VOLUME FOURTEEN BENEFICIAL FINANCE - THE ORGANISATION, ITS DIRECTION-SETTING AND PLANNING, AND THE MANAGEMENT OF CREDIT

CHAPTER 30
CREDIT AND ITS MANAGEMENT : GUIDELINES, POLICIES,
PROCESSES, PROCEDURES AND DELIVERY SYSTEMS

TABLE OF CONTENTS

30.1 INTRODUCTION
30.1.1 THE SUBJECT MATTER OF THIS CHAPTER
30.1.2 BENEFICIAL FINANCE'S CREDIT CREATION ACTIVITIES
30.1.3 THE INVESTIGATION METHODOLOGY
30.1.4 THE LOSSES REPORTED BY BENEFICIAL FINANCE
30.1.5 OVERVIEW
30.1.5.1 Introduction
30.1.5.2 Organisation of the Credit Risk Management Function
30.1.5.3 The Credit Approval Process
30.1.5.4 The Management of Diversifiable Credit Risk
30.1.5.5 Lending for Real Estate by the Core Businesses
30.1.5.6 The Non-Core Businesses of the Structured Finance and Projects Division
30.1.5.7 Participation in, and Funding of, Operating Joint Ventures

30.2 ORGANISATION AND STRUCTURE OF THE CREDIT RISK MANAGEMENT FUNCTION
30.2.1 POLICY-MAKING AUTHORITIES
30.2.1.1 The Board of Directors
30.2.2.2 The Credit Policy Committee
30.2.3 DELEGATED LOAN APPROVAL AUTHORITIES
30.2.3.1 Introduction
30.2.3.2 The Board of Directors
30.2.3.3 The Credit Committees
30.2.3.4 Individual Credit Approval Authorities
30.2.4 SUMMARY AND CONCLUSIONS

30.3 THE MANAGEMENT OF DIVERSIFIABLE CREDIT RISK
30.3.1 INTRODUCTION
30.3.2 CLIENT EXPOSURES
30.3.2.1 Prudential Policies
30.3.2.2 Monitoring of Large Exposures
30.3.2.3 Management of Large Exposures
30.3.3 INDUSTRY EXPOSURES
30.3.3.1 Prudential Policies
30.3.3.2 Monitoring of Industry Exposures
30.3.3.3 Management of Industry Exposures
30.3.4 SUMMARY AND CONCLUSIONS
30.3.4.1 Large Client Exposures
30.3.4.2 Exposure to Commercial Property

30.4 CREDIT RISK MANAGEMENT IN THE CORE BUSINESS DIVISIONS
30.4.1 CREDIT RISK MANAGEMENT POLICIES AND PROCESSES
30.4.1.1 Introduction
30.4.1.2 Initiation of Loans
30.4.1.3 Approval of Loans
30.4.1.4 Settlement of Loans
30.4.1.5 Management of Loans
30.4.2 APPLICATION OF THE POLICIES AND PROCEDURES IN PRACTICE
30.4.3 A CASE STUDY IN CREDIT RISK MANAGEMENT: STEMIN PTY LTD
30.4.3.1 Introduction
30.4.3.2 Initiation of the Facility
30.4.3.3 The Credit Submission
30.4.3.4 Approval of the Facility
30.4.3.5 Security
30.4.3.6 Settlement of the Facility
30.4.3.7 Management of the Facility
30.4.3.8 Summary and Conclusions in respect of the Stemin Facility
30.4.4 SUMMARY AND CONCLUSIONS

30.5 BENEFICIAL FINANCE'S "NON-CORE" BUSINESS: THE STRUCTURED FINANCE AND PROJECTS DIVISION
30.5.1 INTRODUCTION
30.5.2 THE BUSINESS ACTIVITIES OF THE STRUCTURED FINANCE AND PROJECTS DIVISION
30.5.3 CREDIT RISK MANAGEMENT POLICIES AND PROCEDURES
30.5.4 CREDIT RISK MANAGEMENT IN PRACTICE
30.5.4.1 Introduction
30.5.4.2 Initiation of Loans
30.5.4.3 Approval of Loans
30.5.4.4 The Structuring of the Facilities
30.5.5 A HINDSIGHT REVIEW BY BENEFICIAL FINANCE
30.5.6 SUMMARY AND CONCLUSIONS

30.6 BENEFICIAL FINANCE`S OPERATING JOINT VENTURES
30.6.1 INTRODUCTION
30.6.2 RESPONSIBILITY FOR MANAGEMENT OF BENEFICIAL FINANCE'S PARTICIPATION
30.6.3 THE INITIATION, FUNDING AND MANAGEMENT OF THE JOINT VENTURES
30.6.3.1 Initiation
30.6.3.2 Funding of the Joint Ventures
30.6.3.3 Management of the Joint Ventures
30.6.4 TERMINATION OF THE OPERATING JOINT VENTURES
30.6.5 A HINDSIGHT REVIEW BY BENEFICIAL FINANCE
30.6.6 SUMMARY AND CONCLUSIONS

30.7 FINDINGS AND CONCLUSIONS
30.7.1 BENEFICIAL FINANCE'S EXPOSURE TO REAL ESTATE
30.7.2 THE CORE BUSINESS ACTIVITIES OF THE GENERAL BUSINESS DIVISIONS
30.7.3 THE NON-CORE BUSINESS ACTIVITIES OF THE STRUCTURED FINANCE AND PROJECTS DIVISION
30.7.4 THE OPERATING JOINT VENTURES

30.8 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT
30.8.1 TERM OF APPOINTMENT A
30.8.1.1 Term of Appointment A(a)
30.8.1.2 Term of Appointment A(b)
30.8.1.3 Term of Appointment A(c)
30.8.1.4 Term of Appointment A(d)
30.8.1.5 Term of Appointment A(e)
30.8.2 TERM OF APPOINTMENT C

30.9 APPENDICES
A The Credit Policy Committee
B Credit Committee
C Credit Authority Limits
D Lessons Learned From Problem Loans
E Lessons to be Learned from Joint Ventures

30.1 INTRODUCTION

30.1.1 THE SUBJECT MATTER OF THIS CHAPTER

This Chapter reports the results of my examination of Beneficial Finance's management of the credit risk associated with its business operations between July 1984 and February 1991, the period covered by my Investigation. Simply stated, credit risk is the risk that a borrower will be unable or unwilling to repay its loan as and when it is required to do so. The management of credit risk encompasses the processes of initiation, approval, settlement, monitoring, and recovery of finance facilities provided by Beneficial Finance to its customers.

There are two distinct aspects of the credit risk faced by a financial institution that must be managed:

(a) The first is the risk associated with each particular loan, that the borrower will be unable or unwilling to repay the loan, and pay interest, as and when it is due.

