CHAPTER 36
TREASURY AND THE MANAGEMENT OF ASSETS AND LIABILITIES
AT BENEFICIAL FINANCE
TABLE OF CONTENTS
36.1 INTRODUCTION
36.2 SCOPE OF THE INVESTIGATION
36.3 THE TREASURY DIVISION OF BENEFICIAL FINANCE
36.3.1 LIQUIDITY MANAGEMENT
36.3.2 MANAGING THE MATURITY PROFILE OF ASSETS AND LIABILITIES
36.3.3 INTEREST RATE MANAGEMENT
36.3.3.1 Interest Rate Risk Management
36.3.3.2 Determination of Interest Rates
36.3.4 FOREIGN EXCHANGE RISK MANAGEMENT
36.3.5 THE TREASURY DIVISION AS A PROFIT CENTRE
36.3.6 THE CALCULATION OF THE MONTHLY BORROWINGS EXPENSE FIGURE
36.3.7 THE MANAGEMENT STRUCTURE AND STAFFING OF TREASURY
36.3.8 SYSTEMS, POLICIES AND PROCEDURES WITHIN TREASURY
36.3.8.1 Systems
36.3.8.2 Policies and Procedures
36.4 ASSET AND LIABILITY COMMITTEES
36.5 CONCLUSIONS WITH RESPECT TO ASSET AND LIABILITY MANAGEMENT AND TREASURY OPERATIONS
36.6 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
36.6.1 TERM OF APPOINTMENT A(a), (b) AND (c)
36.6.2 TERM OF APPOINTMENT C
36.1 INTRODUCTION
This Chapter examines the role undertaken by the Treasury and Capital Markets division (hereinafter referred to as the "Treasury division") in the management of the assets and liabilities, liquidity, and interest rate risk in Beneficial Finance. It also examines the responsibilities of the Board and senior management with respect to these matters.
For the reasons stated in this Chapter, the management processes associated with Treasury operations in Beneficial Finance, were in my opinion, contributing factors which led the company to engage in operations which have resulted in the incurring of losses and the holding of non-performing assets. Accordingly, this matter is relevant to my Terms of Appointment A(a), (b) and (c) and C.
As was also the case with the Bank, it has become clear, for the reasons stated in this and other Chapters of this Report, that asset and liability, liquidity, and interest rate risk, management did not receive adequate attention at Board and management level. Had appropriate attention been accorded these matters, the directors and senior management would have had available to them relevant information that would have alerted them to the nature of the changes which were taking place in the asset portfolio of the company and the funding required to support those assets.
As mentioned in Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" of my first Report, I have not examined the operations of other finance companies with a view to determining whether there was, or was not, an industry standard for asset and liability, liquidity, and interest rate risk, management. From information available to the Investigation, it can be said that Treasury operations evolved in line with changes in the financial markets and the financial instruments that were traded in those markets during this period.
I have made an assessment of what would have been, in my opinion, appropriate procedures and practices for Beneficial Finance, having regard to its particular requirements and the specific factual situations that existed from time to time over the period covered by this Investigation. In doing so, I have not applied contemporary standards to past years. I have borne in mind that, over the past eight years, there have been significant developments in the area of Treasury operations, including asset and liability management. I have also, for the purpose of this Chapter, considered the developments and the operation of Treasury systems and procedures that took place in the Bank during the period under investigation.
36.2 SCOPE OF THE INVESTIGATION
The Investigation covers the operations of the Treasury division in the period 1984 to early 1991. It has considered evidence provided by persons who participated in the operations of the Treasury division and who were also familiar with that division's systems and procedures. The Investigation has had regard to evidence arising from the examination of various other members, or former members, of the staff of Beneficial Finance, and to a wide range of documents, including material before the State Bank Royal Commission.
36.3 THE TREASURY DIVISION OF BENEFICIAL FINANCE
The responsibility for asset and liability management in financial institutions should be undertaken at a high level and include representation from the Treasury division. Planning, lending and accounting divisions should share that responsibility. This is because both the "assets side" and the "liabilities side" of the balance sheet need to be managed with an awareness of what is currently taking place in all operational areas, but also having regard to what is planned or expected for the future. Accordingly, asset and liability management should be an important consideration in the future planning and policies of a finance company.()
Although an asset and liability committee was established to manage the assets and liabilities of Beneficial Finance at certain times during the period under investigation, by and large, asset and liability management within Beneficial Finance became, by default, a function of the Treasury division.()
The establishment and subsequent abandonment of the asset and liability committees within Beneficial Finance is discussed later in this Chapter.
The principal function of the Treasury division in Beneficial Finance was to raise funds, either by way of borrowings or capital, to fund the assets of the Company.
I have in the course of this Investigation identified five distinct areas of activity in which the Treasury division participated. I have dealt with four of those in this Chapter. The fifth area, the funding of Beneficial Finance, is covered in Chapter 34 - "The Funding of Beneficial Finance".
The Four areas of Treasury operations that I have dealt with in this Chapter are:
(a) liquidity management;
(b) the management of the maturity profile of assets and liabilities;
(c) interest rate management; and
(d) foreign exchange management.
Certain other asset and liability management functions, that were relevant to the operations of the Bank, are considered in Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" of my first Report. These are not, however, applicable to Beneficial Finance. For example, Beneficial Finance, unlike the Bank, did not carry out investment and arbitrage functions, as it did not trade actively in the financial markets, apart from obtaining funds to satisfy operational needs. As was the case with the Bank, the structuring of lending transactions in Beneficial Finance was the responsibility of the lending divisions and, with limited exceptions, did not involve the Treasury division.
The Treasury division was responsible for registry services. This activity included the collection and recording of data relating to the retail liabilities of Beneficial Finance. I have made some investigation of the conduct of the registry services, as this was an important activity of the Beneficial Finance Treasury division.
Another important function of the Treasury division involved the monitoring of the trust deed compliance requirements of Beneficial Finance. I have reported on this in Chapter 34 - "The Funding of Beneficial Finance".
36.3.1 LIQUIDITY MANAGEMENT
Proper liquidity management is fundamental to the success or failure of a finance company. To maintain the confidence of the market, adequate liquid funds must always be maintained to meet all calls for the return of funds deposited, together with an adequate safety margin to meet unexpected calls, or asset draw downs. Furthermore, proper liquidity management requires that surplus funds are invested in a cost effective manner. Generally, a lower rate of return is achieved on liquid deposits than longer term investments and receivables. Circumstances may arise, and indeed did apply at times covered by this Investigation, where short term rates were higher than longer term rates. In summary, the company's profitability (ie negatively or positively) can be affected by the amount of liquidity in the form of cash held by it for prudential requirements.
In Beneficial Finance, the object of liquidity management was to ensure that the company had available sufficient cash to meet all its financial obligations. A secondary, and important object, was, as mentioned above, to ensure that the funds were managed in the most cost effective way.()
The importance of maintaining liquidity was paramount to Mr F R Horwood, who was, throughout the period under investigation, in charge of treasury management within Beneficial Finance. He had previously experienced a run on funds in the late 1970's when Beneficial Finance was placed in a difficult position in meeting the demands placed upon it.() Having regard to that experience, the Treasury division, under his management, adopted a conservative approach with respect to liquidity.()
The day to day liquidity management of Beneficial Finance was controlled at the Head Office in Adelaide, although funds were borrowed, and lent, by branch offices interstate.
The net funding requirement of the day, and the approximate position for the next two days forward would be calculated on the morning of each day on the basis of the information received from various Company locations on the preceding afternoon. It was the responsibility of Treasury division to go out to the market and generate the liquidity necessary for that day. If there was to be a particularly heavy outflow of funds anticipated, the Treasury would make appropriate arrangements, for the next few days.()
This exercise, was known, within Beneficial Finance, as daily cash flow forecasting. It was generally co-ordinated by an office clerk, under the supervision of Mr J C Hoogland, the Chief Manager of the Treasury division. Mr Hoogland was directly responsible to Mr Horwood.
The objective of daily cash flow forecasting was to keep the Company operating within a limited overdraft capacity without exceeding its approved facility level of $1.0M.()
The integrity of the daily cash flow forecast depended upon the quality of the information obtained by Treasury division from the various lending divisions.
Treasury division had difficulties, throughout the period under investigation, with the timing, and accuracy, of information that came from the lending divisions. Mr J A Baker confirmed that this was a problem with respect to the day to day liquidity management of Beneficial Finance.
