.185 541 235 2 12 56.59%

17 Pactual Brazil – Private 2.353 360 191 4 332 20.48%

18 JP Morgan Chase USA 2.186 313 465 5 298 16.74%

19 Alfa Brazil – Private 2.131 544 346 9 765 21.82%

20 Santos Brazil – Private 2.124 606 189 4 323 12.59%

29


Ironically, the effects of the ‘inflationary’years have resulted in the sector beingtechnologically advanced but, bycomparison internationally, narrower in the nature and breadth of bankingservices offered and from whichrevenues are generated.

The Brazilian financial system ascurrently structured has provided itsparticipants with excellent returns. The average return on net income for the ten largest financial conglomerateswas 23% in 2003. Economic stability,falling interest rates and consequentrealigning of resources towards higher risk portfolios point to a potentialreduction in these returns for theindustry. This, in turn, will be offset asthe overall market for bankablecustomers and the nature of both basicand sophisticated services offered bybanks continues to grow.

Practical difficulties of adoptingthe identification requirements of the EU Savings Directive

30


by Sian Herbert, Bob Harland and Laurent de La Mettrie

Over the last 15-20 years, there has beenincreasing tension between the majoronshore economies and the offshorefinancial centres (both the traditionalisland tax havens and the onshorejurisdictions that place a substantialpremium on banking secrecy) over theextent to which national tax revenueswere being eroded through the use ofoffshore investments and structures.

As national economies experiencedsignificant pressure to reduce rates of direct taxes, so have the majoronshore economies focused increasinglyupon the loss of tax revenue throughfunds held offshore. The use of heavypenalties for tax evasion and complexanti-tax avoidance measures have been invoked by most national taxauthorities with varying degrees ofsuccess. However, in the absence ofcomprehensive information on investorprofiles and concrete information on thesums involved, the tax authorities oftenappear to be groping in the dark.

Achieving a political consensus on themost appropriate way to handle thissituation has not been an easy task, with anumber of prominent financial institutionsand governments collectively recognising

the wider economic implications of taxevasion (and its frequent links to criminalactivities) but acknowledging at anindividual level the profitability of manyaspects of offshore finance.

The predicament has been highlighted inthe differing approaches to the questionof how to counter tax evasion that theUnited States and the EU have adopted.

The United States introduced its QualifiedIntermediary (QI) regime in 2001. Althoughthere were protests in relation to theglobal reach of the regime, there was alsowidespread acceptance of the economicreality of the United States’ ability to:

(a) secure acceptance of the concept of the QI regime in most countries;

(b) require institutions to provide data oninvestments held on behalf of relevantcustomers;

(c) require minimum standards for Know-Your-Customer (KYC) requirements at both national and institutionallevels; and

(d) ensure compliance with the regime on an ongoing basis at relatively littlecost to the United States’ authorities.

The EU’s approach to the problem has developed over a longer timespanreflecting the political reality of theeconomies of some EU member statesprofiting historically from assisting the residents of other member states to shelter or defer their domestic tax liabilities.

By June 2000, there was acceptanceamongst the EU member states of the need for effective taxation of cross-border savings by individuals.Three years of debate within the EU and some key non-member statesresulted in the Council of the EuropeanUnion agreeing to adopt a new lawdealing with the taxation and reporting of savings income in the form of interestpayments (the ‘Savings Directive’ or ‘Directive’) on 3 June 2003. The term‘interest payments’ is broadly definedand, for example, includes dividends onbond funds and the income element ofthe proceeds of the encashment or saleof units in an accumulation fund.

The aim of the Directive is to enablesavings income in the form of interestpayments made in one member state toBeneficial Owners1 to be made subjectto effective taxation in accordance with

31


Sian HerbertDirector, UK Anti-Money Laundering Team


Laurent de La MettriePartner, Tax and Legal Services,Luxembourg

Tel: 352 49 48 48 32 04Email: [email protected]

Bob HarlandPartner, Tax and Legal Services, UK


1 Individuals resident for tax purposes in another member state.

the national laws of the latter memberstate. It does this by requiring financialinstitutions that make payments ofinterest cross-border to submitparticulars of the payee and the interestpayment to the tax authorities of theterritory in which the institution is based.This information is then passed to thetax authorities where the recipients areconsidered to be resident underarrangements for the exchange ofinformation. A number of territories havethe option of charging a withholding taxas an alternative to the exchange of information2.

It is apparent from the experience of a number of financial institutions whichare seeking to apply both the reportingand withholding regimes that thesystems’ implications of compliance with both are considerable. The relativelyshort timescale that is available tosecure operational readiness is posing a significant burden on those responsiblefor systems development andimplementation, as well as productdevelopment and marketing.

The territorial application of the Directiveis not just limited to the existing EUmember states: it also embraces themember states’ dependent territories e.g.Jersey, The Cayman Islands, Netherlands

Antilles, as well as Switzerland,Liechtenstein, Andorra, San Marinoand Monaco. Although extensive, theterritorial scope is clearly less than thatachieved by the United States with its QI regime. The Directive imposes,however, significant new requirements on all financial institutions involved in thepayment of interest to beneficial ownersin the EU, irrespective of the location ofthe institution’s headquarters.

The implementation of the Directive hasconsiderable implications for mostfinancial institutions that provide servicesand products to individuals, particularlyfor institutions with operations in thosejurisdictions that have elected to apply a withholding tax.

The work involved in preparing for theoperation of the Directive is extensiveand the scale of the task often onlybecomes clear as projects get underway.Issues identified include:

• The Directive may impact not onlymost aspects of private banking andretail fund management, but also morespecialised areas of businesses suchas private equity and hedge funds;

• The basic data on investments requiredfor the day-to-day application of theDirective is not readily available and

systems need to be put in place toensure that reports of interest paymentscan be compiled and reviewed;

• The interpretation of the Directivevaries between most territoriesaffected by it, leading to the risk of omissions and the need for coordination of advice from all relevant jurisdictions beforeimplementing systems changes; and

• The application of the detailedrequirements, such as identification of individuals and the reliance on otherlegislation, is fraught with difficultiesand these are often underestimated.

Despite the scale of the task and theacceptance that the only direct returnappears to be acknowledgement ofcompliance with the Directive, there is a general recognition that the SavingsDirective has to be applied rigorously.The chairman of one of the world’slargest banking groups has gone onrecord publicly as saying that hisorganisation would meet its obligationsto comply with the Directive, regardlessof the cost. In the longer run theDirective will pose important questionsto major institutions as they review theirproduct offerings to private clients,including the location of their offshoreoperations and the extent to which they

Practical difficulties of adopting the identificationrequirements of the EU Savings Directive continued...

32


2 Austria, Belgium, Luxembourg, Switzerland, Jersey, Guernsey, the Isle of Man and, probably, Liechtenstein, Andorra, San Marino and Monaco.

retain and attract as customers,individuals with limited enthusiasm for tax compliance. In the immediateterm, however, companies need toconsider urgently their ability to comply with some of the fundamentalrequirements of the Directive, includingthe ability to identify to whom interest is being paid and the systems’requirements that will enable them to record and report the necessaryinformation to the authorities. The remainder of this article willconsider some of the practicaldifficulties that compliance with therequirements of the Directive will create.

Identification of the Beneficial Owner

The key to the Savings Directive is theidentification by the economic operator(normally a financial institution) who ispaying the interest (or securing itspayment) of the Beneficial Owner, (i.e., the individual who receives theinterest payment).

To be able to comply with the Directive,the economic operator needs to applyadequate KYC procedures that meet the Directive’s requirements. For thepurposes of the Savings Directive,reliance can be placed on the KYCrequirements of the First EU Money

Laundering Directive. However, it is notyet clear whether, or to what extent,financial institutions will be able to align or effectively leverage their existing anti-money laundering (AML)procedures to satisfy the requirements of the Savings Directive (see Figure 1).

Convergence of requirements?