(b) The second is the risk associated with the overall nature of the loan portfolio. A lender must ensure that the portfolio does not involve a concentration of risk upon particular borrowers, industries or geographic areas. If, for example, a large proportion of the portfolio is comprised of loans granted for use in commercial property development, then a downturn in the property market can have disastrous implications for the financial institution, as a large proportion of its borrowers will be unable to repay their loans. As I shall describe, that is precisely what occurred in the case of Beneficial Finance.

The management of credit risk is of fundamental importance to a financial institution like Beneficial Finance. A finance company faces a variety of risks in carrying on its business, including the risk of changes in interest rates, the risk of running out of cash (liquidity risk), and, usually, foreign exchange risk. In the end, though, credit risk is the most fundamental. It is the risk that, if realised, can most quickly and completely ruin the company.

The realisation of credit risk was the single most important cause of Beneficial Finance's contribution to the financial position of the Bank Group as described by the Bank and the Treasurer in February 1991. It lies at the very heart of my Investigation.

Although this Chapter is titled "Credit and its Management" and generally refers to loans, Beneficial Finance's risk exposures were often more in the nature of equity than debt. The distinction between equity and debt is not always clear, and was especially obscure in respect of Beneficial Finance's non-core business activities. Fundamentally, a lender expects to be repaid the amount of the loan, and to receive a set rate of return, called interest, as compensation or "rent" for the use of the money. The management of credit risk involves ensuring, so far as possible, that the lender will in fact be repaid, and receive the agreed rate of return. For an equity participant or owner, there are no such assurances. An owner enjoys the benefits, and runs the risks, of an asset going up or down in value, or of a business being successful or not.

Beneficial Finance's risk exposures that were intended to be loans often involved the equity risk of assets going up or down in value, and some equity investments were structured with the intention of ensuring an agreed rate of return.

The complex mix of equity and debt exposures was particularly present in Beneficial Finance's participation in joint ventures, where it both held an equity interest and provided the financial backing, if not the actual funding, for the venture. Beneficial Finance's participation in joint ventures is examined in Section 30.6 of this Chapter.

30.1.2 BENEFICIAL FINANCE'S CREDIT CREATION ACTIVITIES

At the time of its acquisition by the Savings Bank of South Australia in April 1984, Beneficial Finance specialised principally in smaller real estate and housing loans, and vehicle and equipment leases.

Beneficial Finance diversified its business activities after it became a wholly owned subsidiary of the new State Bank in July 1984, in large part because of the increased competition the company faced in its traditional markets from the newly deregulated licensed banks. Beneficial Finance's expansion was into those areas where the opportunities created by the economic environment were greatest. The principal changes were:

(a) First, Beneficial Finance engaged in corporate lending after July 1984, a business it had not previously carried on to any significant extent. Corporate lending in 1988 represented 39 per cent of new lending, up from 11 per cent in 1987, 6 per cent in 1986, and 2 per cent in 1985. Most of its corporate lending was property related.

(b) Second, Beneficial Finance's business expanded after 1984 to include the financing of, and equity participation in, large structured finance property projects. This business was an extension of Beneficial Finance's traditional lending for real estate, but differed in the size of the exposures, the nature of the projects, and the structuring of the financing arrangements, usually on a tax-effective basis, a widely used arrangement until 1988 when the Australian Taxation Office issued a ruling effectively banning its use.

(c) Third, Beneficial Finance expanded its core businesses into specialised, niche markets by forming operating joint ventures in partnership with small entrepreneurs that were perceived as having both expertise and access to business in those markets.

The activities of Beneficial Finance that involved the incurring of credit risk can accordingly be regarded as comprising:

(a) The general business divisions that carried on Beneficial Finance's so-called core business activities of smaller loans, usually secured by real estate mortgages, and motor vehicle and equipment leasing.

(b) The Structured Finance and Projects division, and its predecessors, the Corporate Services division and Investment Banking division, which carried on the so-called non-core businesses of large structured finance transactions, and corporate lending.

(c) Beneficial Finance's operating joint ventures, which involved the creation of credit risks outside Beneficial Finance's own systems and procedures.

Generally speaking, the businesses conducted by the core business divisions remained basically sound in the period reviewed by the Investigation, although they were, naturally enough, affected by recent economic recession. I have, however, investigated the lending for real estate acquisition and development by those business divisions. The statements made by the Bank and by the Treasurer in February 1991 expressly stated that the financial problems of Beneficial Finance were particularly associated with its property lending portfolio.

Beneficial Finance's non-core business activities, which involved equity participation in, and lending to, larger commercial property developments and project-specific joint ventures, were conducted by a single business division established in March 1986. The division, which was headed by Mr E P Reichert throughout the period covered by my inquiry, was twice re-organised and renamed. It was called:

(a) the Corporate Services division from March 1986 until 30 June 1988;

(b) the Investment Banking division from 1 July 1988 until 30 June 1989; and

For the sake of convenience, I will use the name Structured Finance and Projects division to refer to that division and its predecessors. Within these divisions, the non-core activities were not regulated by formally documented policies and procedures, and their activities were generally conducted without regard to the policies and procedures established for the core business activities. It was these non-core business activities that resulted in most of the losses incurred by Beneficial Finance. The disbanding of the Structured Finance and Projects division in May 1990, and the establishment of the Asset Management division at the same time, was not a coincidence.

Beneficial Finance also participated as an equity participant in, and financier to, operating joint ventures which carried on businesses that were extensions of Beneficial Finance's core business activities into specialised and niche finance markets.

30.1.3 THE INVESTIGATION METHODOLOGY

Central to my Terms of Appointment is the cause of the losses reported by Beneficial Finance. In particular, Term of Appointment A requires me, among other things, to:

(a) Determine what matters and events caused the financial position of Beneficial Finance as reported in February 1991 (Term of Appointment A(a)).

(b) Identify the processes which led Beneficial Finance to engage in operations which resulted in material losses, or to Beneficial Finance holding significant non-performing assets, and to determine whether those processes were adequate (Terms of Appointment A(b) and A(c)).

(c) Identify the procedures, policies and practices adopted by Beneficial Finance in managing significant assets that became non-performing, and to determine whether those procedures, policies and practices were adequate (Terms of Appointment A(d) and A(e)).

(d) Determine whether adequate or proper procedures existed for the identification of non-performing assets, and assets in respect of which a provision for loss should be made (Term of Appointment A(f)).

Answering these Terms of Appointment naturally required that I examine, in detail, the policies, procedures and processes relating to Beneficial Finance's management of the credit risk associated with the provision of finance to its clients. Shortly stated, my examination involved the following steps:

(a) Identification of the nature and source of Beneficial Finance's losses and non-performing assets, to determine the particular areas of its business activities that should be examined.

(b) Reviewing the policies, procedures and processes relevant to the management of credit risk in those areas of Beneficial Finance's operations.