"Well, Rhys was a member of the executive committee so he had full access to all the budgets, all the management reports which came from the line divisions. He would have had problems on almost a day to day basis with some of the branches in the States wanting to settle something and not having told him or often as the case might be saying they wanted the money and then finding out that the solicitors at the other end hadn't finalised the transaction and they didn't settle it. So you have ups and downs like that but that's not unusual, I've got to say, in a finance company or any sort of lending institution. The Treasury side does sort of have the problem of making sure that the assets side is nicely correlated all the time." ()
These difficulties were also confirmed by Mr Horwood and Mr Hoogland.()
It must be acknowledged that some difficulties experienced by the company in predicting cash flows were unavoidable. Mr M Chakravarti has said, by way of example, that it was not possible to predict settlement dates for some transactions because reliance was placed on third parties, such as equipment suppliers for leasing transactions.
As a result of the difficulties with daily cash flow forecasting, Beneficial Finance would, on occasions, be caught with insufficient funds, and be overdrawn beyond its limit. Conversely, on occasions the company would be left with excessively large cash funds on deposit.()
To overcome these difficulties a policy was implemented in the late 1980's which required that forty eight hours notice be given to the Treasury division for drawdowns greater than $5.0M and twenty four hours for drawdowns between $2.0M and $5.0M. For amounts less than $2.0M, notice was to be given by late afternoon the prior day. Mr Baker gave evidence that, together with Mr Horwood, he took steps to encourage more timely and accurate information from the lending divisions.
"I really think that while Treasury at Beneficial was irritated at times by the line divisions not indicating properly, they wouldn't have been much worse than any institution and I think Rhys was a strong manager to make himself known - known to everyone and I certainly encouraged him to thump the desk and we got to a stage where we told the branches, as I recall, that they should give 48 hours notice and if they didn't draw the money on 48 hours - after 2 days then we would charge the branch interest. You know all sorts of things like that were done to try and put some discipline into it." ()
The August 1987, Internal Audit Report for the Treasury division confirmed the difficulties relating to the information provided to the Treasury division.()
The level of information coming to the Treasury division from the lending divisions improved over time, in both its timing and accuracy.() Throughout the period under investigation, however, the timing and accuracy of the information was far from satisfactory.
The failure to provide timely and accurate information to the Treasury division did, on occasions, result in additional costs being incurred by Beneficial Finance as a result of inaccuracies in the daily cash flow forecast. It also resulted in a failure to maximise profit, because funds were not utilised in the most advantageous manner. It did not, however, lead to any substantial or long term losses. If Beneficial Finance borrowed too much money, and accordingly had a surplus of funds, it would place those funds in the overnight or seven day markets and possibly take a short term loss.()
As a consequence of the difficulties in cash flow forecasting in both the short term and longer term, a two or three day liquidity buffer of surplus cash was used to assist in cash flow management.() There was an opportunity cost associated with holding cash of this amount in that the investment decision was dictated by matters other than the interest rates in relevant financial markets.
The stand-by facility buffer was set at 7 per cent of the total debt of Beneficial Finance.
"For many years the level of stand-by was determined by a calculation relating to pure liquidity, what was likely to happen in the next three months, what could we lose in the way of money in an emergency situation, and we based a hypothetical emergency on what happened in 1979 when the company did have an emergency and we looked back and determined what sort of reserves were appropriate. That was a little too complex for Mr Baker who wanted a simple statistic and he initially chose this figure of 7%. It was drawn really out of the air and I would suggest it was very high." ()
Mr Horwood acknowledged that, with better forecasting systems, this stand-by facility could have been reduced, and, it was reduced later when information did improve. The comfort provided by the stand-by facility was, to some extent, illusory, because to have drawn from those funds would have indicated to the market that Beneficial Finance was in some difficulty. Such a situation would have increased the potential for a liquidity crisis that the stand-by facility was intended to avoid. When Beneficial Finance did experience difficulties with liquidity in 1990, it agreed, at the request of the Bank, not to draw on those funds. If the amount of this facility had been reduced it would have marginally added to the profitability of Beneficial Finance.()
Mr Baker has submitted that the 7 per cent buffer was not "drawn really out of the air" but rather reflected a figure which, from his experience in finance company operations, he considered was appropriate. He further submits it was not an excessive amount. The fact remains that this was an amount which was determined arbitrarily, and did not reflect the changing liquidity needs of the company.
In addition to the daily cash flow forecasting, Beneficial Finance's Treasury would, whenever required, and, in particular, if difficulties were being experienced with the forecasting, project its cash flow requirements for the next month. At times, the Treasury division also prepared cash flow forecasts for the next twelve months, or to the next major reporting date such as the end of the financial year.
Difficulties were experienced within the Treasury division in the preparation of these medium term and longer term cash flow forecasts. The forecasts could not be made with any accuracy owing to the limitations of the computerised Finance Receivables System purchased by Beneficial Finance in 1987. The Finance Receivables System was acquired with the approval of the Executive Committee(). It was the system used by Beneficial Finance to record the details of the company's assets. The Finance Receivables System was not able to provide an adequate information base for the lending divisions to estimate the level of future debtors' receipts. In addition, the system was unable to distinguish between "interest" and "capitalised interest". The capitalisation of interest reduced the amount of cash flow within Beneficial Finance.()
It is acknowledged that deficiencies in information systems were not the only cause of difficulty in predicting cash flows. I accept that some factors such as the early repayment of loans meant that the information recorded on information systems could not be relied upon without further interpretation. The evidence before this Investigation is, however, that the information provided by the systems was inadequate.
The Treasury division was not asked specifically to consider the functions of the system prior to its purchase. In any event, the system was not capable of providing cash flow information to the Treasury division. Mr Horwood stated in evidence that:
"We did not know at that stage, because I suppose Treasury was never asked specifically to look at that system ever. I mean I heard bits and pieces at executive and I suppose to be quite honest I assumed that it would cover cash flow. It never came up specifically. It was not until it was bought and in operation that it did not do it. They realised then it did not do all sorts of things.
That was one of the problems with FRS [Finance Receivables System]. There were lots of others. I mean I am not an expert on FRS but from a Treasury point of view it simply failed to give even the most rudimentary information." () [Emphasis added]
Prior to the introduction of the Finance Receivables System, a cash flow report was included in the Board Papers every three months. For a short period after the introduction of the Finance Receivables System, those cash flow reports continued to be forwarded to the Board. In 1987, the Board requested that those cash flow reports be deleted from the Board file. The forecasts that were produced in the Board Papers were of doubtful quality. Mr Horwood stated in evidence that:
"I think we knew at that stage that the figures we were giving were pretty rubbery because we were simply estimating lots and lots of figures and I think in our own mind we were delighted ... not to have to produce something which we would then use as a management document." ()
There is no evidence before this Investigation that the unreliability of those cash flow forecasts was ever disclosed to the Board, although it is the evidence of Mr Horwood that the Board would have "understood" the limitations on this information.
The difficulty experienced by the Treasury division in preparing medium and longer term cash flow forecasts was compounded by the lack of information coming to it from the lending divisions, and the significant growth in assets of Beneficial Finance. As I have discussed in Chapter 29 - "Direction-Setting and Planning" and Chapter 34 - "The Funding of Beneficial Finance", Beneficial Finance and the Beneficial Group grew at a rate considerably in excess of that planned. Accordingly, any longer term projections as to the company's future funding requirements were inevitably inaccurate. Mr Horwood in evidence stated that:
"We would start off with annual cash flows and they would be out of date within five days. I mean, in the end ... we would do cash flows out to the next reporting date but we concentrated on the next two months, at least we knew more about data for the next two months." ()
From 1987 onwards, Mr Horwood raised his concerns about the extent of the growth of Beneficial Finance and the Beneficial Group.() Mr Horwood complained to Mr Baker on several occasions that the Treasury division could not rely on forecasted growth. Mr Horwood also raised the matter on numerous occasions at executive committee meetings.()
In October of 1989, the Board requested management to provide in the Board Papers a cash flow forecast. Mr P J Erskine, the Company Secretary, recalls that the request was made either by Mr T M Clark or Mr R P Searcy.()
At the April 1990 Board meeting, the Board again requested a cash flow report.