In order to determine the scope of any potential leverage or convergence, it is necessary to appreciate thesimilarities and differences between the regimes, as well as the practicaldifficulties that could be encountered in implementing them. The experience of many financial institutions that havehad to implement the AML requirementsof the EU Money Laundering Directiveindicates that the practical difficultiesshould not be underestimated.

In the July 2002 edition of ‘the journal’3,Andrew Clark and Javier Casas Ruaconsidered some of the moneylaundering risks for banks and indicated

33


3 ‘Money laundering: the risks for banks’ by Andrew Clark and Javier Casas Rua. For further information please visit www.pwc.com/bankingandcapitalmarkets

Figure 1: KYC and anti-money laundering

Source: Article 3, the First EU Money Laundering Directive

Member States shall ensure that credit and financial institutionsrequire identification of their customers by means of supportingevidence when entering into business relations.

the journalTackling the key issues in banking and capital marketsJuly 2002

that, in our experience, many banks fail to ‘make the grade’ by benchmarkingagainst too low a standard and by notaddressing the more strategic issuesassociated with money laundering. They further referred to the fact that the majority of banks place significantreliance on legacy systems and thatthere was a need for ‘harmonisedaccess to information across a bank’ssystems’. The introduction of theSavings Directive effectively acts asanother imperative for organisations tostreamline their systems to make themmore reliable and efficient, but alsocreates another opportunity for banks to ensure that they have the datacapture and manipulation systems thatthey need in order to be fully compliantwith legislation.

Under the Savings Directive, the KYCrequirements that have to be applied byfinancial institutions in identifying theBeneficial Owners of the interestpayment vary according to the dateupon which the financial institutionwhich is regarded as the paying agententered into its contractual relationshipwith the Beneficial Owner, the criticaldate being 1 January 2004 (see Figure 2).

Although there are areas of overlap, arrangements need to be made foradditional KYC information to be


34


Information required to be recorded and verified

Permitted source of information

Data at the institution’s disposal (applying the regulations in force in the state in which the institution is established and to EC Directive 91/308/EEC, the First EU Money Laundering Directive)

Passport or identification card or other documentary evidence

Contractual relationships entered into

Before 1 January 2004 On or after 1 January 2004

• Name• Address

• Name• Address• Country of residence and • Either Tax Identification Number or date and place of birth

Figure 2: Savings Directive KYC requirements

Source: PricewaterhouseCoopers

1. Identity

2. Nature of the business

• Purpose and reason for opening the account or establishing the relationship

• Anticipated level and nature of activity to be undertaken• The various relationships of signatories and underlying

beneficial owners• The expected origin of the funds to be used within the

relationship• Details of occupation/employment (in the case of a

personal banking relationship)

Elements of identity Individual Corporate entity

• Name• Address• Date of birth• Nationality

• Registered no. and name• Registered address• Directors, owners and shareholders

Figure 3: Elements of KYC under the First EU Money Laundering Directive

Source: Joint Money Laundering Steering Group: Money Laundering Guidance Notes 2003 (UK)

requested by the institution if theprescribed information is not disclosedon the documentation required forcontractual relationships establishedafter 1 January 2004 (see Figure 3).

Similarities between the different regimesprovide an opportunity for banks to makeuse of existing procedures; a comparisonof the two regimes’ key elements arediscussed in Figures 2 and 3.

Complementary documentary standardsIn terms of the documentation that canbe accepted to verify the identity detailsprovided, there are similar documentarystandards under both regimes, so forexample, an individual customer’sidentity can be verified with reference to a passport or national identity cardunder both regimes. Furthermore, Article4 of the EU Savings Directive states thatan entity will be deemed to be a payingagent (and thus reportable) unless it canprove otherwise by reference to ‘officialevidence’. According to early guidanceissued by the UK Treasury, for example,‘official evidence’ includes a copy of thecertificate of incorporation or certificateof trade or equivalent, together withevidence of the company’s registeredaddress4 (i.e., evidence allowed underthe EU Money Laundering Directive).

The underlying purpose of thedocumentationIn the underlying purpose of theevidence gathering, there is a clearoverlap with the AML regime. The keypurposes of the documentation gatheredunder the Savings Directive Regime aretwo-fold. They are, firstly, to assistinvestigators during the course of anysubsequent investigation and, secondly,for the financial institution to be able todemonstrate its compliance with theregime, specifically, that the informationbeing reported on an annual basis canbe supported.

Although these similarities andconsistencies provide financialinstitutions with opportunities for usingexisting information gathered for AMLpurposes and imply that the underlyingsystems can be used for capturingongoing information, there are areaswhere it may not be possible to rely on arrangements in place related to the existing AML regime. Figure 4summarises some of the key differencesbetween the two regimes.

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Differences Savings Directive Regime The EU AML Regime

Relationship to be verified

Verification of additional information

Looking through the corporate veil

Availability of concessions

Contractual relationship

Date and place of birth, where Tax Identification Number not available

Legal persons not reportable

No de minimis limit

Business relationship

Not mandatory

Verification of beneficial owners and principal controllers

Verification of identity not applicable for one-off transactions under €15,000

Figure 4: Differences between the two regimes


4 Paragraph 9.7, Paper 9: Obligations of Paying Agents: Payments to Residual Entities, UK Treasury 2003

Differences between the regimes

Of the matters established in Figure 4 on page 35, it is worth considering, inparticular, that verification of the dateand place of birth and indeed the Tax Identification Number do not formpart of the existing AML regime and their recording and verification under theEU Savings Directive are therefore likelyto have significant data capture andsystems design implications. Further,with the Financial Actions Task Forcetaking an increasingly risk-basedapproach to AML and the availability of concessions under the AML regime(such as one-off transactions) that donot apply under the Savings Directive,firms may increasingly find that individualsfor whom they have a requirement toreport under the Savings Directive have infact not been identified at all – as one ofthe permitted AML concessions has beenapplied. The changes to processes, thecost of system enhancements and theadditional training for staff to enable themto understand and record the enhancedinformation should not be underestimated.

The timing of the implementation of theSavings Directive is particularly concerningfor those financial institutions whichadapted their systems to cope with theKYC and the systems requirements ofthe current United States withholding tax

regime for investors in US securities onlyfour years ago.

Some practical issues to consider

New customers – Where the verificationof new customers is consideredappropriate under the Money LaunderingDirective, in this cost-conscious world,banks are increasingly using electronicchecks as a means for verifying identity.This involves credit reference agencieswho provide information regarding thenumber of times a name appears in key databases, rather than obtaining‘evidence’ of identity such as passportsor identity cards. The Savings Directiveis silent on the use of automated orelectronic methods for verifying identity.As a result, it is not yet clear what bankswill need to ‘perform’ in order to verifynew customers in accordance with therequirements of the Savings Directive orin verifying them electronically under theMoney Laundering Legislation.

Existing customers – Another issuerelates to existing customers that do nothave KYC information on file becausethey became customers prior to theintroduction of the First MoneyLaundering Directive. Although outwardlythe KYC requirements for existingcustomers are less stringent than fornew customers, life is rarely

straightforward and it is necessary forfinancial institutions to deal with thisissue in relation to both:

(a) the relatively routine situations inherentin cross-selling within a diversifiedfinancial services group; and

(b) less frequent events, such as transfersof business within the same group ormergers and acquisitions.

As well as the customers who were notidentified because they were customersbefore the Money Laundering Directivecame into force, there may also becustomers who should have beenidentified under the Money Launderingregulations but have not been because of breakdowns in processes. Figure 2, on page 34, indicates that the SavingsDirective clearly states that pre 1 January 2004 institutions can rely on the data that should have been collectedunder the AML regime. There is a risk thatsome of the expected information issimply not there.

Some institutions, at the urging of theregulators, but also on their owninitiative, are undertaking a review of theirexisting customer base to identify thosecustomers who failed to be identified inaccordance with the Money LaunderingRegulations. However, frequently this isbeing done on a risk basis and does


36


little, certainly in a retail environment, to meet the EU Savings Directiverequirements as much of the‘identification’ is being done throughelectronic checks. More forward-thinkingorganisations, with a multi-regional clientand operational base are increasinglybeing proactive so that the identificationof customers is documented through theuse of passports and other identitypapers. Customers identified in this wayare therefore likely to meet therequirements of the Savings Directive.However, substantial existing customerremediation projects are time consumingand expensive and have not yet beenundertaken by all institutions.