(c) Examining a significant selection of loan files to determine how the policies, procedures and processes were applied in practice. In undertaking this stage of my Investigation, I selected a sample of twenty one non-performing loans, drawn from both the core and non-core businesses, for detailed examination. Only non-performing loans were examined, because my Terms of Appointment require me to identify the matters and events that caused Beneficial Finance's financial position as at February 1991.

In essence, the examination of the twenty one particular non-performing loans involved:

(a) An extensive examination of the loan files, with particular emphasis directed to the evaluation of the critical elements of the loan transaction, and the adequacy of Beneficial Finance's management of those elements, including its compliance with its policies and procedures.

(b) Discussions, where necessary, with Beneficial Finance staff involved with the loan facility to clarify and confirm information from the files. In some cases, formal interviews were conducted under oath.

(i) client details and financial information;

(ii) background to the loan facility;

(iii) changes in the loan facility;

(iv) a chronology of events during the term of the loan facility;

(v) a discussion of the critical events in the loan transaction, including evaluation of compliance with approved policies and procedures; and

(vi) an evaluation of Beneficial Finance's management of the loan, and the conclusions of the review.

Of the twenty one loans examined, I have reported the results of five of those investigations. Three are reported as Case Studies in Chapters 31 - "Case Study in Credit Management: East-End Market" to Chapter 33 - "Case Study in Credit Management: Pegasus Leasing" of this Report, one is reported in Chapter 39 - "Mortgage Acceptance Nominees Limited", and the fifth is summarised in Section 30.4.3 of this Chapter. In selecting the credit facilities reported, and the information that is reported publicly, I have had regard to the need to:

(a) preserve, so far as possible, the confidentiality of Beneficial Finance's affairs;

(b) ensure that existing and future customers of the Bank Group can be confident that their dealings will not be disclosed to the public;

(d) avoid, as far as practicable, prejudice to or interference with the ongoing operations of the Bank and the Bank Group.

I have weighed against the desirability of preserving the confidentiality of Beneficial Finance's affairs, the legitimate expectation of the public that the results of my Investigation into the Bank Group will be made generally available to the citizens of South Australia.

The reports I have provided of my Investigation of particular non-performing loans have, in two cases, been restricted by confidentiality requirements:

(a) in the report of a core business real estate loan involving a loan to Stemin, included as section 30.4.3 of this Chapter, the names of joint venture parties have been suppressed upon advice from the Bank, to maintain client confidentiality; and

(b) the report in Chapter 39 - "Mortgage Acceptance Nominees Limited" does not disclose the names of some parties, and excludes information bearing upon a possible legal dispute.

The transactions reported were selected in part because the clients' dealings with the Bank Group were a matter of public notoriety, so that publication of my Report would not be detrimental to relations between the Bank Group and those customers or between the Bank Group and its other customers, present and future. Principally, however, the loans reported were selected for publication because, in my opinion, they demonstrate the principal features of Beneficial Finance's credit risk management identified by my Investigation.

30.1.4 THE LOSSES REPORTED BY BENEFICIAL FINANCE

An initial task of my Investigation was to identify those areas of Beneficial Finance's business operations which resulted in the company holding significant non-performing assets. The following table sets out the pattern of non-performing loans within the Beneficial Finance Group as at 30 April 1991⁽⁾:

Real Estate	Number		$M	Per Cent of Non- Performing Loans by Dollar Amount
Beneficial Finance		561	574.4		68
Joint Ventures
Mortgage Acceptance Nominees Ltd		9	56.5		7
Other		10	1.1		-
		580	632.0		75

Leases
Beneficial Finance		217	11.4		1
Assets Risk Management Limited		906	10.3		1
Joint Ventures
Pagasus Leasing		112	16.0		2
Leasing Corporation		129	8.5		1
Mortgage Acceptance Nominees		92	7.0		1
Allied Western Finance		58	5.9		1
Sturt Finance		1	0.3		-
		1515	59.4		7

Other
Beneficial Finance		71	141.3		17
Assets Risk Management Limited		60	0.2		-
Joint Ventures		293	9.3		1
		424	150.8		18

Total
Beneficial Finance		849	727.1		86
Assets Risk Management Limited		966	10.5		1
Joint Ventures		704	104.6		13
		2519	842.2		100

It is evident from the above table that Beneficial Finance's highest incidence of non-performing loans (in dollar value terms) were in the area of real estate lending, and joint ventures. The table does not distinguish between real estate loans made by the core business divisions, and the Structured Finance and Projects division.

30.1.5 OVERVIEW

30.1.5.1 Introduction

The management of credit risk was a critically important aspect of the supervision, direction and control of Beneficial Finance's business operations. As a financial institution, credit risk was the most fundamental risk it faced. It was the failure of Beneficial Finance to adequately manage that risk that was the single most important matter that contributed to its financial position in February 1991.

30.1.5.2 Organisation of the Credit Risk Management Function

The general "organisation" of Beneficial Finance's credit risk management function as distinct from the "execution" of that function was, in my opinion, adequate and appropriate. The Board of Directors generally involved itself in important matters of credit risk management policies and procedures, and a Credit Policy Committee was established to ensure that policies and procedures were adequate.

30.1.5.3 The Credit Approval Process

In my opinion, subject to the exceptions referred to below, Beneficial Finance's delegated credit approval authorities, and the credit approval process, were generally adequate. The system of delegated credit approval authorities was established by the Board of Directors, which retained to itself the ultimate approval authority. All major loans required approval by directors, and some others had to be submitted to the Board for ratification. The approval authority limits were stated in terms of the percentage that the loan represented of Beneficial Finance's shareholders' funds. The percentage limits were higher in the case of loans secured by real estate.

My opinion regarding the adequacy of the credit approval process is, however, subject to three exceptions:

(a) the established credit approval procedure was not followed in the case of some major transactions of the Structured Finance and Projects division;

(b) there was no structured procedure to evaluate Beneficial Finance's participation in operating joint ventures; and

(c) the loan approval procedure was not applied in respect of Beneficial Finance's funding of the operating joint ventures in which it participated as a joint venture party.

30.1.5.4 The Management of Diversifiable Credit Risk

A critical failing of Beneficial Finance's credit risk management policies was the absence of any prudential policy limiting the company's total exposure to commercial property. Although there were various policies intended to ensure that the property-related loan portfolio included a diverse range of projects, there simply was no cap placed on the total exposure, which grew to be about 60 per cent of the portfolio by the end of 1989. That excessive and imprudent exposure inevitably meant that Beneficial Finance was seriously damaged financially by the collapse of the commercial property market in 1990.

30.1.5.5 Lending for Real Estate by the Core Businesses

I am satisfied that the credit risk management policies and procedures that applied to Beneficial Finance's core business operations conducted by the business divisions were generally adequate and appropriate, and that they were usually observed in practice. The losses realised in respect of the core business were principally the result of a general over-reliance on the continuing strength of the property market when exercising judgments in respect of a loan, and more particularly of the excessive exposure to real estate. The rise in property values, particularly after 1987, encouraged over-investment. Beneficial Finance had traditionally specialised in property-related loans, which combined with the absence of a prudential limit on its exposure, meant that the core businesses were over-exposed to an over-heated market. The policies and procedures could not protect Beneficial Finance from the collapse of that market. Simply stated, with the benefit of hindsight, Beneficial Finance did not recognise the unsustainable nature of the market prices for property in 1988 and 1989.