Ultimately, a cash flow report was presented to the May 1990 Board meeting.() The delay in providing the report was caused by the difficulties experienced by Mr Horwood in being able to develop a system to enable an accurate report to be prepared for the Board.()
Even after the cash flow forecasts were again included in the Board folders, they were still potentially inaccurate.()
In fact, as the business of Beneficial Finance and the Beneficial Group became greater in volume, and more complex, the difficulties in providing accurate cash flow forecasts increased. Mr Horwood gave evidence that:
"The business became more and more complex and ... the more complex it got the harder it was to get any sort of reasonable cash flow data ... it would have cost us, I mean, we felt vulnerable but we did get through. So I guess whatever data we dreamt up and sort of assumed did work albeit imprecisely." ()
Mr Horwood agreed that the lack of longer term cash flow forecasting caused problems, and demonstrated an inability, within Beneficial Finance, to organise funds in the most profitable way.
"I am sure they did. Yes, I am sure they did because even on a one or two month view you do tend to lose track of longer term maturities, when things are coming up. You really need to be able to look at and plan your maturities at least over year. So I am sure they did ... Yes, that's right, or we might panic to cover some position in two months' time knowing there was a significant lead time because we had simply lost track of the fact that there was a major outflow probably coming on top of very heavy lending at the same time. So yes, it did have an impact. It is hard to measure exactly how much." ()
Liquidity management within Beneficial Finance was always "lending driven". The company operated on the basis that the lending divisions within Beneficial Finance and the Beneficial Group should write as many loans as they could, and leave the Treasury division to find the necessary funds.()
As a result, the Treasury division was often under intense pressure to find funds, and on occasions, feared that it would experience a substantial shortfall. Until late 1990, however, it was able to meet the demands to fund the growth of Beneficial Finance.()
During 1990 Beneficial Finance experienced liquidity problems. This was as a result of a significant decline in asset quality, and its resulting adverse impact on the financial position of the Company. At the same time the Company took steps to sell some of its assets to the Bank. This sale of assets is dealt with in Chapter 34 - "The Funding of Beneficial Finance". By August of 1990, adverse publicity, and a down grading in Beneficial Finance's credit rating, had impaired its ability to obtain funds on the same basis as previously. The lending divisions were still continuing to lend monies at the same interest rates at which they had lent prior to the down grading of the rating. The Treasury division was not able to obtain funds in the market at the required rate. The only way in which Beneficial Finance would have been able to maintain its liquidity was to borrow at distress rates. This would have sent a further signal to the market that it was experiencing difficulties.()
Beneficial Finance's liquidity, after August of 1990, was also adversely affected by the withdrawal of Prospectus No 65 from the retail market. Beneficial Finance was unable to replace the prospectus due to the uncertainty of its financial situation. The circumstances surrounding the withdrawal of Prospectus 65 are examined in more detail in Chapter 35 - "Beneficial Finance - Prospectus 65" and Chapter 34 - "The Funding of Beneficial Finance".
As mentioned above, the liquidity problems experienced by Beneficial Finance in 1990 were the direct result of the marked deterioration in the company's financial position, arising in particular, from the lowering of its asset worth. The problems were not the result of Treasury division's role in liquidity management. Over the years, the Treasury division's guiding principle and approach to liquidity management was conservative and this was reflected in strategic plans. The strategic plan 1987-1992, for example, stated the basic approach that was to be followed from 1987 onwards:
"... Liquidity will be increased to such a level that Beneficial will continue to trade regardless of a major collapse in the financial market. This will be achieved by lengthening the average term of borrowings to three years providing the stabilised portfolio of funds and utilising swap and other techniques to meet term matching objectives." ()
Although conservative in approach, Treasury division was required to service the continual and increasing demands for funds from lending divisions to finance the significant asset growth, asset growth being the major strategy pursued by the Managing Director and senior management of the asset generating divisions. Although, as noted in Chapter 29 - "Direction-Setting and Planning", the Board was expressing concern that infrastructure within the company should maintain pace with the growth in assets, it did not take steps to curb that growth, even though it outstripped the budgeted targets by a significant degree.
Mr Baker has submitted that he had confidence in Mr Horwood and the Treasury staff to obtain funds required by the company's growth. He noted that until mid 1990 his confidence was justified.
Difficulties and concerns relating to the extent of growth of the company, and the provision and reliability of cash flow information, were raised by Mr Horwood on several occasions with the Managing Director, and other senior management of the asset generating divisions.
In addition, cash flow reporting to the Board, which had occurred on a three month basis up to 1987, lapsed for a lengthy and critical period of time, recommencing only in May 1990. That period of time marked the significant growth path of Beneficial Finance. The Board requested the re-introduction of cash flow forecasts in October 1989, and again made a request in April 1990. It is significant that, upon receipt of cash flow reports in May 1990, the Board became aware of the high proportion of company assets which were not generating cash income.
In my opinion, on the basis of the evidence referred to in this Chapter, the Board, the Managing Director, and senior management of the asset generating divisions, failed to appreciate the importance of the role of the Treasury division in liquidity management, and they underscored the importance of cash flow forecasting for informed decision making processes with respect to the growth in operations of the company. In this respect each of the responsible officers concerned did not adequately or properly supervise, direct and control the affairs of the company.
36.3.2 MANAGING THE MATURITY PROFILE OF ASSETS AND LIABILITIES
As discussed in Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" of my first Report, continual movements in a balance sheet require management to minimise the risk associated with any mis-matching, and to take full advantage of the potential benefits associated with any mis-matching.
It is not possible to perfectly match the maturity profile of the assets and liabilities of a finance company, and it is for this reason that all well managed financial institutions adopt "techniques" to minimise potential risks ie swaps, etc.
Beneficial Finance did not manage its balance sheet to minimise the risks associated with the mis-matching of the assets and liabilities. After 1987, the liabilities always tended to be longer dated than the assets. Beneficial Finance's policy was to borrow for the longest possible term:
"... We weren't specifically borrowing this liability today to fund that asset. What we were doing was we were looking at the whole of the assets of the organisation and then trying to match the liabilities against that, that was the principle behind it. But as for funding portfolio long, that was, I suppose the principle. I mean Rhys' philosophy was that if we can fix, you know, get a long term committed funding in for, say two, three or four years, that is far preferable to run a very short adhoc book of, you know, 90 day or at call money and this was in total a totally different view to running, a conservative view I suppose, of running treasury as opposed to something like, Tri-Continental which basically ran its whole book at call and it also meant that obviously if there was anything you had the funds committed for a long term period ... if there was anything that was adverse." ()
Beneficial Finance was prepared to pay more for its funds to lengthen its liability portfolio. Between 1987 and 1990, the liability portfolio was lengthened in accordance with the strategic plan referred to earlier in this Chapter.() In 1990, longer term funds became harder to find. One consequence of this approach was that the cost of funds to Beneficial Finance was higher than it would otherwise have been had a shorter term funding policy been adopted.
The principal computer system used within the Treasury division for managing the liabilities was the registry system. This system dealt with the registration and utilisation of information relating to debenture holders, and the recording of principal and interest for retail borrowers. In addition, the system carried a number of "reports" relating to the maturity profile of liabilities. Unlike the Bank Treasury, the Treasury division in Beneficial Finance did not prepare a profile of assets, nor did the lending department. Some Treasury divisions in other financial institutions prepared a profile of assets, that provided an overall summary of the characteristics of the company's assets. The Treasury division at Beneficial Finance did not prepare such a profile of assets. The Treasury division used the information recorded on the Finance Receivables System to obtain a view of the assets of the company, on an asset by asset basis. If the Finance Receivables System produced reliable and useful information this, in principle, would have given the Treasury division an informed understanding of the assets of the company. The integrity of this method of reviewing the characteristics of the company's assets was, however, entirely dependent upon the reliability of the information on the Finance Receivables System. As reported previously, the Finance Receivables System had limitations with regard to the provision of certain information, and some reliability problems in relation to information produced from the system. Accordingly, the Treasury division did not have appropriate information regarding the asset structure of the company to adequately control the mis-match of the maturity profile, or, indeed, the interest rate risk. It is equally clear that if the Treasury division had attempted to prepare a profile of assets, this also would not have been reliable because of the inadequacy of the information contained on the Finance Receivables System.()
In November of 1987, the Chase Bank Risk Management System was purchased to assist with the asset and liability management of the company, and, in particular, the management of the interest rate risk. By early 1991, the system had been developed so that an approximate view of assets and liabilities could be modelled on that system. This development provided a basis upon which the mis-match in the maturity profile, and interest rate profile, could be better managed.()
The 1987-1992 Corporate Strategic Plan acknowledges the lack of a formalised asset and liability management system within Beneficial Finance as a weakness to be tackled. The development of an asset and liability management system was also referred to in the 1988-1993 and the 1990-1992 Corporate Strategic Plans.