IT systems and controls

A common failing has been the inabilityof IT systems to perform the simplest of analytical functions. Frequentlycompanies are unable to produce asimple analysis of the customer base –even by jurisdiction or type of customer– as the details though possibly capturedat point of contact, are not recorded onthe systems.

In many cases, financial institutions are unable to provide this information for even one part of an organisation (or product), let alone across the entity.This is often due to the presence ofnumerous legacy systems and theoutcome of acquisition and business

reorganisation, resulting in an inability tocommunicate with each other effectively.

This suggests that the apparently simple matter of collating and reportinginformation – as anticipated by theSavings Directive – may prove to be an obstacle to compliance for manyinstitutions in the banking sector. Unless these underlying systems issuesare resolved, it is likely any attempt to leverage existing information andprocesses for the purposes ofcompliance with the Savings Directivewill prove unsuccessful.

The convergence of KYC

Developments in relation to the SavingsDirective must also be understood interms of the wider trends that areapparent in the industry and in the widercontext of the businesses’ core processes.

Such a convergence has the potential to present businesses with bothopportunities and threats; a threat in thatdata management issues, such as dataprotection legislation, need to behandled carefully, but equally anopportunity in that in the long run,compliance or client identification can betransformed from a cost absorbing issueto a value enhancing element of thebusiness (see Figure 5).

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AMLCustomer

mailing andmarketing

TaxInvestmentsuitability

Convergence of KYC requirements?

EU SavingsDirective

Qualifiedintermediaries

OECD action

Figure 5: Convergence of KYC requirements


A number of facets of regulated financialbusiness incorporate different KYCrequirements, not just those associatedwith AML and the Savings Directive.Customer relationship managementsystems (CRM), for example, need tocapture relevant and up-to-date KYCinformation for a number of reasons,ranging from the simple task of mailing a bank statement to targeting specificproducts based on a customer’s profile.Successful targeting can only beachieved by understanding thecustomer’s needs and objectives, as well as transaction history.

Investment managers have a fiduciaryduty to make decisions that are in thebest interests of their customers orclients. To be able to fulfil this obligation,the investment manager is required tohave collected and updated, whereappropriate, information pertaining to thefinancial circumstances of the customeror client along with their specificinvestment objectives.

However, where these different facetshave been acknowledged, financialinstitutions have often blended togetherthe different requirements, assuming that the KYC information gathered in onecontext is applicable in all othercircumstances, whether it is AML, tax,investment suitability or CRM driven. By assuming that compliance with

one KYC regime satisfies all others,management is exposing itself topossible regulatory censure.

The challenge for financial institutions ishow to satisfy the various requirementsas efficiently as possible, avoiding undueduplication and yet ensuring regulatoryintegrity. Firms can maximise the benefitof their customer knowledge base bybringing data management for thedifferent regimes together into oneintegrated system and furthermore using it as the basis for more effectivesales targeting. This ‘convergence’ ofKYC requirements also provides financialinstitutions with an opportunity tominimise the cost burden associatedwith the customer due diligence (initialand ongoing).

In light of these issues, forward-thinkingorganisations should be building aholistic framework fully integrated intothe business’s processes and controls,facilitating enhanced ‘all purpose’ use of customer data in a cost efficientmanner, while seeking to achieveenterprise-wide compliance withregulatory and legal requirements.

Conclusion

On the face of it, the EU SavingsDirective legislation is relativelystraightforward in terms of the reporting

requirements it introduces (i.e., thatinformation regarding interest paid toBeneficial Owners is shared betweenmember states or withholding tax isenforced). However, as is often the case,the reality of embedding the legislationinto an institution’s day-to-dayoperations is fraught with difficulties. The EU Money Laundering Legislationhas been in existence for in excess often years and many reputable financialinstitutions, despite significant cost andeffort, still find they fall short ofregulatory expectations and incur finesand public censure as a result, seriouslydamaging a brand that has beendeveloped at considerable expense.Management which is complacent andbelieves that it is compliant with theSavings Directive because it complieswith the existing Money Launderinglegislation, may well be deluding itself. An institution’s ‘regulatory compliance’team often sees tax compliance as a taxdepartment issue and there is littlediscussion and cooperation betweenthem. We believe there is also a degreeof complacency within tax departmentsbelieving that compliance with theSavings Directive is relativelystraightforward because of the reliancethat can be placed on the MoneyLaundering Directive. However, relianceon the Anti-Money Laundering legislationto meet the identification requirements of the EU Savings Directive, whilst


38


permitted, may result in non-compliance.This is not only because of the actualdifferences between the regimes butalso, and equally significantly, becauseof the practical difficulties of suchreliance, the concessions that areallowed under the AML regime and the business practices of companies.When these known risks are combinedwith the reality of large organisations, i.e. that processes and controls arefrequently not followed, the risk of afinancial institution being found to benon-compliant with the Savings Directiveis significant.

We urge strongly, therefore, thatmanagement asks three questions of its teams:

• Do the systems and processes inplace enable the data required underthe Savings Directive to be captured,sorted, analysed and reported?

• Is the data required under the SavingsDirective already captured and verifiedas part of the existing AML KYCprocedures?

• Are the AML KYC procedures actuallyfollowed in practice?

Some will no doubt be surprised by theresponse they receive.

39



40


by Jan Schreuder, Chris Potter and Mark Vos

Increasing focus on security

A day rarely passes without a press reportrelating to a security breach or issue.Every financial services organisation nowfaces increasing security threats to itspeople, assets and operations from suchdiverse sources as:

• terrorism;

• fraud (financial crime), both internaland external;

• organised crime, including moneylaundering; and

• numerous information security threats(i.e., hackers and computer viruses).

The level of complexity involved inmanaging such a diversity of threatsmeans that security has become a significant and increasing cost of doing business.

Balancing security issues

This article addresses how anorganisation can sustain a successfulsecurity function without negativelyimpacting its competitive position.

In the current environment of increasingsecurity threats there are a number ofkey considerations organisations shouldbe addressing:

• getting security governance structures right with clearly articulated roles and responsibilities;

• obtaining executive level buy-in and sponsorship;

• using security as a business enabler, not just a cost;

• establishing a security awarenessprogramme; and

• continuing to assess and adjust security capabilities to changes in the environment.

In order to tackle this, a new approach to security management which respondsto each of these threats in a coordinated,cost effective and efficient way needs tobe developed.

Some financial services organisations are spending millions of dollars ontransforming their security functions andimproving their security managementpractices across a range of areas, including:

• risk management;

• information security;

• fraud and investigations;

• forensics;

• anti-money laundering;

• physical security;

• business continuity; and

• crisis management.

For many organisations, this investmentrepresents a significant shift away fromthe manner in which they have traditionallymanaged security. It is also placing hugedemands on their security people todevelop new management skills.

Key questions facing organisations inthis climate are:

• How big an issue is security?

• How much security is enough?

• What is the best way to addresssecurity risks?

• How will it impact the business?

41


Jan SchreuderPartner, Risk Management, Australia


Mark VosSenior Manager, Risk Management,Australia


Chris PotterPartner, Financial Services, UK


How big an issue is security?

Unfortunately, many organisations needto experience the significant impact of anegative security event before realisingthat security is a huge issue. Of course,by then, it is too late.

While past experience has been that the majority of threats have come frominternal sources, recent experience isthat external attacks are significantly on the increase, changing the balancefrom internal to external threats. This does not mean that there are fewerinternal threats but a greater number ofoverall threats to an organisation.