30.1.5.6 The Non-Core Businesses of the Structured Finance and Projects Division

In contrast, the Structured Finance and Projects division effectively observed no set policies or procedures. Although it did have regard to those policies and procedures applicable to the business divisions, the Structured Finance and Projects division was regarded as a highly skilled and specialised division engaged in business activities that were beyond the pale of the company's normal policies. The division would live and die according to the skills and expertise of its senior managers who controlled its activities.

The business activities of that division involved large transactions, often involving equity participation, and were concentrated in commercial property development. Decisions were made by senior management often without careful or independent analysis by credit risk analysts, or by other relevant internal or external experts. The managers placed far too much faith in the expertise of their clients, and of themselves, without regard to the basic tenets of credit risk analysis.

The business strategy of the Structured Finance and Projects division was to undertake larger transactions involving often complicated mixes of equity participation, debt funding, and the provision of guarantees. The fundamental failures of the division in undertaking that business were:

(a) an excessive concentration on commercial property development, accompanied by an apparently absolute faith in the profitability of such projects;

(b) a failure to have regard to the basic principles of credit risk evaluation and management; and

(c) a tendency of senior management to initiate and recommend deals based on their own judgment and in the pursuit of new business, essentially ignoring the need for careful analysis through a structured evaluation and approval procedure.

30.1.5.7 Participation in, and Funding of, Operating Joint Ventures

Beneficial Finance's business development strategy included the formation of joint ventures with small, entrepreneurial financiers operating in specialised niche markets that, although they were an extension of Beneficial Finance's core business activities, were outside its experience and expertise. It was hoped that, with Beneficial Finance's financial support, the partner could use its expertise to grow a business from which both would profit.

The joint ventures resulted in the creation of credit risks outside the framework of Beneficial Finance's own policies and procedures. Although Beneficial Finance was to approve larger loans made by the joint ventures, there was a tendency to rely on the recommendations of the joint venture partners who, after all, were perceived to have skill and expertise that Beneficial Finance did not possess. In practice, it was Beneficial Finance's joint venture partners, and not Beneficial Finance, that made the decisions relevant to management of the joint ventures' credit risks.

It was Beneficial Finance, however, that essentially bore that risk. In most cases, its joint venture partners did not have anywhere near the financial capacity to meet their share of any significant losses associated with the joint ventures' loan portfolios. Indeed, the partners' lack of financial strength was the very reason that they entered into the joint ventures.

Beneficial Finance did not impose any prudential limits on its exposure to particular joint ventures. Even more importantly, there was no credit review and approval mechanism within Beneficial Finance in respect of the provision of funds to the joint ventures. With almost unlimited funding available to them, the joint ventures grew rapidly, as they were able to make loans unconstrained by funding limits. That inevitably placed downward pressure on credit standards.

30.2 ORGANISATION AND STRUCTURE OF THE CREDIT RISK MANAGEMENT FUNCTION

30.2.1 POLICY-MAKING AUTHORITIES

30.2.1.1 The Board of Directors

The ultimate policy-making authority within Beneficial Finance was, of course, the Board of Directors. Beneficial Finance's Articles of Association vested the management and control of the business and affairs of the company in the directors. Pursuant to Article 27(1), the directors' powers were exercisable in a duly convened meeting of directors at which a quorum of at least two directors were present.

Among the important functions of any Board of Directors is ensuring that Management has established policies, procedures and internal controls that are appropriate to the company. In the case of Beneficial Finance, I am satisfied that the Board of Directors did actively consider the company's lending policies and procedures, and gave directions to Management in respect of those policies and procedures. One example will illustrate the point. A memorandum to the Executive Committee dated 30 March 1987, prepared by the company secretary, Mr B Barton, said the following in respect of the Board of Directors' meeting held on 27 March 1987:

"When you read the Board minutes and the various action items arising from the meeting you will realise that there was considerable discussion and comment regarding the credit transactions presented for the consideration of Directors.

Some of the queries arose due to using standard headings produced by word processing (particularly in relation to valuations - whether the valuation is present or current rather than end valuation) which were not appropriate to the particular transaction being reported. There is also the continuing problem of giving sufficient pertinent information in one or two pages to enable the Board to have a clear enough understanding of the proposed transaction.

Other queries related to lending standards many of which have been covered before, but which I now include below to assist in forming our continuing policy guidelines.

A summary of the matters raised by the Board is as follows:

i) The summary of the credit transaction is to include a further heading note under the existing one relating to guarantees:

"Unless otherwise indicated, all valuations are from Panel Valuers, addressed to Beneficial, and are for mortgage purposes only."

ii) All Panel Valuers must advise the extent of their professional indemnity insurance cover as a pre-requisite to dealing with them.

iii) As a rule, no large advances should be made outside of the major metropolitan and regional centres.

iv) Valuations must be correctly nominated as "end", "present" or "current".

v) Where credit advances have already been made, a brief comment on the payment history should be included in the summary.

vi) A policy is to be decided on the financing of small shopping centres. Some concern was expressed about their viability.

vii) No further exposure to Retirement Villages is to be undertaken until our current involvement has been satisfactorily reduced.

viii) The current policy on valuing securities subject to a second mortgage is to be advised to Board. There should be some scaling to take into account possible interest arrears and other costs related to the first mortgage.

ix) The Board continues to be concerned at 100 per cent financing and interest capitalisation.

x) Income from any project must be able to cover the interest commitment to Beneficial.

xi) An exposure limit is required in relation to bloodstock leasing on behalf of Pegasus Leasing.

It is apparent that Regional presentations of the credit transactions will have to be prepared with greater care to ensure that the extent of queries, which adversely reflect on Management, are significantly reduced. Effective checking in Head Office will also be required.

In summary, the emphasis must be on quality even though this may affect the extent of our future growth pattern in relation to receivables." [Emphasis added]

As I shall describe, however, there are three critical areas in which the Board of Director's supervision and direction of policies and procedures was not adequate:

(a) the Board of Directors did not establish a prudential limit on Beneficial Finance's exposure to commercial property;

(b) the specialised Structured Finance and Projects division did not regard itself as being bound to observe the policies and procedures that applied to the core business; and

(c) there were inadequate policies and procedures in respect of Beneficial Finance's participation in, and funding of, operating joint ventures.

Importantly, the involvement of the Beneficial Finance Board of Directors in the management of credit risk went beyond the review of policies and procedures. The Board of Directors was, as well, the ultimate credit approval authority for all of Beneficial Finance's larger loans and financing transactions.