Mr Horwood commented that, in 1990, asset and liability management had improved:
"Contrary to 1979 Beneficial finds itself with a relatively well balanced liabilities book with the re-pricing structure of assets and liabilities more or less in line and with the cash flow maturity of assets somewhat shorter than of its liability." ()
As with liquidity management, the limitations of the financial systems within Beneficial Finance inhibited the Treasury division in exercising adequate management of the asset and liability profile of the company. Despite strategic plans evidencing the need for a formalised asset and liability system, the Board, the Managing Director, and senior management of the asset generating divisions, did not accord to this management responsibility of the company's affairs the priority it deserved. This in fact is given emphasis by the increasing risk arising from the significant growth and diversification of the business activity of Beneficial Finance. In this respect the Board, the Managing Director, and the Senior Management of Beneficial Finance, in my opinion, failed to adequately or properly supervise, direct and control the affairs of the company.
36.3.3 INTEREST RATE MANAGEMENT
36.3.3.1 Interest Rate Risk Management
The object of interest rate risk management is to minimise the risk of adverse interest rate movements whilst providing the opportunity to benefit from any favourable movement.
As with mis-matches in the maturity profile of assets and liabilities, it is impossible to exactly match the interest rate profile of assets and liabilities. Throughout the period under investigation the Treasury division deliberately ran a gap in the interest rate profile of assets and liabilities with a view to making a profit.()
The evidence before this Investigation suggests that, until 1991, the strategy of running an interest rate risk was never formally approved by the Beneficial Finance Board. An interest rate risk had been run by the Treasury division prior to Mr Baker's appointment as Managing Director of the company, and this continued after Mr Baker became Managing Director. Mr Horwood would discuss with Mr Baker some of the larger risks that were being taken and obtain his approval.() Mr Horwood in evidence stated that:
"John [Baker] largely tended to operate in a sort of a collegiate way and he left it to the individual operator almost to determine that sort of thing. You would take as big a risk as you felt was appropriate. And provided you won, I guess that was all right. And until 1989 I must say that the data was reasonably rough and to have actually have attempted to quantify it or to have tried to limit it might have been fairly difficult." ()
This reinforces Mr Horwood's earlier evidence that:
"It was difficult to have limits on interest rate risk management when we did not have sufficiently good data to know exactly where we were."
Mr Horwood also added that he did not think that:
"Interest rate risk management was something which the Board knew much about or indeed showed a great deal of interest in."
Mr Baker has disputed Mr Horwood's evidence. He submits that he and Mr Horwood had agreed that the interest rate mis-match should be limited to 10 per cent, and that this policy was understood by the Board. Members of the Board have also submitted that they sought to understand the Company's management of interest rate risk.
Until 1991, Mr Horwood was left with a very wide discretion to run an interest rate risk. I have formed the conclusion that the taking of such a risk was not formally authorised by the Board. The general strategy that Mr Horwood took, however, was approved by Mr Baker.()
In April of 1991, Special Submission No 332, on interest rate risk management, was presented to the Board. That submission acknowledged that interest rate risk management had been the responsibility of the Treasury division. The submission continued:
"The company is now in a position to more accurately measure the interest rate risk profile. Currently, there are no approved limits to which current IRRM must conform. This submission seeks to remedy that shortcoming."
That submission recommended detailed limits over various periods for the mis-match of the interest rate profile of assets and liabilities.
The fact that there was a gap in the interest rate profile was shown in various graphs in the Board Reports for many years prior to the introduction of the policy proposed in Submission 332. In addition, Mr Horwood would, from time to time, discuss this gap at Board meetings.()
The extent of the policy discretion left to Mr Horwood in managing the interest rate risk was, in my opinion, inappropriate. This opinion should not be viewed as a direct criticism of Mr Horwood. The management of interest rate risk is one of the major risks that must be managed in the operations of a finance company. For the Board and the Managing Director not to formally direct the limits of permissible risk in this area of operations is, in my opinion, to fail to provide the supervision, direction, and control, that would be expected. In this context, I am in agreement with Mr Hoogland, who gave evidence that a prudent financial institution in a deregulated financial market should have had a policy limiting the extent of this risk.()
The limitations of the financial reporting systems and the lack of information provided from the asset generating divisions to the Treasury division meant that the extent of the interest rate risk could not be accurately measured.
Between the period 1987 and the introduction in 1991 of the policy presented in Submission 332, interest rate risk was managed by the use of various financial instruments. These instruments, often referred to as "synthetics" and/or derivative financial instruments, enabled Beneficial Finance to change the interest rate profile and reduce the associated exposure. Such instruments are now widely used in treasury operations of financial institutions to protect certain types of assets. The instruments used included interest rate swaps, forward rate agreements, and options.
Mr Horwood gave evidence that:
"... The techniques used by Beneficial were to, through models, calculate repricing data on both assets and liabilities, and then use derivatives or synthetic instruments such as swaps, options, futures or swaptions, which is a combination of swap and option, to bring the interest rate risk on the portfolios to a desired position. That desired position may not necessarily have been one where all of the interest rate risk is nullified, but it was a position that the Treasury was prepared to run against their expectations of interest rates in the future, and the Treasury profit then derived largely from the additional net interest income which might result from movements in interest rates which were subsequently covered by those instruments." ()
Mr Hoogland gave evidence to this Inquiry that:
"The lack of information coming from the lending divisions referred to earlier made the task of interest rate management difficult. But with the better flow of information brought about by the introduction of the Asset and Liability Committee and the Chase BRMS [Bank Risk Management System] System the ability to measure and monitor the interest rate gap gradually improved. By using the Chase BRMS System the Treasury was able to determine the volatility of the asset portfolio to changes in interest rates as opposed to the volatility of liabilities to changes in interest rates and measure the profit impact that would occur at different levels of interest rates. This was an ongoing development from 1988. Prior to the introduction of the Chase BRMS System the knowledge of the volatility of the asset side was not nearly as sophisticated." ()
36.3.3.2 Determination of Interest Rates
The responsibility to determine the price at which borrowings were raised lay principally with Messrs Horwood and Hoogland, who set pre-determined guidelines for relevant terms. These guidelines were determined once a week, and transmitted to the fund managers located interstate. The Treasury staff and fund managers would then work within these guidelines. The funds manager in each of the branches had some discretion in setting rates on small retail transactions up to $0.25M. The discretion was generally in the order of 0.25 per cent for long term supporters of Beneficial Finance. Large facilities were negotiated by Mr Horwood, with formal authorisation's being obtained from the Beneficial Finance Board only where the lender required evidence of Board approval.
The Treasury division determined the price it would pay for funds of a particular maturity having regard to the yield curve appropriate to the term of the debt together with the margin above Bank bill rates normally paid by Beneficial Finance. Beneficial Finance was prepared to pay a higher rate of interest on longer term borrowings. For retail debentures, the price was set by Mr Horwood and approved by the Beneficial Finance Board after consideration of competitors rates and yield curve factors.
Until the introduction of the cost of funds system in 1990, the company did not have a mechanism for communicating to its lending divisions the actual cost of funds applied to particular transactions. Instead, pricing bulletins were published periodically which set indicative lending rates. Rates contained in the bulletins were set having regard to market rates, and did not necessarily reflect the cost of funds to the company.
With the introduction of the Cost of Funds system in 1990, the Treasury division suggested pricing parameters to the lending divisions for almost every lending deal.()
It is the submission of Mr Chakravarti and Mr Baker that the profitability of transactions was considered, and was the subject of analysis, by company officers. This analysis was, however, based on an assumed cost of funds reflecting the company's historical experience in fund raising. Until 1990 this analysis was inadequate as it was not based on timely cost of funds information.
The Cost of Funds system had two important roles, ie:
(a) It enabled a reliable notional divisional profit to be attributed to Treasury by means of transfer pricing.
(b) It enabled Beneficial Finance to accurately measure whether particular lending transactions were profitable or not by reference to a reliably determined cost of funding the transaction. Before that time, the profitability of specific transactions could only be assessed by performance of the ad hoc analysis of the costs of the transaction. While this approach was barely acceptable for a company operating in a steady market where funding costs did not change, it was inadequate for a company faced with difficult market conditions and a rising cost of funds. Mr Baker submits that, at all times, the margins achieved by the company were sufficient to ensure its profitability.