A particular and topical risk area isInternet banking. Many retail banks haverecently suffered a wave of attacks,where fraudsters send out e-mailsdirecting customers to a fake websiteand requesting them to enter theirpasswords and other details. Significantlosses are occurring from these attacks.The main impact, however, is not in thelosses but the investment of banks’resources responding to these attacks.Banks are also concerned that fears oversecurity are slowing the uptake ofInternet banking by their customers. As aresult, some banks, for example, arenow seriously considering rolling outstronger authentication measures to their

Internet banking customers. This slowsaccess, however, affecting ease andattractiveness of use and increases thecosts in providing such services.

Organisations must also comply with anincreasing level of legislation and regulationrelating to security. This includes:

• United States homeland securitylegislation;

• the US Patriot Act;

• anti-money laundering legislation;

• privacy legislation such as EuropeanData Protection laws; and

• critical infrastructure protectionlegislation in many territories.

Furthermore, security and fraud-relatedlosses form a significant component ofmost financial institutions’ operationalloss exposures under new regulatorycapital measurement approaches beingintroduced by Basel II.

To ensure the appropriateness of theirdesign and operational effectiveness,there is also the need for management to reassess security controls. These are key aspects of Sarbanes-Oxley S404compliance for SEC registrants.

Regulators are increasingly expectingfinancial services companies to complywith good practice standards forsecurity. In December 2000, aninternational standard, ISO/IEC 17799(based on the British Standard, BS 7799)was issued and companies around theworld are increasingly using it tostructure their security processes.Regulators are beginning to refer to suchstandards in their rule-books.

Managing security in an insecure new world – Striking the right balance continued...

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The types or nature of negative securityevents experienced most frequently inthe information systems area weremalicious code (‘viruses’) (59%),unauthorised entry (40%) and denial of service (36%). Two-thirds (67%) of the executives said the most likelysource of the attack or breach washackers or terrorists while 31% blamedunauthorised (internal) users. In termsof methods of attack, the primarymethod listed was exploitation of aknown operating system vulnerability(39%), abused valid useraccount/permissions (30%) andunintentional/user error (28%). While34% of companies surveyed currentlyuse wireless technologies, only 5%reported that a wireless applicationwas the source of an intrusion.

Findings from: The State of InformationSecurity 2003, a worldwide study by CIOmagazine and PricewaterhouseCoopers1.

1 For information, please visit www.cio.com/research

How much security is enough?

A common perception is that security is a ‘tax on doing business’. The day therequired security investment outweighsthe income of the business, its veryviability is in question. It stands toreason, therefore, that there must be alimit on how much an organisation shouldspend on security-related matters.

Before this question can be effectivelyanswered, however, the security risks to a business need to be understood, both quantitatively and qualitatively. For instance, how likely is theoccurrence of a serious security threat and what impact will it have on the business and its reputation? How effective will management be inresponding to this threat in order toneutralise it as quickly as possible whileminimising its impact? Once thesequestions can be clearly answered andunderstood, how much should be spentwill be easier to determine in order tobalance the cost of security against therisks to the business.

What is the best way toaddress security risks?

It is becoming more common fororganisations to strive for a ‘best fit’solution as opposed to obtaining ‘best

practice’ in every security-related matter.Conforming to best practice can be anextremely expensive exercise that doesnot necessarily deliver business benefitsequal to or greater than the expenditurerequired to get there.

A best-fit model is instead aboutunderstanding what the risks are and applying the most appropriate risk mitigation strategy to reduce them,as opposed to applying best practiceprocesses regardless of the associated risk.

How will it impact the business?

Security has often been used to focus on the concept of exclusion(i.e., preventing unauthorised access to internal resources). However, in anincreasingly virtual business environmentwhere Internet-based applications aredeployed by customers, employees,suppliers and other business partners,security is as much about appropriateinclusion (i.e., allowing access to theright people).

It is critical to strike the right balancebetween keeping the security risks atbay and not impacting the business somuch that its competitive edge suffers.

Getting governance right

To respond effectively and efficiently to the growing number of securitythreats, a coordinated response acrossthe organisation is required.

Many organisations are now reviewingtheir security functions and determiningthe best organisational and governancestructures to deal with these threats.

Clearly defining the roles andresponsibilities of the different levels of management and different functionsresponsible for security is essential toensure that the organisation can respondappropriately to a security threat. Recentsecurity events have shown that thoseorganisations which responded early andin a coordinated way were best able tominimise their loss exposure.

Many organisations are re-defining therole of Chief Security Officer (CSO) as afirst step in this process. Previously, thetraditional CSO role was often concernedprimarily with physical security. The newrole is much wider, with the CSO oftenbeing given responsibility for all securitymatters related to the organisation.

Having a centralised group for securitymatters under the CSO helps provide asingle, enterprise-wide view of security

43


risk, indicating overlaps and gaps infraud, protective and information securityrisk. It also facilitates consolidating andleveraging loss incident reporting. Thisgroup will also have the ability to quicklyescalate responses to significantincidents or emerging crises and willprovide a single interface for doing so.

Over the next few years, more organisationsare expected to adopt this structure.

Another example of the changingsecurity environment is the role of the ITSecurity Manager. This role is expandingbeyond traditional IT security due to thechanging nature of security threats,which are now too sophisticated to beisolated in silos such as IT Security,Fraud and Investigations, CrisisManagement and Forensics. An ITSecurity Manager now has to work muchmore closely with other security groupsto identify and mitigate risk, as a

particular threat might involve all of theabove three areas.

Many IT Security Managers still reportinto IT, and only a small proportion havestarted moving their reporting line awayfrom the Chief Information Officer (CIO)

to the CSO (a ‘dotted’ reporting line tothe CIO still normally exists).

Another important changing trend is thereporting line of the CSO. Some largeglobal financial services organisationsnow have their CSO reporting directly tothe Chief Executive Officer (CEO), orreporting to a direct report to the CEOsuch as the Head of Risk Management.

It is vital for the executive team to supportthe adopted security structure to havesignificant awareness of security-relatedmatters and to encourage a securityconscious culture within the organisation.Without executive level support, the CSOwill be a sole voice without the requisitelevel of authority. This, of course, will leadto the breakdown of a successful securityfunction.


44


Security status reporting intended for senior management outside theInformation Technology (IT) departmentwill become more common with theadoption of business processes thatintegrate elements of securitymanagement.

PwC’s Information Security – A StrategicGuide for Business 20042

CSOs will be more strictly accountablefor expenditures; consequently, they willadopt security management practicesthat contribute more directly to fulfillingbusiness objectives. Doing this willrequire CSOs to work with managementacross departments to evaluatebusiness risks and, accordingly, applybudget and other controls.


More than half (62%) of the companiessurveyed said that their securityorganisation reported directly to theCIO and IT. Other companies said theirsecurity organisations reported to theCEO (16%), risk management, internalaudit or legal counsel (10%), the CSOor Chief Privacy Officer (8%) and theCFO (5%).

Only 2% of companies had a securitycommittee overseeing informationsecurity.

When asked if their organisation’sphysical security was integrated with IT security, 28% or 2,169 surveyrespondents answered ‘yes’. Of thisgroup, close to half (47%) said IT andphysical security policies andprocedures were integrated and 37%said both IT and physical securityreport to the same executive leader.16% of companies reported that theirorganisation had a committee of bothIT and physical security employees.

Findings from: The State of InformationSecurity 2003, a worldwide study by CIOmagazine and PricewaterhouseCoopers

2 For information, please visit www.pwc.com or www.security-survey.gov.uk

Integration with wider riskmanagement practices

To be effective, security risk analysisprocesses have to be integrated with an organisation’s overall risk framework.This is vital to ensure buy-in frommanagement and the business.

This also means that for banks to beaccredited at the highest operational risk level available under Basel II – the Advanced Measurement Approach –the security risk management approachhas to meet a number of qualitativestandards in common with otherelements of operational risk.

In practical terms, these require that a bank must have an independentoperational risk management functionresponsible for:

• the design and implementation of thebank’s operational risk managementframework and methodology;

• codifying firm-level policies andprocedures concerning operational riskmanagement and controls;

• the design and implementation of arisk-reporting system for operationalrisk; and

• developing strategies to identify,measure, monitor and control/mitigateoperational risk.