The particular obligations of the directors and management of a company depend upon the allocation of responsibilities within that company. The particular circumstances in which the business of a company is conducted can impose additional duties on the directors, particularly in respect of the necessary skills that the directors must exercise in performing some specialised functions. This is the case where directors are involved in approving complex credit submissions. By undertaking that role, the directors of Beneficial Finance brought upon themselves a duty to bring to the company the skill and experience necessary to fulfil that role. In approving large loans, the directors undertook an essentially executive task, giving rise to an obligation to exercise the necessary degree of skill in credit evaluation demanded by that function.

30.2.2.2 The Credit Policy Committee

The composition and functions of the Credit Policy Committee are best explained by a 28 July 1989 Board Meeting Action Items paper, which described the operations of the Credit Policy Committee as:

"Credit Policy Committee

This committee or its equivalent, which meets monthly, has been in existence for nine years. Its composition has been a blend of experienced lenders with Head Office performers and line roles. One of its prime, continuing functions has been to review existing, and agree new, lending policies and procedures, based on the current economic climate and market trends, loss experience and corporate plan objectives and strategies." ⁽⁾

The membership of the Credit Policy Committee at July 1987 and July 1988 is shown at Appendix A. The minutes of those meetings do not deal with approvals of specific loans. The Credit Policy Committee was concerned with policy matters, and did not specifically involve itself in credit approvals, although some members did participate on certain of the credit committees.

30.2.3 DELEGATED LOAN APPROVAL AUTHORITIES

30.2.3.1 Introduction

Although Beneficial Finance's Articles of Association vested the management and control of the business and affairs of the company in the directors, it is clear that the directors could not be expected to undertake every management and control function in the company. Accordingly, Article 26(2) empowered the directors to delegate their powers and duties under the Articles to the Managing Director, and Article 27(5) authorised them to delegate their powers to a committee or committees consisting of one or more directors.

In making such delegations in respect of the granting of loans by Beneficial Finance, the Board of Directors reserved to itself, and to committees of directors, the ultimate authority to approve large loan facilities.

From the beginning of 1988, credit approval authority limits were established according to the size of the loan measured as a proportion of Beneficial Finance's shareholders' funds. The policy provided for a quorum of four directors, including one State Bank representative, to approve loans of up to 25 per cent of the company's capital base. The policy adopted was summarised in the minutes as follows⁽⁾:

Per Cent Share- holders’ Funds		Based on Real Estate First Mortgage $M	Other Secured $M

>25	All available directors
15-25	Quorum of our directors including one State Bank Representative	27.0	20.0
10-15	Two directors, including on State Bank Representative	16.0	12.0
5-10	National Credit Committee	10.5	7.5
5	National Credit Sub-Committee	5.0	3.5
2.5	Regional Sub-Committee	2.5	1.5

The dollar limits increased over time, in line with increases in Beneficial Finance's shareholders' funds. Below the level of the Credit Committees and Sub-Committees, certain officers were granted approval authorities according to a system of seniority. Until December 1988, approval authorities were allocated on the basis of title and position. On 19 December 1988, however, the Credit Policy Committee agreed that, because of the confusing variety of titles in each State, authorities should be allocated to designated individuals, and a master list maintained by the Division, National Credit Manager, and Internal Audit. Thereafter, the Managing Director set personal limits for managers of various levels of seniority, up to a maximum based on recommendations made by the General Manager of the relevant division. The General Managers were permitted to delegate specific authorities unless specifically prohibited⁽⁾.

30.2.3.2 The Board of Directors

In addition to all transactions in excess of the approval limit of the National Credit Committee, the approval of the Board of Directors was also required for:

(a) all real estate transactions, other than owner-occupied houses, where the security was located in population centres of less than 50,000 people; and

(b) transactions where the loan to security ratio, called the Advance Security Ratio or ASR, was 100 per cent, whether or not interest was capitalised.

The following transactions had to be reported to the Board (by way of a Summary of Credit Transaction) for ratification⁽⁾:

Registered First Mortgage Security over Real Estate

Any approval for more than $0.5M taking the total exposure to a client above $3.0M, and single approvals of more than $3.0M.

Other Security

Any approval of more than $0.5M taking the total exposure to a client above $2.5M, or single approvals of more than $1.5M

Increases in Approvals

Additional approvals on facilities previously approved by directors which are within 10 per cent of the total exposure limit approved. Such increases could be approved by the National Credit Committee provided that increases of more than $0.5M were subsequently reported for ratification.

30.2.3.3 The Credit Committees

The credit committees had responsibility for reviewing and approving credit submissions. Each of the credit committees and sub-committees had a delegated credit approval authority which permitted them to approve loans up to a fixed amount that varied according to the nature of the security provided by the borrower.

As noted, the structure of the delegated credit authorities was revised in January 1988 to link the limits of those authorities to the level of Beneficial Finance's shareholders' funds.

The composition of the Credit Committees changed from time to time, as did the structure of those committees. Appendix B identifies members of the Credit Committee during the period from June 1988 to February 1991.

The approval limits of the various credit committees for lending on real estate by way of first mortgage and for other secured lending in the period from January 1988 to May 1990 is set out at Appendix C.

30.2.3.4 Individual Credit Approval Authorities

The credit approval process also assigned authority levels to certain individuals. There were four levels of authority into which individuals were grouped according to their title or position. The exact titles within each grouping varied in line with changes to Beneficial Finance's organisational structure. Prior to the organisational restructure which took effect from 1 May 1990, the titles of each authority level within the various divisions were:

Level A	Structured Finance and Projects: Chief General Manager
	Business Divisions : General Manager

Level B	Structured Finance and Projects: Regional Managers
	Business Divisions : State Managers

Level C	State Credit Managers

Level D	Branch Managers and Area Managers

The Board set maximum approval limits for Levels A, B and C. The Managing Director then set personal limits for each individual in Levels B, C and D up to the maximum, based on recommendations of the appropriate Level A officer.⁽⁾

30.2.4 SUMMARY AND CONCLUSIONS

In my opinion, the general organisation and structure of Beneficial Finance's credit risk management function was adequate and appropriate.

The principal policy-setting authority, the Board of Directors, did involve itself in policy matters. A specialised Credit Policy Committee was established to review and supervise credit policy matters.

The Board of Directors reserved to itself the authority to approve larger credit transactions, measured by reference to Beneficial Finance's capital base. The Board established an adequate system of delegated credit approval authorities, and a tiered system for multiple reviews of credit submissions.

As I shall describe, my conclusion that the organisational structure of Beneficial Finance's credit risk management system was adequate and appropriate is subject to two exceptions. They are:

(a) the overriding of that system by senior managers of the Structured Finance and Projects division in respect of some significant transactions; and

(b) the absence of an adequate system for the evaluation and approval of participation in, and funding of, Beneficial Finance's operating joint ventures.