"It [the Cost of Funds system] was really more valuable to the company - not so much Treasury but the company to simply point out where transactions were being done at no profit or at a loss as I am sure occurred at times and so on." ()
It is difficult to understand why the Board, the Managing Director, and senior management, did not, during the period of exceptional and unplanned growth (ie period of high risk/exposure), establish a process that ensured that it was known whether a particular lending transaction was or was not profitable by reference to the actual cost of funding the transaction. Such a process would have provided to those parties responsible for policy and business direction setting, valuable information that may have served as a check on the general or specific lending policy adopted and particular lending transactions undertaken.
I am of the opinion, for the reasons stated in this Chapter, that the Board, the Managing Director, and senior management failed to adequately or properly supervise, direct, and control the management of lending transactions in that they did not ensure that there were adequate procedures in operation to determine the profitability of lending transactions that were entered into by Beneficial Finance.
36.3.4 FOREIGN EXCHANGE RISK MANAGEMENT
Beneficial Finance had a policy of not accepting any exchange rate risk. If any foreign exchange transaction was negotiated, the debt was converted by the use of cross currency swaps into Australian Dollars in an exchange rate risk free way. Notwithstanding this policy, on three occasions prior to 1986, the Treasury division entered into transactions in the cross-currency swap market in which the exchange rate risk on the principal was removed, but some exchange rate risk on a proportion of the continued interest was not.
The Beneficial Finance Board was aware, in these three isolated instances, that some exchange rate risk was not covered. Having regard to the dollar amount involved this position was justifiable.
I have not become aware of any information which suggests that Beneficial Finance has sustained losses during the period under the investigation, as a consequence of the way in which this risk was managed.
36.3.5 THE TREASURY DIVISION AS A PROFIT CENTRE
The concept of the Treasury division as a profit centre in its own right was developed during the period covered by this Investigation. Commentary has been included here for the purpose of completeness, and to provide a better understanding of how operations within the Treasury division changed and progressed in overall effectiveness over that period of time.
The 1987-1992 Corporate Strategic Plan stated that Beneficial Finance's Treasury division was to be a profit centre in its own right. It was proposed that the division act as an in-house banker providing matched term funds to the retail and corporate divisions on a pooled or marginal basis. This never occurred. Unlike the Bank's Treasury, the Treasury division never operated as an in-house bank.
It was not until 1987 that the Treasury division was recognised as a profit centre. Mr Horwood had been proposing that the Treasury division be recognised as a profit centre for some time. He believed that, in this way, the contribution of the Treasury division could be properly assessed.
In Mr Horwood's view, a proper transfer pricing system was essential if divisional profits between the lending and borrowing divisions were to be meaningful.()
Transfer pricing is an accounting process by which the divisions within a finance company that use funds are debited with the notional cost of funds. That cost would include the interest cost, and might also include an allocation of the cost of the company's infrastructure or overhead expenses. The process requires the arbitrary determination of the transfer price regarding such elements as apportionment of the overhead. For that reason, both the use of the transfer pricing system, and the extent of the cost that is attributed to the funds by the application of the system, can be controversial. To the extent that the operating divisions are required to pay for the funds that they use, there is a reduction of their profits. The Treasury operation of a finance company is, by the process of transfer pricing, credited with a fee for providing a service, namely, the provision of funds to the operating division. For the reasons that I have discussed in Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" of my first Report, I am of the view that transfer pricing is essential to properly assess the relative contributions of the various divisions in a finance company. Mr Horwood gave evidence that:
"If you are to have a meaningful profit centre, both lending and borrowing, you must have a proper and meaningful transfer pricing system." ()
Prior to the introduction of the cost of funds system in 1990, a basic transfer pricing system was used. Lending divisions were charged with the cost of funds determined by using an indicative market rate, plus a margin, which approximated the margin Beneficial Finance paid over the market rate when borrowing. It is Mr Horwood's evidence that the transfer pricing rate approximated the Company's borrowing rate for domestic fund raising and that at times the Company was able to borrow at a lower cost of funds particularly from offshore markets. In addition to recovering interest costs, the transfer pricing arrangements recovered certain direct costs incurred by the Treasury including transfer fees, brokerage charges, and prospectus expenses. This arrangement did not, in my view, meet the Company's requirements for a soundly based transfer pricing system because the cost of funds was not accurately reflected in the transfer price.
The introduction of a reliable transfer pricing system within Beneficial Finance was, in my view, essential to enable the actual cost of funds to be reflected in lending rates, and to more accurately assess the contributions to profit made by the various divisions within the company.
The failure to implement an effective system of transfer pricing until 1990 meant that Beneficial Finance, prior to that date, was not in a position to assess the effectiveness of its funds allocation, and to price its loan products. In my opinion, this was particularly important where the Company's financial standing, and its cost of funds, was subject to change. It is axiomatic that it is not possible to determine the profitability of a lending transaction unless the company knows the total costs of the funds which it is providing to its customers.
The reliability of divisional profit reports within Beneficial Finance was uncertain. One problem lay in the difficulty of attributing a profit on funds raised to the Treasury division. The adjustments made were arbitrary, especially prior to the introduction of the Cost of Funds system and consequently were the subject of disputes between the different divisions. As a consequence, continual adjustments were made to the monthly divisional profit figures. There is, however, no reason to suspect that the operations of the Treasury division were not conducted in a profitable manner.
The transfer pricing arrangements implemented by Beneficial Finance did no more than allocate the costs incurred by the Treasury division in obtaining funds, to the lending divisions. This enabled a basic calculation of the profitability of the lending divisions to be made and provided recognition that the Treasury contributed to the profit earned by the Company through its lending activity. The arrangements did not provide a capacity to measure and report upon any profit arising from dealing activity by the Treasury or by its interest rate mis-matching of assets and liabilities. Any profit or loss arising from such activity was reflected only in the Company's profit and loss accounts.
36.3.6 THE CALCULATION OF THE MONTHLY BORROWINGS EXPENSE FIGURE
The calculation of the monthly borrowings expense figure was the responsibility of Mr T D Auld, the Treasury Accountant. The monthly borrowings expense figure represented the actual interest expense incurred by Beneficial Finance each month. The monthly calculated figure directly affected the monthly reported company profit. The higher the borrowing expense figure, the lower the company's profits.
The borrowings expense figure was calculated by Mr Auld by looking at the actual cost of funding deals from one month to the next, and identifying the interest payments that had been made in that period. This figure was manually calculated by Mr Auld from information available on the registry system and other supporting records.
As a check on the actual figure, Mr Auld would estimate the borrowings expense for that month by using an averaged interest figure from the registry system. Not unexpectedly, there would, on occasions, be a discrepancy between the average figure and the actual figure.() Furthermore, there were occasions when the difference between the supposedly true figure and the average check figure was substantial, and could not be easily explained.
The actual borrowings expense in a typical month was approximately $25.0M. The variations that were experienced were in the order of $0.2M. As a percentage of the monthly borrowing expense figure, this was looked upon by Mr Auld as not being a particularly large variation. It was, however, a significant variation in the context of the monthly profit reporting of Beneficial Finance.()
This variation made it difficult for the company to compare its profitability on a month by month basis. The borrowings expense figure was a major expense within Beneficial Finance.()
Mr Auld concedes that, even after revising the monthly borrowings expense figures, he could not always feel comfortable that the figure was absolutely correct. He was confident, however, that the figure was within approximately 1 per cent of the correct figure. That difference, was not insignificant with respect to the monthly reported profits of Beneficial Finance.()
I have identified three causes of the difficulties in calculating the monthly borrowings expense figure.
Firstly, insufficient time was given to Mr Auld to calculate the figure. In late 1988, at the direction of Mr Chakravarti, and to meet State Bank Group reporting deadlines, it was decided that the monthly profit reports would be prepared three working days after the end of the month. Previously, they were prepared twenty working days after the end of the month. As a result, the Treasury division was required to provide the monthly borrowings expense figure on the second working day of the month. The information that was required to calculate this figure could not be obtained from the registry system until, at the earliest, the afternoon of that day. The requirement for the figure to be calculated at such an early stage was the subject of some dispute between the Treasury division and the Accounting division.()
Secondly, in view of the time constraints, and the fact that the calculations were manual and of a complex nature, it was important to have an experienced and senior officer such as Mr Auld perform the calculations. In light of his other responsibilities, it was understandable that delays occurred from time to time in finalising the figures.