Furthermore, a bank’s internal operationalrisk measurement system must beclosely integrated with the day-to-dayrisk management processes of the bank. Its output must be an integral part of theprocess of monitoring and controlling thebank’s operational risk profile. The bankmust also have techniques for allocatingoperational risk capital to major businesslines and for creating incentives toimprove the management of operationalrisk throughout the firm.

There must be regular reporting ofoperational risk, threats and exposuresand loss experience to business unit

management, senior management and tothe board of directors. The bank musthave procedures for taking appropriateaction according to the informationwithin the management reports. Manybanks are building these processes intointegrated security and operational riskmanagement systems.

Finally, the bank’s overall risk managementsystem must be well documented. There must be arrangements in place forensuring compliance with a documentedset of internal policies, controls andprocedures concerning the operationalrisk management system, which mustinclude policies for the treatment of non-compliance issues such as, in thiscase, security risk matters.

As the number of security threatsincreases and becomes more diverse in nature, it is important to align theapproach to dealing directly with thesethreats and their associated risks.

Many organisations are developing risk-based decision analysis processes toenable them to allocate security resourcesand prioritise security projects. A crucialcomponent of the risk-based decisionanalysis is an organisation’s risk and valuemap, which compares the expectedannualised costs of security eventsbefore and after the security investment.

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Some organisations are extending this concept further by establishingsecurity as a separate profit centre and calculating a return on security, (i.e., the return on the capital invested in security activities).

Evaluating return on investment (ROI) on security expenditure is by no meansuniversal. A recent UK governmentsurvey, entitled Information securitybreaches survey 2004, showed that,while spend on information security is increasing rapidly, less than half of all businesses ever evaluate their ROI on this investment. Instead, mostbusinesses treat security as an overheadrather than an investment. It is notalways the case that lack of return oninvestment calculations equates to lackof investment. However, without thisinformation, it can be difficult to prioritisesecurity spend against other projects.Senior management can also regardsecurity as forced expenditure ratherthan something that can bring positivebusiness benefits. Surprisingly, the mainreason why businesses do not estimatereturn on investment is that no-one asksfor it. This was the case in almost a thirdof businesses.

Although there is not yet a generallyaccepted way to measure ‘return onsecurity’, there is a general acceptancethat the value related to risk reduction

attributed to security needs to be relatedto the cost of security. Some organisationsare implementing sophisticated systemsand models to do this.

Enabling the business

All organisations are using technology to get closer to their customers. In thepast, strong defences surrounding theorganisation have been implemented to avoid external access into systems.This is changing as organisations wish to integrate customer systems offeringfeature-rich functionality to theircustomer base.

The challenge is to maintain security,while moving away from the traditionalperimeter security models whereby onlyemployees were allowed in, while stilleffectively controlling access to systemsand information. Businesses need tomake sure the right people have accessto the right systems at the right time. It is equally important to blockunauthorised people. Establishing robustdata classification models and identitymanagement processes and systems arekey to successfully facing this challenge.

Identity management processes (see Figure 1) involve robust controls to make sure that users:

• are who they say they are;

• can see only the information that isappropriate; and

• are set up on systems when they joinand are deleted from systems whenthey leave, efficiently and promptly.

The increasing complexity of IT systemsmakes it difficult to control user access.As more businesses provide access totheir systems to customers, businesspartners and suppliers online, the challenge increases.

The average employee often needs toaccess several different IT systems for


46


their daily work. The bigger thecompany, the more systems eachindividual uses. As a result, companiesare increasingly automating the processfor granting, changing and removingaccess. The Information security breachessurvey found that 16% of all businessesand 31% of large ones now do this.

Single sign-on, where a user has a singleuser ID and password across allsystems, has been an area of focus formany organisations. Users find this lesspainful and are less likely to choose easypasswords or write them down. Undersingle sign-on, a breach can enableunauthorised access to all the systems a person uses. Stronger authentication(i.e., two-factor, with tokens, smart cardsor biometrics) can mitigate this risk.

The DTI survey mentioned abovereported that businesses with singlesign-on alone, without strongauthentication, had a higher thanaverage incidence of unauthorisedaccess. In contrast, the early adopters of strong authentication suffer far fewer incidents.

Benchmarking securitycapabilities

An effective way to determine securitystrategy and its implementation is toassess the level of maturity of anorganisation’s security function(s) bybenchmarking them against industrypeers. One way of doing this, which is currently being adopted by someorganisations, is the development of acapability maturity model based on theconcepts originally developed by theSoftware Engineering Institute at Carnegie Mellon University.

The objectives of such a capabilityassessment are generally to:

• determine the maturity levels of theinstitution’s security organisation,people, processes and technology; and

• establish a target maturity level and the actions required to get there.

Organisations are using processes suchas these to transform their securityfunctions to be better aligned andfocused on business objectives.

Building security awareness

Raising the awareness of security in an organisation is often a challengebut it is vital for developing a strongsecurity culture.

47


Organisations will continue to redefine

or refine the role of the security group.

Security groups will continue to focus

more on policy making and less

on operations.


Aut

hent

icat

ionAccess

control

User management

Enterprise userdirectory

Figure 1: Identity management


Some key actions an organisation canperform to raise security awareness are:

• provide self assessment tools for the business;

• assess staff compliance with securitypolicies through the standard staffappraisal process;

• communicate regularly with thebusiness and align security matters tobusiness risk (talking their language);

• engage directly with the business –establish an effective communicationstrategy/plan; and

• provide user education programmes –get management buy-in to ensureeach staff member attends.

Implementing some, or all, of thesemeasures will assist in developing a security-aware culture.

Conclusion

The ever increasing threats to banks ofoperating in heightened risk environmentsthroughout the world raise seriouschallenges for management teams.Developments around risk governance,control and assessment are underway,however, within many leadingorganisations, as we have describedabove, but there is an opportunity alsofor management to rethink the way thatsecurity is viewed as a business enabler,rather than constraint, and measuredfrom an investment or cost perspective.

Management teams that embrace thesenotions will be strongly positioned tosustain a successful security function,which will support and even enhance the performance of the very businessunder threat.


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49



50


by Frank Janik, Michael Harris and Henning Heuerding

In the beginning there was Asia

As a result of a combination of factors,including rapid growth in lending, poorlending and monitoring criteria and risinginsolvencies due to the Asian EconomicCrisis in the 90s, many banks in the Asia Pacific region found themselvesburdened with significant levels of Non-Performing Loans (NPLs). Some fiveyears later significant progress has beenmade with the removal of an estimatedUSD$1 trillion in NPLs from bankbalance sheets through a variety ofmeans including NPL sales, morefocused collection actions and tighteningof credit procedures. However, despiterecovering Asian economies, significantNPL problems still remain in the region and NPL transactions are expected to continue in mature markets such as Taiwan and Korea, as well as inemerging markets such as China, India and the Philippines.

And now there is Europe

With a number of European economiessuffering financially, the NPL problemhas emerged within Europe. Distressedfunds that enjoyed significant successwith NPL transactions in Asia are now

setting their sights firmly on Europe, withGermany presently at the heart of thedistressed market. Other countries thatare attracting attention include Poland(especially once mooted tax reliefreforms are passed), the Czech Republic,Turkey and Russia.

Asian hotspots

Notwithstanding the increased focus on Europe, there are still significanttransactions underway in Asia, with Taiwan continuing to lead the way. First transactions in India and the Philippines are now also expected, as legal reforms to make the sale ofNPLs easier have recently been passedin both countries.

The mature markets of Japan and Koreaare also expected to be a source ofongoing transactions, whilst everyone is cautiously waiting to see what willhappen in China.

An overview of key Asian countries is outlined below.