30.3 THE MANAGEMENT OF DIVERSIFIABLE CREDIT RISK

30.3.1 INTRODUCTION

As stated above, the credit risk management policies of a financial institution are of two distinct types:

(a) Those policies relating to the credit risk associated with a loan to a particular borrower. That type of credit risk is commonly called non-diversifiable credit risk.

(b) Those policies relating to the credit risk arising from the overall exposure of the total loan portfolio to particular borrowers, industries and geographic areas. That risk is commonly called diversifiable credit risk.

Diversifiable credit risk is that credit risk which can be reduced, or even eliminated, by the adoption of prudential policies calculated to ensure that the loan portfolio does not involve a concentration of risk - that is, that the loan portfolio does not include excessively large loans to particular borrowers, and is not excessively concentrated upon particular industries, or upon particular geographic areas. As stated by the Reserve Bank of Australia in Prudential Statement A1, "Prudential Supervision of Banks":

"Undue concentration of risk can expose a bank to losses and diminution of capital. A bank can reduce risk by working towards, and maintaining, a deposit book and loan portfolio that are diversified both geographically and industrially. Banks generally impose limits on the amounts of funds they will accept from or advance to, any one client or group of related clients to reduce the degree of risk."

These comments apply, with equal force, to all financial institutions. This Section describes how Beneficial Finance Corporation monitored and managed that particular aspect of the credit risk profile of its loan portfolio during the period under review.

30.3.2 CLIENT EXPOSURES

30.3.2.1 Prudential Policies

The Board of Directors approved prudential limits for the company's maximum credit exposures to particular clients which were based upon a proportion of its capital base, subject to approval of a higher exposure by the Board of Directors.

Before January 1988, the general prudential limit was 10 per cent of Beneficial Finance's shareholders' funds. At its meeting on 27 November 1987, the Board:

"... noted that a number of transactions recently considered by the Board were well in excess of the 10% of shareholders' funds limit previously established by the Board. Management was requested to submit a policy paper to the January meeting setting out the basis for establishing a higher maximum limit. Deals above that limit to only be considered if the excess has been set with other lending institutions." ⁽⁾

At its meeting on 29 January 1988, the Board approved a new large exposure policy which was related both to the nature of the loan, and to the system of delegated loan approval authorities. The new policy provided for a quorum of four directors, including one State Bank representative, to approve loans of up to 25 per cent of the company's capital base. No express limit on the size of the credit exposure was set where the loan was approved by all available directors.

Subsequently, however, an absolute exposure limit of 30 per cent of shareholders' funds was imposed, although the minutes of the Board of Directors' meetings do not record the limit being considered or approved. The minutes of the meeting held on 24 February 1989, at which a report on Beneficial Finance's exposures in excess of $5.0M was considered, record that:

"There are a number of clients where the total exposure is close to or greater than the prudential limit of 30 per cent of shareholders' funds. Management was asked to ensure that the limit was not exceeded." ⁽⁾

The Board directed Management, in one case where the "total exposure of $45.5M exceeds 30% of shareholders' funds ... to take immediate action to sell down the exposure." ⁽⁾

At its meeting on 25 May 1990, the Board discussed the prudential exposure limits, the minutes noting that:

"The prudential exposure limit to any one client or group is to be reconsidered and recommendations put to the June Board meeting. The Board believed a limit of $20.0-$25.0M should apply, with larger deals or exposures co-ordinated with State Bank." ⁽⁾

At the June 1990 meeting, the Board accepted Management's recommendation that the prudential maximum exposure limit be reduced from 30 per cent to 20 per cent of shareholders' funds⁽⁾, representing a maximum exposure limit of $38.0M.

30.3.2.2 Monitoring of Large Exposures

The Beneficial Finance Board of Directors received half-yearly reports of the large exposures of Beneficial Finance. Although infrequent, these reports were, so far as my Investigation has determined, accurate and complete. The reports were compiled manually from information regarding client exposures provided by all Beneficial Finance branches.

The scope of these half-yearly exposure reports to the Board changed over the period 1984 to 1990, as the size of Beneficial Finance's exposures increased. The reports presented from 1984 to September 1986 included all exposures of more than $2.0M in real estate, and $1.5M for other loans. In March and November 1987 only exposures of $3.0M or more were reported, and in June 1988 the lower limit for reporting was increased to $5.0M.

The Board also received, in later years, quarterly exposure reports which summarised the proportion of the loan portfolio represented by different exposure levels, providing a concise profile of the exposure levels in the portfolio.

30.3.2.3 Management of Large Exposures

The increase in Beneficial Finance's capital after 1984 allowed it to increase significantly the size of its large exposures. Between 1 July 1984 and 30 June 1990, Beneficial Finance's capital increased by 226 per cent, from $58.1M to $189.5M.

The change to Beneficial Finance's prudential policy meant that the increase in the size of its exposures was even greater. The half-yearly exposure review presented to the Board of Directors on 5 September 1984 showed that, as at 26 July 1984, Beneficial Finance had only five exposures to clients or groups of clients of $5.0M or more, the largest being $5.9M, or about 10 per cent of the company's capital. Exposures of more than $2.0M for real estate, and other exposures of more than $1.5M, totalled only $87.0M out of total net receivables of $469.2M.

By 30 September 1990, however, the credit risks by exposure to client groups as shown in the Quarterly Report on Risk Exposure⁽⁾ were:

	Amount of Risk
Range	$M		% Total

Less than $20.0M		2,387.0		71.8
$20.0M to $24.9M		67.6		2.0
$25.0M to $39.9M		548.0		16.5
Greater than $40.0M		322.9		9.7
		3,325.5		100.0

The September 1990 Quarterly Report showed that, as at September 1990, Beneficial Finance had twenty four client exposures in excess of $25.0M. Of the total exposure of $870.9M to those clients, $428.9M, or 49.2 per cent, was non-performing. The three largest non-performing loans were $60.4M, $50.3M and $46.2M.

The changing nature of the risk profile of Beneficial Finance's loan portfolio was commented on by the Board. It has been noted above that, on 27 November 1987, the Board observed a number of transactions being submitted for approval that were "well in excess" of 10 per cent of shareholders' funds, and accordingly increased the prudential exposure limit in January 1988. At its meeting on 31 August 1989, the Board considered that:

"The high emphasis on transactions $25.0M to $39.9M seems too high compared to historical exposure levels. Mr Baker agreed to develop policy guidelines having a more satisfactory spread." ⁽⁾

Although Beneficial Finance did, on occasion, undertake credit exposures which exceeded the 30 per cent of capital limit, the large exposures of Beneficial Finance were generally within the 30 per cent prudential limit. This was assisted by Beneficial Finance's increasing capital; the exposure of $45.5M noted earlier as being in excess of the 30 per cent limit in February 1989, which the Board directed was to be sold-down was, in fact, not sold-down, as shown by its listing among large exposures in the June 1990 report to the Board. The increase in capital, however, brought that exposure under the 30 per cent limit.