For a substantial part of the period under investigation, Mr Auld was solely responsible for the calculation of the borrowings expense figure. If more staffing resources had been directed towards this area to assist Mr Auld, it is possible that the figure would have been more timely, and more accurate.()
Thirdly, the registry system was inadequate to provide the information within the time constraints imposed. Although the necessary information was on the registry system, a great deal of the work necessary to produce the figure was undertaken manually. Accordingly, the calculation of the figure was prone to subjective judgment and error.
The introduction of a system that amongst other things, could have assisted with this calculation may have prevented the difficulties which arose.()
The difficulties with the monthly borrowings expense figure caused some friction between the Treasury and Accounting divisions. At one stage, the Accounting division suggested that responsibility for the function should be transferred from the Treasury division. Mr Horwood rejected that suggestion.()
On occasions, due to the difficulties in accurately calculating the expense figure within the required time, the "estimated figure" was used for monthly profit reporting purposes.()
The problems with respect to the calculation were gradually improved by the introduction of the Econintel system throughout 1989 and 1990.()
I am of the opinion that the situation in relation to the calculation of the monthly borrowing expense was a significant administrative defect in the reporting requirements of Beneficial Finance. I am further of the opinion that, it was inappropriate to use the estimated averaged figure in the monthly profit reports. The reported monthly trading results were potentially erroneous.
The evidence before me in this matter is illuminating. It shows that Senior Management were prepared to accept a risk of significant misstatement of a key performance measure and thus the supply of unreliable information to the Board. It demonstrates their inability to rise above their own division's interests to ensure that the overriding requirements of the company as a whole were met.
36.3.7 THE MANAGEMENT STRUCTURE AND STAFFING OF TREASURY
During the period covered by the Investigation, Mr Horwood held the most senior position in the Treasury division. His title changed as follows:
|
Date |
Title |
|
29 June 1981 |
Treasurer |
|
1 July 1988 |
Chief General Manager, Treasury and Capital Markets |
|
1 May 1990 |
Executive Director, Treasury and Capital Markets |
Organisation charts, available from July 1988, indicated the following changes to the structure:
|
Effective Date |
No of Staff |
Direct Reports to Mr F R Horwood |
|
1 July 1988 |
10 |
Assistant Treasurer |
|
Treasury Accountant |
||
|
Funds Manager |
||
|
||
|
||
|
||
|
||
|
Funds Officer Queensland |
||
|
1 May 1990 |
N/A |
Registry Manager |
|
Debentures Sales Manager |
||
|
Treasury Accounting (Senior Manager) |
||
|
Treasury (Chief Manager) |
||
|
Liquidity Manager |
||
|
Funds Manager |
||
|
||
|
||
|
22 May 1990 |
32 |
Manager Registry Services |
|
Senior Manager Treasury Administration |
||
|
Senior Manager Retail Funding |
||
|
Funds Manager |
||
|
||
|
||
|
Manager Liquidity Management |
||
|
Chief Manager Treasury |
||
|
November 1990 |
31 |
Manager Registry Services |
|
Senior Manager Treasury Administration |
||
|
Senior Manager Retail Funding |
||
|
Funds Manager |
||
|
||
|
||
|
Manager Liquidity Management |
||
|
Chief Manager Treasury |
||
|
Manager Treasury Systems |
||
|
1 May 1991 |
38 |
National Funds Manager |
|
General Manager product Development |
||
|
Manager Treasury Systems |
||
|
Chief Manager Treasury |
The organisational charts were confirmed as correct by Mr Hoogland and Mr Auld.()
For most of the period under investigation Mr Horwood, Mr Hoogland, and Mr Auld, held senior positions in the Treasury division. Mr Hoogland held various titles including Assistant Treasurer in 1988, and Chief Manager Treasury in 1991. Mr Hoogland was responsible for the management of many of the features of liquidity risk, interest rate risk, and foreign exchange risk, of Beneficial Finance. Although he was subordinate to Mr Horwood, as the company grew, more of the larger transactions were personally handled by Mr Hoogland.()
Mr Auld's titles included Treasury Accountant and Senior Manager Treasury Administration although his duties and responsibilities remained fairly much the same throughout his time in the Treasury division. Mr Auld was responsible for all the Treasury accounting type functions, including the recording of all Treasury division `deals', and all the swaps, including cross currency swaps. He was responsible for the preparation of prospectuses, the advertising of the same, and the day to day administration of the Treasury division. He was also responsible for calculating the monthly borrowing expense figure.()
The Funds Managers were located in the various State branches, and reported direct to Mr Horwood. They had responsibility for raising retail funds in their respective States under the direction of the Treasury division. Retail funds generally covered transactions of less than $0.1M of a straight forward nature. The managers in Victoria, and New South Wales, also had responsibility for raising funds in the wholesale markets.()
Funds Managers were located interstate to improve Beneficial Finance's access to funding sources and major brokers. This was done by creating personal contact with the brokers and taking steps to enhance the company's credibility in those States.
The retail funds manager, Mr C Matthews, was based in Melbourne. He was responsible for managing fund raising, and, in particular, for seeking support for Beneficial Finance's prospectus issues in the eastern States. For large transactions, or for retail deposits, Mr Matthews had a limited discretion as to the setting of interest rates. Generally rates were set and advised to him every Monday by the Adelaide office.()
Prior to 1988, the structure of the Treasury division was relatively simple. The majority of positions reported directly to Mr Horwood. As the Beneficial Finance Group expanded and the Treasury division became more sophisticated, additional positions were created. At 1 May 1990, managers for registry, debenture sales, and liquidity management were appointed. At 22 May 1990, fourteen staff reported to the Manager Registry Services. In November 1990, the Manager Treasury Systems was appointed as a result of a policy decision to decentralise system staff into operational areas, including the Treasury division.
In my opinion, insufficient resources were put into asset and liability management and the obtaining of accurate information for that purpose. As a result, there was an element of "guess work", particularly in managing the interest rate risk.
The need for more staff to assist Mr Auld and to manage the interest rate risk, was exacerbated by, and in part caused by, the deficiencies in the asset and liability systems within the company. Systems deficiencies have been commented on in earlier sections of this Chapter and are discussed in more detail below.
36.3.8 SYSTEMS, POLICIES AND PROCEDURES WITHIN TREASURY
A Treasury division requires adequate systems, policies, and procedures, to manage and control the operation of the division. The normal process for their development is for recommendations to be presented by management for the consideration, and if appropriate, approval of the Board.
36.3.8.1 Systems
Beneficial Finance's Treasury division used several major computer systems throughout the period under this Investigation.
The registry system was an old system which was developed `in house' in the 1970's, Mr Horwood having designed a significant part of it. The registry system was the single system which carried details of all the retail liabilities of Beneficial Finance, including the volume of liabilities, interest rate on the liabilities, and maturity dates of the liabilities. The system was adequate for the purposes for which it was being used, but it was difficult to program and adapt to changing circumstances. It did, however, adequately provide for the retail side of Beneficial Finance's liabilities.()
The Chase Bank Risk Management System was an asset/liability interest rate risk management system. It was purchased in November 1987. The system provided for the analysis of different interest rate scenarios on the lending and borrowing profiles. It allowed a more sophisticated approach to interest rate management. It was developed through the late 1980's, and by the end of 1990, was in a position to provide useful information. It could not, however, be relied on even at this late stage to provide an exact analysis. It provided a facility that the Treasury division previously did not have. The system was used by over 50 per cent of industry participants. It took Beneficial Finance a considerable time to develop this system to its fullest potential.() The effectiveness of the system depended, to a large extent, on the integrity of the information from the Finance Receivables System. It also required a high level of manual manipulation of data to convert that information into the required form. This led to the potential for further error, and an unacceptable delay between the reporting date and the availability of position reports relevant to that date.()
A Compas software package was acquired by Beneficial Finance in 1987 to process standard money market transactions, and to calculate interest on borrowings. It was unable to process more complex multi-currency deals arising from overseas transactions. As a consequence, a combination of manual and computer systems were used to monitor and record these dealings. By 1989, the system became unsuitable because of the volume and complexity of deals being processed.()
In June 1989, the Econintel system was purchased as a replacement for the Compas system. Econintel was able to process a wide range of Treasury transactions including standard money market deals, multi-currency swap transactions, and futures. The system was purchased to assist in the level of information available for asset and liability management. It did not perform as satisfactorily as had been hoped by Mr Hoogland and Mr Horwood. It was undoubtedly an improvement on the Compas system. With the benefit of hindsight, it may have been better if a different asset/liability system had been purchased. One consequence of purchasing the Econintel system instead of an alternative was that it took a longer time for the system to become properly operational. Another consequence was that additional time and expense had to be committed to develop the system.()
The Cost of Funds system was developed in-house, and installed on 1 July 1990. It was designed to provide an accurate and realistic cost of funds charge between the Treasury division and all other Beneficial Finance divisions. Thus it enabled the calculation of transfer pricing on individual transactions. The transfer price used for Treasury division purposes was based on market interest rates, adjusted for Beneficial Finance's margin paid to the market, and a small margin representing the Treasury division's direct costs such as brokerage fees, transaction charges, and prospectus expenses. The system enabled the accounting division to calculate transfer prices more accurately. As discussed previously, it enabled the lending divisions to accurately identify the cost of their funds. The introduction of such a system at an earlier time would have assisted significantly by making known to the lending divisions the cost of funds.