Taiwan – The clean-upcontinues

Transactions in the second half of 2003saw Taiwan remain the most active NPLmarket in Asia. In the fourth quarteralone, eight banks launched publicauctions intended to dispose ofapproximately NT$1254.5 billion(USD$3.7 billion) of NPLs. Three of theseauctions closed in December 2003

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Frank JanikDirector, International AdvisoryGroup, Thailand


Henning HeuerdingPartner, Transaction Services,Financial Services, Germany


Michael HarrisPartner, Corporate Finance andRecovery, China


What is an NPL?

Definitions vary widely from territory to territory and are dictated by:

• An institution’s own definition of an NPL;

• Regulatory definitions (often arrearstiming-based);

• Accounting rules & guidelines; and

• Commercial considerations (forward-looking).

Broad view on NPLs

• Loan that has either ceased, or is likely to cease, to perform inaccordance with contractual termsagreed with a borrower; and

• Can include those loans already in default or those which, in thejudgment of the lender, will default inthe future (largely due to underlyingweakness of the business of the borrower).

resulting in a total NPL market size for2003 of approximately NT$195.4 billion(USD$5.8 billion), which was a slightincrease on 2002.

One of the key drivers for continuedgrowth in the market has beengovernment efforts to reduce the overalllevel of NPLs. The Ministry of Finance(MOF) announced in 2002 that it wantedall banks to achieve an NPL ratio of nomore than 7% by the end of 2002 and5% by the end of 2003 and maintain a Bank International Settlement (BIS)capital adequacy ratio of no less than8% by the end of 2003. A number ofbanks had not achieved these targets as at December 2003. In addition, the MOF announced in June 2003 a proposed change loan classificationsystem, including the definition of anNPL. The proposed changes wouldresult in all loans with overdue principalor interest payments of 3 months and/orwhere legal action for recovery has beencommenced by the bank being classifiedas NPLs. We understand that these new classifications are set forimplementation in 2005. If enacted, it islikely that the level of NPLs for potentialdisposal is set to rise.

Investor appetite for NPLs appears to have remained robust. Lone Star was the largest buyer in 2003 (withUSD$1 billion) closely followed by two

domestic investors, the ChinaDevelopment Assets ManagementCompany (CDAMC) and the TaiwanAssets Management Company (TAMCO).

It will be interesting to see how theincreasing levels of NPL transactions in Europe will affect the Taiwan market.However, with hundreds of NT$ billionsof NPLs still to be resolved, we expectTaiwan to remain the most active marketin Asia in the short term. Compared with2002 the sales in 2003 resulted inincreased prices, mainly due to animprovement in the real estate market

which is experiencing a moderaterecovery after a 3-year slump. This trend isalso anticipated to continue. It is expectedthat commercial banks will continue to be the primary source for NPL sales.In addition to the established investors, it is likely that smaller venture funds maystart to enter the market.

A summary of key 2003 transactions in Taiwan is outlined in Figure 1.

Korea – Credit card driven defaults

With major bank growth in the last fewyears driven principally by credit cardgrowth, it is perhaps no surprise that themajor NPL sellers in 2003 were creditcard companies, who have been forcedto sell delinquent loans in order to meetthe Korean government’s mandated non-performing loan percentage requirementof 10%. Approximately USD$4.9 billionof credit card loans and receivables were sold in 2003, with Lone Star again the largest buyer (with approx USD$2.67 billion). However, sale priceshave been below expectations resultingin significant losses for the selling banks. As a result it is expected that the 10%delinquency rate threshold will berelaxed, or abolished entirely, with theresulting effect that sales in 2004 andbeyond are likely to decline.

Non-performing loan transactions – A review of what is happening in Asia and Europe continued...

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Why sell NPLs?

• Investor demand;

• Clean-up of the balance sheet(possible rating advantages);

• Comply with national regulatory orlegal requirements;

• Improve regulatory capital/re-deploy equity;

• Reduce exposure to problemindustries/balance portfolio;

• Lack of resources to manage NPLsin-house;

• Outsource a non-core operation;

• Facilitate a shift in the bank’s strategy;

• Investor relations aspects;

• Establish alliances with buyers; and

• Free up management time.

In the corporate loan sector, there has also been activity with approximatelyUSD$1.7 billion NPLs for sale, and there is an active secondary debt market, withreported trades in the last quarter of 2003of approximately USD$159 million. This isprincipally due to creditors attempting toacquire senior debt positions to lead orimprove their positions (e.g. to influencerestructuring negotiations).

China – Will the giant awake?

After initial announcements and marketactivity by Huarong AMC, China OrientAMC and Cinda AMC in late 2001, it looked to be the start of an expected

53


Why buy NPLs?

Value realisation strategies of buyers

• Gain control of the borrower andrestructure the enterprise (proprietaryor fund investment);

• Onward sale (usually investment banks);

• Quickly liquidate theoperations/collateral;

• Arbitrage;

• Securitisation (usually investment banks); and

• Tax-driven.

The investors’ attributes

• Willingness to take risks (and corresponding rewards);

• Availability of funds for equity/mezzanine investment;

• Speed of decision-taking;

• Flexibility; and

• Portfolio considerations.

Figure 1: Key transactions in 2003 in Taiwan


Seller Approximate Size (NT$ billion) Winning bidderHwa-Nan Bank 13.2 Shinsei BankInternational Commercial Bank of China 10.0 –Grand Commercial Bank 7.9 CerberusChinfon Bank 7.1 OrixKaoshiung Business Bank 32.7 Lone StarAntai Bank 7.8 ColonyBank of Overseas Chinese 10.0 ColonyLand Bank 21.5 TAMCOCooperative Bank 25.5 CDAMCTaichung Commercial Bank 5.2 CDAMCFarmers Bank 15.0 Result not knownChung Hsing Bank 36.0 Lone Star – tranche 1 (NT$20 billion)

Lehman Brothers/TAMCO Consortia – tranche 2 (NT$16 billion)Taitung Business Bank 3.5 Result not known

flood of sales, from both assetmanagement companies, and lookingtowards the future commercial banks.Activity in 2002 was limited primarily to pre-closing activity, which ultimately led to the closing of two additionalportfolio sales in March 2003 to foreigninvestor-led groups. Huarong AMC sold a portfolio with a face value ofUSD$1.3 billion to a consortium led by Morgan Stanley. Goldman Sachsacquired a portfolio from Huarong AMCwith a face value of USD$240 million.

The reasons for the limited number of transactions are many and includegovernment bureaucracy during therequisite approval process. Prior to theHuarong AMC/Morgan StanleyConsortium and Huarong AMC/GoldmanSachs transactions, NPL activity in Chinahad been limited to only a few sales,primarily by China Orient AMC, totallingUSD$440 million. In these earliertransactions, the successful buyer wasUS-based Chenery Associates.

The latter part of 2003 witnessed asubstantive increase in the NPL auctionactivity within China. In December 2003,Huarong AMC awarded a portfolio to aconsortium comprising Morgan Stanleyand GE Capital. Total ‘legal claim’ on the portfolio was approximatelyUSD$360 million, comprising OutstandingPrincipal Balance and Accrued Interest.

Transaction paperwork is currently beingprocessed for final approval by requisitegovernment Ministries and Commissions.

Huarong AMC is currently working withapproximately 7-8 ‘winning bidders’ in attempting to close approximately 17-18 different loan pools which wereincluded in the Huarong II InternationalSealed-Bid Auction. Negotiations arebeing finalised with winning biddersrumoured to include Lehman Brothers,UBS Warburg, JP Morgan Chase,Goldman Sachs, Citigroup, MorganStanley and at least one domestic bidder.

China Construction Bank has recentlyoffered for purchase (vis-à-vis the sealedbid format) a USD$480 million portfolio ofsettled assets (analagous to the US REOwhere title and physical possession ofreal estate assests as partial or totalsettlement for the obligation from thedebtor have been transferred to thelendor – refer to footnote on page 59 for further explanation). Bids weresubmitted and opened on 27 May 2004.Winning bidders included Morgan Stanley(2 pools) and Deutsche Bank (1 pool).