30.3.3 INDUSTRY EXPOSURES

30.3.3.1 Prudential Policies

At the time of its acquisition by the Savings Bank of South Australia in April 1984, Beneficial Finance was already well established in property financing. The company's 1984 Annual Report indicated that lending for short-term construction and bridging finance represented 32.2 per cent of gross receivables, and longer term advances on established properties represented a further 35.8 per cent. The average loan size was, however, small - $0.137M for construction and bridging finance, and only $27,000 for longer term advances.

Over the years after 1984, the Board of Directors approved a variety of prudential policies related to Beneficial Finance's traditional lending markets. For example, policies were approved limiting the exposure to funding for sub-divisions and caravan parks, and limiting the exposure to real estate away from major population centres. Before October 1989, the subdivision limit approved by the Beneficial Finance Board was $100.0M. This limit was increased by the Board on 19 October 1989 to $200.0M. On 24 November 1989, the Board added the rider that the maximum exposure to any one project or stage of a project was not to exceed $20.0M. A portion of the $200.0M total exposure limit was allocated to each of Beneficial Finance's divisions as follows:

	Limit $M

Structured Finance
Loans		90
Co-owned		15
Southern Business Division		55
Northern Business Division		40
		200

No prudential policies were, however, considered or adopted to limit Beneficial Finance's exposure to the commercial property generally, or to construction and development in particular. There were, based on the evidence before me, simply no applicable prudential policies in that regard.

Mr J A Baker, the Managing Director of Beneficial Finance, said in a submission to my Investigation that there was a "general understanding" with the Board of Directors that "real estate receivables should be about 50 per cent of the total portfolio." ⁽⁾ That limit was not, however, documented as a policy, and was not observed in practice.

In a later submission to my Investigation, Mr Baker said that a calculation showing that 68 per cent of Beneficial Finance's losses were associated with its real estate loans was roughly in line with the total exposure to real estate.⁽⁾

The Board did, on several occasions, expressly refer to the need for a limit on the company's overall exposure to commercial property, or to particular segments of the market. For example, the minutes of the Board of Directors' meeting on 24 April 1987 record that the Board, in reviewing the monthly operating review for March 1987, addressed the issue of Beneficial Finance's exposure to real estate:

"Sales Mix: The Company's Risk Exposure in the real estate area was highlighted, with over 40% of sales in this area. The 1987/1988 budget is to consider the mix in sales with a view to reducing exposure in the real estate portfolio." ⁽⁾

The strategic plan subsequently presented to the Board did not address the matter of Beneficial Finance's exposure to real estate, and no policy or practice limiting that exposure was implemented.

Again at its meeting on 26 August 1988, the Board questioned whether a prudential policy limiting the company's exposure to construction and development finance might be necessary:

"The Board queried whether there should be a cap placed on the extent of Construction and Development business written by the company, particularly in view of the high levels of arrears and problem loans. A report will be prepared for the Board for the October meeting in which consideration will be given to setting limits by State or other geographical divisions and by type of project".⁽⁾

The minutes of the next Board meeting, held on 29 September 1988, record that a discussion of Beneficial Finance's Queensland operations "led to discussions on wider company matters", which included:

"There could be a need for increased conservatism in the Company's lending in view of possible future economic uncertainties producing greater downside risks. Care needs to be taken to ensure that we are not too heavily involved in specific areas of the market." ⁽⁾

A report on major problem construction and development loans was reviewed by the Board at its meeting on 28 October 1988, but no prudential policy was considered.

The result of the absence of a prudential policy to limit the company's exposure to commercial property was that the risk asset portfolio became far too heavily exposed to commercial property.

30.3.3.2 Monitoring of Industry Exposures

Each month, the Board of Directors of Beneficial Finance received, as part of the monthly operating review, a summary by division of the company's receivables and risk assets. That summary identified the total receivables classified as Real Estate, Construction and Development, Structured Finance, Projects and Commercial "products".

The report did not, however, provide any classification of credit exposures according to the associated industry exposure. It was not possible to identify, from the monthly reports, the company's total exposure to commercial property, nor to particular sectors of the commercial property market.

Such a report was requested by the Board at its meeting on 24 February 1989, the minutes of which record that:

"The Board requested a report at the March Board Meeting on Beneficial's exposure to two areas:

(a) CBD throughout Australia

(b) Resort area investments" ⁽⁾

A list of client exposures in both areas was presented to the Board on 31 March 1989.

The Board did receive, however, quarterly reports regarding Beneficial Finance's risk exposures, which identified the company's total exposures (including equity exposures) to "real estate". These reports clearly showed the extent of the total property exposure, although not its detail. The exposure report for the December 1989 quarter showed that Beneficial Finance's exposure to real estate was 56.4 per cent of the company's risk assets.

30.3.3.3 Management of Industry Exposures

As noted above, concerns were expressed, from time to time, regarding aspects of Beneficial Finance's property exposures. For example, the minutes of the Board meeting on 31 August 1989 record that, in the course of a discussion regarding the East End Market, "concern was expressed about the exposure of the State Bank Group to other Adelaide CBD buildings". There is no indication, however, that this expression of concern was translated into effective action to rectify the exposure. Mr Baker said in his submission to my Investigation that efforts were made to increase Beneficial Finance's non-real estate business, particularly motor vehicle leasing.⁽⁾ Those efforts, however, did little to restore a prudent balance in the loan portfolio.

In September 1990, the State Bank's industry exposure report stated that Beneficial Finance's risk exposure to the commercial property market represented 60.1 per cent of its risk assets.

The over-exposure to property was acknowledged by Beneficial Finance's Management in 1990. In September 1990, Management presented a report to the Board of Directors titled "Lessons Learned from Problem Loans", which identified particular failings of Beneficial Finance's credit risk management, the consequences of those failings, and actions being taken or to be taken to remedy the situation. Among the failings identified in the report were inappropriate prudential limits and exposures, and management information systems that were not adequate to monitor the growth and concentration of specific portfolios and risk assets. The consequences of these failings were said to be a "failure to recognise particular risks and vulnerabilities in the event of cyclical economic downturns." Action being taken to remedy the situation included the development of a group-wide central commitment register, a reduction in prudential limits to 20 per cent of shareholders' funds with more conservative calculation methods, and specific portfolio profile research to be undertaken by the Credit Policy Committee.

A business plan for the 18 months ended 30 June 1992, prepared in 1990, listed as an element of the Australian Business division's "action plan", the maintenance of a "prudent portfolio mix". Its "target" was to ensure that, during the plan period, real estate products did not exceed 50 per cent of the portfolio.

30.3.4 SUMMARY AND CONCLUSIONS

30.3.4.1 Large Client Exposures

The Beneficial Finance Board of Directors established prudential policies allowing credit exposures of up to 30 per cent of Beneficial Finance's capital base to a client or client group. The company did, on occasion, extend credit facilities which exceeded its own prudential limit of 30 per cent of capital.