Although the technology available for Treasury management during the period under investigation was limited, in my opinion, the use made of the systems that were available was less than effective. The evidence before the Investigation is that higher priority was given to developing systems required by the asset creating divisions than was given to systems required by Treasury and for effective assets and liability management. In my opinion, the Board, senior management and the Treasury division should have recognised much earlier than it did the need for better information to manage the interest rate risk and further, should have acted sooner to implement the Chase Bank Risk Management System. Further, if closer attention had been given to the Econintel system it may have been developed more fully and been more useful at an earlier time.()
The Group Audit report of Beneficial Finance Treasury, dated 13 March 1991, for the period 29 October 1990 to 10 January 1991, rated the Treasury systems as "satisfactory", given the introduction of the Econintel system.()
In my opinion, for the reasons stated in this Chapter, the systems in use in the Treasury division throughout the period under investigation were inadequate. I find that this was as a result of the emphasis by Beneficial Finance on the lending side of its business, and the lack of attention given to the development of appropriate systems for asset and liability management. The purchase of the Finance Receivables System is an example of the implementation of a major and costly system without its functions having been adequately assessed against the important information needs that were required to be serviced. As in the case of the Bank, the improvements that were made to systems used by the Treasury division were initiated by the Treasury division. The Treasury division carried the burden of the development of these systems.
Mr Baker has submitted that steps were taken to ensure Treasury systems requirements were met. He recalls that development of the Econintel and cost of funds systems were given high priority by the systems department. While his submission is not disputed, it does not go to the central point of concern which is that the information requirements of the company, specifically the cash flow forecasting, and asset and liability management functions, required reliable and timely information which could only come from asset management systems. The evidence is that the main asset management system, ie Finance Receivables System, did not adequately meet these information needs.
In my opinion, it was incumbent on the Board, the Managing Director, and the senior management, to ensure that adequate systems were in place that would provide timely and reliable information for effective asset and liability management. The Board, the Managing Director and senior management, in my opinion, failed to adequately or properly supervise, direct, and control the affairs of the company with respect to this critical aspect of good financial management practice.
36.3.8.2 Policies and Procedures
It is a matter of prudence and sound administrative practice that organisations should formalise their policies and procedures.
Documentation of policies and procedures in the Treasury division was limited. Successive Internal Audit Reports concluded that the documentation was not sufficient, and that there was an unacceptable level of reliance on the knowledge, memory, and ability, of individual staff members.() It was fortuitous, that during the entire period of the 1980's, Mr Horwood was available to provide the "institutional memory" in this important area of Beneficial Finance's operations.
Although a policy manual for the registry area was developed over time, it was not as comprehensive as was necessary for staff to understand the procedures that were required in the administration of this important area. ()
The operations of the Treasury division would have been improved if a formalised and updated policy and procedures manual had been in existence at the time that a new product or system was introduced. This was only done with respect to the Econintel system.()
An adequate Treasury division manual was never created. Treasury division embarked on the creation of such a manual in 1990, but it was never finished. Mr Horwood conceded that it was desirable that there should have been a formal policy manual in place.()
I am of the opinion that criticism of the lack of documentation of policies and procedures in the March 1991 Group Audit Report was justified.() As the Executive responsible for the Treasury, Mr Horwood can be adversely criticised for failing to ensure that procedures were appropriately documented; that policies and procedures were permitted to "drift" without the firm direction of the Board and the Managing Director, is also a matter that warrants adverse criticism.
36.4 ASSET AND LIABILITY COMMITTEES
The importance of the existence of an asset and liability committee has already been discussed. In a memorandum to the Bank Board, dated 28 June 1984, with respect to the establishment of such a committee, Mr Clark said:
"Of vital importance to the new Bank is the management of an interest spread - the difference between what we pay for our money and what we had lent it at.
Equally important is the management of the asset and liability side of our balance sheet to see that the Bank is safely funded and safely invested.
To oversee the task it is recommended that we appoint an asset-liability management committee ..."
I have also referred in Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" to a paper presented to the asset and liability management steering committee in 1988 by Mr L Fusco and Mr P Takos. That paper commented that:
"As ALM [Asset & Liability Management] is of such importance and has such wide ranging ramifications it is essential that the senior executives have the major role in the ALM decision making process and thus form the basis of our Almac [Asset & Liability Management Committee]."
Mr Horwood also gave evidence to this Inquiry of the importance of an appropriate asset and liability committee, and, in particular, the importance of senior management playing its part. Mr Horwood gave evidence that:
"It [the Asset & Liability Committee] was our attempt to try to get the whole company involved in this process. I would have to say that it did fail because we could never get the people ... Eric Reichert I know never attended once. I do not think Manob Chakravarti did. John Baker never attended once and so on ... it lacked the teeth that it really needed." ()
Mr Horwood continued:
"These things are a waste of time unless they involve everyone and they have real teeth ... because really, they should control the entire business collection of the company." ()
Mr Baker has submitted to the Inquiry that he was ex-officio a member of the Committee, that he received copies of minutes of meetings, and that he discussed the minutes with Mr Horwood from time to time. In my opinion, this was not sufficient, and it was important for Mr Baker to have attended meetings of this vital Management Committee.
An asset and liability committee was first formed within Beneficial Finance in approximately 1980. This committee was mainly concerned with the setting of interest rates. When Mr Baker became Managing Director of Beneficial Finance in 1982 the asset and liability committee was disbanded at Mr Baker's direction. Mr Horwood gave evidence that Mr Baker was not a "fan" of asset and liability management. This was a move that Mr Horwood disapproved of, and that he vigorously pressed with Mr Baker.
From that time until 1985 there was no formal or informal asset and liability committee within Beneficial Finance.()
A formal asset and liability management committee was not re-established until August of 1988. According to Mr Horwood, in the period between 1985 and 1988 asset and liability management was discussed at executive committee meetings and other meetings.() Mr Horwood's comments are supported by Mr Baker, who submits that the abandonment of the Asset and Liability Management Committee was associated with the Executive Committee's taking over responsibility for overall asset and liability management.
In my view, the allocation of responsibility for asset and liability management to Executive Committee, and the manner in which the Executive Committee discharged this responsibility, was inappropriate. This view reflects my belief that the asset and liability management function was of such importance that it should have been given a very high profile in the management of the company's business.
The 1988 asset and liability management committee was known by the acronym "ALAC".
This asset and liability committee did not manage the assets and liabilities of the company in the true sense. It was, in essence, a committee which was led by Treasury, and dealt with Treasury matters.()
This asset and liability committee did not deal with the asset structure of the company. In particular, it did not deal with the portfolio mix of the company. Accordingly, it did not deal with the over-exposure of the company to the property market, and to transactions that were characterised by poor cash flow and the capitalisation of interest. Mr Horwood has given evidence that a properly constituted asset and liability committee would have dealt with such matters and I accept that, and agree. In any event, as I have already commented, the evidence before this Investigation is that the systems adopted within Beneficial Finance throughout the period of investigation were not sufficient to provide adequate information of the portfolio risks that existed, and the consequences of not managing those risks.
The asset and liability committee of Beneficial Finance met separately from the rest of the Bank Group. I accept Mr Horwood's evidence that the asset and liability management of Beneficial Finance ought to have been considered in terms of the various risks to the entire Bank Group. Mr Horwood gave evidence that:
"It is the Group risk which you had to look at and perhaps sort of highlights why separate ALAC committees made little sense unless they were reported through the same group which looked at the totality of everything."()
The members of the asset and liability committee were the Chief General Manager - Treasury, the General Managers of the Northern and Southern Business divisions, the Director - Business Development, the Chief Manager - Strategic Development, the Manager Corporate Planning and Budgeting and the Asset/Liability officer. The constitution of the Committee changed over time.