With China preparing for the entry of foreign banks in 2007 and a number of domestic banks planning for stockmarket listings, the pressure is clearly on to address the significant number of NPLs believed to exist (due to limitedreporting requirements Chinese NPLs

are estimated to be anything fromUSD$375 billion, according to officialstatistics, to more than double thisfigure). ICBC-Guangzhou Branch’s recent appointment of financial advisors in relation to its intended sale of aportfolio of NPLs may be a sign that the environment is about to change.Bank of China-Guangzhou Branch has also recently appointed a financialadvisor for a similar sale. While it is hardto say which will go to market first, eitherone will be the first international auctionof NPLs from one of China’s big fourcommercial banks.

Whether government bureaucracy can be overcome will dictate whether theChinese NPL market finally now starts to meet its potential.

India – The winds of changeblow through

Historically debt recovery in India hasbeen hugely problematic, mainly due to a legal system often resulting in years of litigation. This has had the effect of dissuading borrowers withunderperforming businesses fromseeking equitable voluntary settlements(as they knew that legal action would takeyears). The inability to recover debts in atimely manner (or even to estimate thetiming of recovery) is a major impedimentto investors buying NPLs.


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In India, there have been severaldevelopments which indicate that anumber of NPL transactions are likely to occur over the next few years. Thekey development has been the issuanceof guidelines by the Reserve Bank ofIndia (RBI) on the operations of AssetReconstruction Companies (ARCs). The Act is aimed at improving the abilityof secured creditors to enforce theirsecurity interests which in turn will helpcreate an enabling environment forsetting up ARCs. It is hoped that thisstrengthening of lender rights will lead to quicker debt dispute settlements and ultimately investor interest as theenvironment for debt recovery becomesmore predictable. Two ARCs havealready been established, the AssetReconstruction Company of India Ltd(ACRIL) and Asset Care Enterprise (ACE)and several more are awaiting RBIapproval. ACRIL is close to completingits first acquisition of NPLs, with a facevalue of USD$450 million.

To pave the way for greater levels offuture NPL sales, the RBI has recognisedthat further tax, legal, regulatory andforeign direct investment issues need to be resolved and, in this regard, hasrecently appointed advisers to assist in the establishment of a workableframework for ARCs.

The Indian NPL market continues to makethe structural improvements which shouldresult in increased activity for distresseddebt investors.

Philippines – Momentum is gathering

A year after the Special Purpose VehicleAct (SPV) was passed, no sizeable NPLtransactions have yet been completed.Whilst a number of smallish transactionswere started, all have broken down dueto pricing issues.

Another factor is the restrictions onforeigners owning land in the Philippines,which means that most transactions will involve joint ventures with localinstitutions. However, this issue is notexpected to slow down the salesprocess once transactions have begun.

An interesting feature of the NPL marketin the Philippines is that the SPV Actdictates that the loans themselves willnot be sold but rather the underlyingassets collateralising the loan whichhave been seized by the banks – referredto as Non-Performing Assets (NPAs).

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Who are the sellers?

• State-owned banks;

• Listed banks;

• Asset management companies(AMCs);

• Insurance and finance companies; and

• Previous buyers looking to exit theacquired portfolio.

Asia wrap

Historically active markets:

• Japan;

• Indonesia;

• Thailand; and

• Korea.

Currently active markets:

• Taiwan; and

• China.

Likely future markets:

• Philippines;

• India; and

• Japan revisited.

Slow/winding down markets:

• Thailand;

• Malaysia; and

• Indonesia.

The success of the United CoconutPlanters Bank in its bid to recover P22 billion worth of NPAs idle assets viaaution (sealed bid process), will be keenlywatched by the investor community. Due diligence for this sale is currentlyunderway and bids are expected in mid to late July 2004.

Japan – Time to re-visit

The NPL market has been well establishedin Japan for some seven years, with thefirst deal occurring in 1997 when Cargillpurchased Yen 5 billion of NPL debt fromthe Bank of Tokyo. Since then, nearly allmajor Japanese financial institutions havecompleted one or more sales.

Whilst sales have been steadilydecreasing since 2000, with Yen 43.2 trillion of NPLs held by banks atthe end of March 2002 (according to latestGovernment statistics), NPL activity isagain tipped to rise.

Europe – The nextopportunity?

With many banks across Europe carryingsignificant NPL levels, investors are nowfirmly active in Europe, hoping to replicatethe significant gains made in the Asianmarkets over recent years.

Attracting the most interest at the momentis Germany, closely followed by several

countries within the Central and EastEuropean region.

Only time will tell whether European banksand governments will learn from historicaltransactions in Asia when managing theircredit portfolios.

To date, relatively few large NPLtransactions (i.e., portfolios of €100million plus) have been sold successfully;in the countries attracting the mostinterest, notably Germany, investor interest remains high.

The principal factor which determinesthe prices paid in these new emergingmarkets is information risk, with theinvestors asked to bid on the basis ofinformation which often provides themwith too many uncertainties. Added to

this, there have been examples of poor packaging of debt and unclear,poorly managed sale processes. Other factors contributing to the slow start of NPL transactions in Europe are regulatory in nature, e.g. tax relief,spreading losses, complex accountingtreatment of portfolio sales, asset/loantransfer issues etc.

Outlined below is a summary of keycountries where NPL transactions areexpected to occur in the near future,together with the key issues affectingsuch activities.

Germany – Another Taiwan?

Whilst the German banking industry isnot in crisis, a combination of decliningbank lending, waves of corporateinsolvencies, a real estate slump and apoorly performing economy have all ledGerman banks to shed non-performingor non-core loan operations.

Successful NPL portfolio transactions todate have mainly involved non-Germanassets and have included:

• The sale by Dresdner Bank of twolarge NPL portfolios;

• The purchase by Lone Star of a €225 million portfolio from theinsolvent Gottard & Metallbank;


56


Who are the buyers?

• Investment banks;

• Distressed debt funds;

• Financial houses;

• Local financial companies;

• State-owned AMCs;

• Commercial banks;

• Creditors;

• Shareholders;

• Suppliers;

• Customers; and

• Competitors.

• A €500 million Real Estate portfolio,comprising a mix of West and EastGerman assets, again bought by Lone Star (who were supported by aconsortium of investment banks); and

• 1 distressed consumer transaction(approx size €180 million).

The biggest barrier to successfultransactions in Germany is price which is affected by the following factors:

• Continuing decline in the value of underlying collateral (real estate in particular);

• Present lack of a common NPLclassification standard which in turn influences provisions;

• Poorly run sales process (high information risk and costsengaging in a transaction);

• Little direct government support of tax relief or mandation of NPL sales(unlike in certain Asian countries andthe USA); and

• German banks are better capitalised to manage non-performing loans,hence less pressure to sell (unlike some Asian banks).

As a result, it is likely that the return levelsof Asian transactions are unachievable toNPL investors in Germany.

With an estimated German NPL market of approximately €350 billion, NPLtransactions are expected to be theroute chosen by many banks to addressor rebalance their current portfolioexposures, thereby freeing up capitaland allowing banks to focus on moreprofitable business lines, and investorinterest remains high.

Czech Republic

With bad debts of USD$8.6 billioncentralised in the Czech ConsolidationAgency at the end of 2002, NPL activity is on the rise.

Three major portfolios have already beensold and this, combined with a welldeveloped legal framework and real estatesystems, plus the on-the-ground presenceof distressed debt investors, points toincreasing levels of NPL transactions.

Slovakia

As with the Czech Republic, NPLs are now mostly centralised with the Slovenska Konsolidacni (SK). At June 2003, SK reported NPLs ofUSD$3.1 billion, with 68% representingdebts of companies already subject tobankruptcy proceedings.

SK has already sold one portfolio forapprox 2.8 cents in the dollar; however a developing legal framework, combinedwith local conditions, have to dateconfined the buyers to local companies.

Poland

Notwithstanding some 22% of NPLs in commercial banks as at June 2003,there have been few NPL transactions todate. Due to poor tax treatment on loansales (from a selling bank’s perspective)and a legal environment that makes debtrecovery action a lengthy process, thereis presently relatively little interest inentering into NPL transactions.

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Sales strategies

In theory, three principal salesstrategies are open to most sellers:

• Private placement;

• Auction/bid process; and

• Securitisation.

These are not mutually exclusive. One strategy may apply to the wholeportfolio or to different pools; or eachof the three strategies could be appliedto different asset pools dependent onan assessment of how value will bemaximised and the exact priorities ofthe Bank. For example, if maximisingthe net proceeds is paramount then anauction or securitisation process willbe preferable; if speed of sale isparamount then a private placement islikely to provide the quickest exit route.

However, with EU accession resulting inlegal and real estate changes, potentialtax concessions and the presence ofinternationally-owned banks, the NPLmarket is expected to be significant inthe next two to three years.

Russia

Many of the essential regulations are notyet in place to make NPL sales attractiveto both sellers and investors. Furthermore,economic conditions in the last few yearshave limited the attractiveness of Russiaas a place for investment, especially in distressed debt. However, over thepast five years, the Government hasundertaken significant efforts to improvethe financial sector, including the

establishment of The Agency forRestructuring Credit Organisations (ARCO)in 1999. ARCO’s main tasks include bankexaminations and provision of assistanceto banks in their restructuring andrecapitalisation efforts, as well as NPLmanagement and workout.

According to the Russian Central Bankstatistics, 43% of bank loans have beenissued by the five largest Russian creditorganisations. At the same time, theirportfolios account for about two thirds of overdue loans shown in banks’balance sheets. As of 1 June 2003, thecountry’s five leading banks had a totalof RUR 29.65bn (USD$970 million) inbad loans, or 3% of loans, against RUR48.3bn (USD$1.6 billion), or 2% for theRussian banking system as a whole. It isdifficult to say to what extent thesefigures reflect the real situation. Pre-lending scrutiny by the banks and theprevailing debt security and debtrecovery practices contribute to therelatively low portion of bad debts.

As a result, the market for NPLs is onlynow emerging. However, investors arestarting to make overtures and a numberof transactions are expected to occur in the next two or three years.

Turkey

The Turkish financial sector has sufferedsignificant crisis in recent years.Escalating political uncertainties, loss of credibility in the exchange rate regimeand disinflation programmes whichcaused interest rates to rise sharply inNovember 2000 resulted in the abolitionof the exchange rate peg in February2001. This subsequently led to a seriouscontraction in the private sector that, in turn, exerted an adverse impact onthe asset quality of the banking sectorand increased the credit risk of banks.

As a result of these financial conditions,approximately 20 banks have failed and been transferred to the SavingsDeposit Investment Fund (SIDF) since1997. As at 30 June 2003, over 125,000loans have been transferred to theCollection Department of SDIF, around1,000 of which are majority shareholderloans, over 11,000 others are corporateloans and approximately 115,000 areindividual loans.

Resolution of non-performing loans isnow the next step for the restructuring of the Turkish banking sector, as well as for the Turkish economy as a whole. A number of regulatory and banking actchanges have been passed to facilitateNPL resolution, including the passing ofAct No 4743, which came into force on


58


Europe wrap

Major markets:

• Germany.

Markets to watch:

• Czech Republic;

• Poland; and

• Russia.

Slower/smaller/more difficult markets

• Slovakia;

• Slovenia;

• Romania; and

• Hungary.

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31 January 2002, and provided taxincentives in order to resolve theproblem loans and mobilise bank assets.NPL sales are considered to be theprimary avenue to achieve these aims.

According to the result of dual audits,together with the Banking Regulationand Supervision Authority’s (BRSA) ownassessments, receivables, classified asnon-performing were USD$5.4 billion as at 31 December 2001. This hadincreased to approximately USD$8 billionas at the end of 2002.

In late 2003, the SDIF appointingadvisors on the disposal of an initialportfolio of primarily Turkish Liradenominated corporate and commercialloans with an equivalent outstandingprincipal balance of approximatelyUSD$300 million. The exposures werealmost all secured by real estatecollateral. Whilst a number of local andinternational investors submitted bids(after undertaking due diligence on theportfolio), the SDIF subsequentlystopped the sale for internal reasons.

With over USD$8 billion of NPLs still toresolve, it is highly likely that the SDIFwill re-visit NPL sales as a means ofresolving the problems. In this regard, we understand that SDIF has appointeda new board since the last sale and isconsidering various options to address its NPL problems, which may result in further sales in late 2004. The successof any such sale(s) will be a critical factorin whether the Turkey NPL market willprovide opportunities for both local andinternational distressed debt investors.

Conclusion

It is clear that both Asia and Europe still hold immense opportunities for NPLdistressed debt investors. In Asia, the established markets of Taiwan andJapan are again expected to remainparticularly active in 2004, with Chinapotentially providing significantopportunities as the country prepares for the entry of foreign banks in 2007. In Europe, the focus will be primarily onGermany, with an estimated German NPLmarket of approximately €350 billion

and a significant number of transactionsexpected this year as banks continue toaddress their current portfolio problems.

Lessons learned from Asian NPL activity in recent years will need to be transferred effectively by investorsand their advisers to the newopportunities presenting themselves in Europe in order to gain most.

Local market and regulator knowledgewill be critical to the investment processsuccess, epecially since much activity is expected to be led by institutionswhose presence in the area over recentyears has retracted to central sites, suchas London, or even through coveragethrough a fly-in basis. It is in this regardthat investors can enhance riskinvestigation and compete moreeffectively on price.

In China, commercial banks are not allowed (under current law) to sell non-performing loans at any price other than the face amount of the obligation. There is one‘carve out’ for this general rule. If the loan and related collateral can be classified as a ‘settled asset’ then the commercial bank has much more latitude in disposing of the loan and related collateral for less than the face amount. There are generally three types of situations that qualify for the generic title ‘settled asset’ including:

• Actual title to the physical asset (building, machinery & equipment) has been transferred to and recorded in the name of the commercial bank;

• Title to the assets remains with the delinquent borrower but the commercial bank has received a court judgment in favour of the bank - the bank has not transferredtitle yet in order to mitigate the title transfer costs (document stamps etc.); and

• Delinquent borrower and commercial bank have executed a ‘negotiation settlement’ (which acts as a type of friendly foreclosure in order to avoid litigation) and theonly remaining steps are to pay the transfer title tax.


Contact details

Editor-in-chief Editor

Phil Rivett

Tel: 44 20 7212 4686 Email: [email protected]

Darren Meek


Impact of Basel II on the EU economy

Charles IlakoLeader, European Financial ServicesRegulatory Practice, Brussels

Tel: 32 2710 7121Email: [email protected]

Richard BarfieldDirector, Valuation & Strategy, UK


Dr Bill RobinsonHead UK Business Economist, Valuation & Strategy



Mark CasellaPartner, US Capital Markets


Robert WelzelSenior Manager, Capital Markets andInvestment Management, Germany


Graham PhillipsEuropean Hedge Fund Practice Leader, UK


Sergio RoganteSenior Manager, Banking and CapitalMarkets, Brazil



Brazil – A review of the effects of inflation on the banking sector

Graham NyePartner, Banking and Capital Markets,Brazil


Paulo MironPartner, Banking and Capital Markets,Brazil


Practical difficulties of adopting the identification requirements of the EU Savings Directive

Sian HerbertDirector, UK Anti-Money Laundering Team


Laurent de La MettriePartner, Tax and Legal Services,Luxembourg

Tel: 352 49 48 48 32 04Email: [email protected]

Bob HarlandPartner, Tax and Legal Services, UK



Jan SchreuderPartner, Risk Management, Australia


Mark VosSenior Manager, Risk Management,Australia


Chris PotterPartner, Financial Services, UK



Frank JanikDirector, International Advisory Group,Thailand


Henning HeuerdingPartner, Transaction Services, Financial Services, Germany


Michael HarrisPartner, Corporate Finance and Recovery,China



Contact details continued...


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