A charter for the committee was developed at the first meeting.()
The Charter of the Committee began in the following way:
"The function of the ALAC Committee is to manage, by co-ordination, recommendation or direction where appropriate, the interest rate, liquidity, foreign exchange and capital adequacy risk of Beneficial's asset and liability portfolios, both on and off balance sheet, to optimise the risk/return/liquidity trade off in a volatile interest rate market."
The Charter then set out a number of individual functions that the committee was to perform. The principal achievement of the asset and liability committee was that it enabled the Treasury division to raise the status of asset and liability management within Beneficial Finance.()
Meetings were held monthly with regular reports provided from the Treasury and lending divisions. Such reports included interest rates scenarios, new funding opportunities, detailed structure of liabilities, liquidity analysis, economic data, forward lending commitments, and current pre-payment levels.
In late 1990, the asset and liability committee ceased to meet. This has been attributed to the crisis facing Beneficial Finance at that time.
"When the management of the Company [Beneficial Finance] really reverted to being just a crisis management of survival there was essentially no new lending occurring and more particularly where we had very little input into the mix of borrowings we were able to access, where more of Treasury's time was spent in reassuring lenders to Beneficial and other financial institutions who had a financial stake in Beneficial I think at some stage in there the committee just stopped meeting." ()
After the asset and liability committee stopped meeting, its functions continued in the Treasury division.()
On the basis of the evidence before me, I am satisfied that at no time during the period under investigation, was there any person or body responsible for the overall management of Beneficial Finance's assets and liabilities. The focus of the ALAC Committee in the period 1988-1990 was directed to the matter of liability management. By default, the Treasury division and Mr Horwood were left to attempt to manage the assets and liabilities of the company as best they could. As stated above, for some of the period under investigation an asset and liability committee was in existence, but all the evidence tends to the conclusion that this committee was Treasury led, and considered issues that were directly related to Treasury functions.
I am of the opinion that the Board, the Managing Director, and senior management, did not take adequate steps to ensure that:
(a) an appropriate body existed, at all times, with overall responsibility for the management of assets and liabilities of the company; and
(b) that appropriate systems and procedures were in force to provide timely and reliable information to allow for proper management of the assets and liabilities of the company.
36.5 CONCLUSIONS WITH RESPECT TO ASSET AND LIABILITY MANAGEMENT AND TREASURY OPERATIONS
Beneficial Finance underwent significant growth during the period covered by this Investigation. The extent and implications associated with this growth, (which included diversification in the lending activities and the funding responsibilities), required that appropriate emphasis be accorded by the Board and the senior management to the critical task of asset and liability, liquidity, interest rate risk, and systems, management matters.
The Board of Directors, the Managing Director and senior management of the asset generating divisions failed to recognise the need for a co-ordinated high level approach to these matters within Beneficial Finance. Rather, their attention and effort was directed to growing the business. During the period under investigation there was no specific person or organ within the company that, at all times, had responsibility for the overall management of asset and liability, liquidity, interest rate risk, management of the company. The Treasury division of Beneficial Finance, undertook, by default, many of the aspects associated with this management task. Although a formalised asset and liability committee was established, at certain times during the period under investigation, it had, as its focus, Treasury related matters, and was not concerned with overall asset and liability, liquidity, interest rate risk, and systems management.
Without the active support of the Managing Director and the senior managers of the asset generating divisions, effective management in these matters was extremely difficult. The absence of active support for Mr Horwood and the Treasury division was evident in the fact that critical information requirements were not met by the Company's major systems nor by provision, on a timely basis, of reliable information by Lending divisions. As a result, the overall requirements of the Company for co-ordinated management of critical areas were neglected. Some of these matters, as noted in this Chapter, can be stated in summary form as follows:
(a) The ability of the Treasury division to prepare short and long term cash flow forecasts was limited. This hindered effective liquidity management, resulting, on occasions, in excessive funding costs.
(b) Treasury division did not have access to appropriate systems or information regarding the asset structure of the company to enable it to adequately manage the mis-match of the maturity profile of the assets and liabilities, or the interest rate risk, associated with the assets and liabilities.
(c) Prior to the introduction of the Cost of Funds system in 1990, the profitability of the asset generating divisions, and individual lending transactions entered into by those divisions, could not be reliably measured.
(d) Problems were encountered in calculating the monthly borrowings expense figure, and this adversely affected the reliability of the monthly reported profit position.
The management of interest rate risk requires specific comment. For the reasons stated in this Chapter, in my opinion, the Board of Directors of Beneficial Finance, and, in particular, the Managing Director, Mr Baker, failed to adequately or properly supervise, direct, and control, the affairs of the company with respect to this matter in that they did not provide direction regarding, the limits of permissible risk, this being a major matter that must be managed in the operations of a finance company.
As part of the natural justice process, it was put to Mr Baker that he demonstrated a degree of indifference in dealing with these matters. In response he has submitted he was not indifferent, and, in support of his contention he has listed a number of steps that he took, overtime, to contribute to effective Treasury management, and to systems development in particular. I accept that he did the things he says he did, but I find, nevertheless that, by the actions he took, and actions he failed to take, he created an environment within the company that empowered asset generating divisions to ignore the demands for information to meet asset and liability management requirements, and failed to ensure that the needs of the Treasury division were met. Further, whilst accepting that Mr Baker's failings were unwitting, nonetheless I find that as Managing Director of the company, it was his responsibility to ensure that information needs and sound management practices which transcended the needs of individual divisions of the company (but were important to the welfare of the company as a whole) were met. In this respect in my opinion, he failed.
Mr Baker, as the Managing Director, was responsible for directing, co-ordinating and controlling his senior executives and the resources made available to them. He was also responsible for ensuring that relevant information was produced to him and the Board for the effective control of the assets and liabilities of the company. Mr Baker, in my opinion, failed to adequately or properly manage his responsibilities in respect of asset and liability, liquidity, interest rate risk, and systems management. This failure continued throughout the period reviewed by this investigation, despite concerns expressed to him by Mr Horwood concerning business growth, and the resource deficiencies that were inhibiting the ability of Treasury division to monitor that growth.
In reaching conclusions with respect to the conduct of the Non-Executive Directors, I have had regard to the specialist nature of Treasury management and the directors entitlement to rely, within reason, on management who were understood to have expertise in this area.
That the matters referred to above have contributed to the losses suffered by the company can be illustrated by the Board's response to the provision of cash flow information in May 1990. The Board Minutes of 25 May 1990 record that the cash flow projections as at 30 April 1990, "showed that only 56% of total assets were producing regular cash income". While this fact should, no doubt, have been brought to the Board's notice by a more direct measure, the fact is that it was evident from a cash flow report. This example illustrates the value of this asset and liability analysis in ensuring management and the Board had a full understanding of the business for which they were responsible. The provision of cash flow information to the Board at an earlier time may have enabled the Board to identify the Company's problem sooner and respond with the introduction of appropriate remedial action.
36.6 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
36.6.1 TERM OF APPOINTMENT A(a), (b) AND (c)
As has been stated in Chapter 7 - "The Management of Assets and Liabilities at the State Bank" of my first Report, it could not be said that the financial position of Beneficial Finance was directly caused by the manner in which the company managed its assets and liabilities, and conducted its Treasury operations. Nevertheless, for the reasons outlined in this Chapter, management and systems deficiencies in this area of the company's operations, when aggregated with other deficiencies examined in other Chapters of this Report, resulted in the financial position reported at February 1991. The asset and liability management, and the conduct of Treasury operations of the company were, in my opinion, contributing factors in the processes which led Beneficial Finance to engage in operations which resulted in losses and in the company holding non-performing assets as reported by the Bank and the Treasurer in February 1991.
For the reasons stated in this Chapter, I am of the opinion that during the period under Investigation, there was no overall co-ordinated and responsible management control exercised over the asset and liability, liquidity, interest rate risk, and systems management responsibilities of the company, and that the processes adopted with respect to the management of each of these matters were inappropriate.
36.6.2 TERM OF APPOINTMENT C
Having regard to Term of Appointment C, for the reasons stated in this Chapter, I am of the opinion that the operations, affairs and transactions of Beneficial Finance were not adequately or properly supervised, directed or controlled by the Board, the Managing Director, and senior management of the asset generating divisions, in that there was a failure to ensure proper supervision and control over the asset and liability, liquidity, interest rate, and systems management functions of Beneficial Finance.