Beneficial Finance's large exposures increased very significantly in size after 1984, reflecting the changing nature of its business, its increasing capital base, and the higher prudential policy limit for large exposures.

The monitoring and reporting of Beneficial Finance's large client exposures was, on the evidence available to me, adequate.

30.3.4.2 Exposure to Commercial Property

Beneficial Finance's exposure to commercial property was imprudent and excessive. There was no prudential limit on the total exposure, and the exposure was not considered in the course of approving new loans.

By 1990, Beneficial Finance's property-related exposures exceeded 60 per cent of its total risk assets, compared to the average exposure of other finance companies of about 45 per cent. That exposure was an important factor that contributed to the causes of its financial position in February 1991.

Although the Board of Directors did impose limits on certain sectors of the property market, no limit was placed on the total exposure to property, or upon the financing of construction and development projects.

This was a critical failure, and one that had dire consequences because of the particular economic conditions that prevailed in the second half of the 1980's. The ready availability of credit following financial deregulation, combined with expectations of continuing asset price inflation, and the availability of certain taxation advantages provided through tax-effective arrangements such as financing unit trusts, all combined to drive up the values of commercial property to unrealistic levels, particularly after the stock market crash in October 1987. The collapse in property values for 1990 was unexpectedly severe, as the Government's tight fiscal and monetary policies resulted in the economy sliding into a recession.

There is no question that the late 1980's was, with hindsight, a dangerous time to be lending for property acquisition and development. With the collapse of the market, losses were inevitable.

Without a prudential policy limiting its exposure to property, Beneficial Finance was particularly exposed. Although some losses were probably inevitable, the extent of Beneficial Finance's financial problems would, in my opinion, have been significantly less had the company restricted its exposure to the property market to a reasonably prudent level. It did not do so. The responsibility for that failing lies with the Board of Directors and senior management.

In my opinion, the operations, affairs, and transactions, of Beneficial Finance were not adequately or properly supervised, directed and controlled by:

(a) The Directors of Beneficial Finance, in that they failed to ensure the establishment and observance of any formal prudential policy in respect of the company's exposure to commercial property, even though it expressly recognised the need for such a policy.

(b) Mr Baker, the Managing Director of Beneficial Finance, in that Mr Baker failed to take adequate steps to ensure that the exposure of Beneficial Finance to commercial property was:

(i) subject to any prudential limit; or

(ii) otherwise managed or controlled within prudent limits.

30.4 CREDIT RISK MANAGEMENT IN THE CORE BUSINESS DIVISIONS

30.4.1 CREDIT RISK MANAGEMENT POLICIES AND PROCESSES

30.4.1.1 Introduction

This Section describes the policies and processes that applied to the approval and subsequent management of real estate loans by Beneficial Finance's core business divisions in the period under review. As noted previously, although Beneficial Finance was involved in a variety of types of lending, it was the real estate lending activities which materially contributed to the State Bank Group's losses, and so this section focuses on the policies and processes applicable to real estate lending in particular.

The credit risk management process denotes the implementation of policies and procedures for:

(a) the evaluation and approval of loan facilities;

(b) monitoring compliance by borrowers with the terms and conditions of loan agreements;

(c) monitoring the financial position of borrowers with a view to detecting significant developments which may affect the recoverability of a loan; and

(d) taking appropriate corrective action in the event of non-compliance by the borrower, or in the event of a deterioration in the prospects of recovering a loan.

The description and assessment of Beneficial Finance's credit policies and processes has, for the purposes of analysis, been divided into four key stages or tasks in the lending process:

(a) the initiation of the loan proposal;

(b) approval of the loan by the relevant approval authority;

(d) management of the loan after it has been established.

I have reported the results of my examination of the policies and procedures for the identification of non-performing loans, and for establishing adequate provisions for losses, in Chapter 42 - "Bank and Bank Group Provisioning".

The major source of information regarding Beneficial Finance's credit policies and processes is the Policies and Procedures Reference Manual that was issued in July 1989. During the course of my Investigation, the basis for developing the Policies and Procedures Reference Manual was discussed with Mr J Glennie, who as head of the Procedures and Control department of Beneficial Finance, was extensively involved in its drafting⁽⁾. According to Mr Glennie, a need for a new manual was perceived in 1988 as the old manual was unwieldy, and had not been updated, other than in a piecemeal fashion, for a number of years. The objective underlying the drafting of the new manual was to produce a manual which would be more logical and "user-friendly". Changes to the content of the manual were permitted only for the following purposes:

(a) to delete obsolete procedures, such as those relating to products no longer offered;

(b) to rectify inconsistencies within the old manual; and

The Policies and Procedures Reference Manual was intended to provide a set of firm rules, in contrast to the previous manual which had been couched in ambiguous terms using phrases such as "should be done".

In drafting the manual, Mr Glennie and his staff relied upon the previous manual, Management Information Bulletins, Board Minutes, and any other instructions issued up to the date of issuing the new manual. Updates to the Policies and Procedures Reference Manual were prepared from instructions received in Management Information Bulletins from the Credit Policy Committee, in Board Minutes and in other instructional memoranda. Updates were approved by the Divisional Manager responsible if they related to one division only, or by the Executive Committee and the Managing Director if they related to more than one division.

My Investigation has approached the task of identifying the credit policies and procedures of Beneficial Finance throughout the period under review by focussing on the current Policies and Procedures Reference Manual, and then reviewing the various sources of change as mentioned above to identify dates when significant new policies and procedures were introduced. The description of the credit policies and processes in the following sections records only the more significant policies and procedures, to provide an indication of the overall scope and adequacy of the recorded policies and procedures that operated within Beneficial Finance.

30.4.1.2 Initiation of Loans

Initiation of loans denotes the process of instigating new business, obtaining data in relation to a prospective borrower and preparing a credit submission which provides Beneficial Finance management with the background to the transaction, the proposed structure of the loan facility, analysis of the proposal (including assessment of any valuation) and the rationale for recommending the transaction.

Credit submissions for real estate loans were required to be prepared according to a standard format which detailed the information that must be obtained and provided to the credit approval authority.⁽⁾ Account Managers were also required to prepare a document titled "Summary of Credit Transaction", which was essentially a condensed one page version of the credit submission, for all transactions to be approved by Credit Committee or higher authority, or requiring Board ratification.⁽⁾

The standard format credit submission for real estate lending was divided into two sections - a summary section, designed to cover key points and to be the only information sent to the Board, and supporting information. The summary section was in four parts:

(a) A Transaction Summary, including details of:

(i) the borrower;

(ii) the proposed total exposure;

(iii) the purpose of loan;

(iv) calculation of the loan-to-security ratio, called the Advance Security Ratio or "ANR";

(v) pricing of the loan;

(vi) loan term;

(vii) re-payment structure;

(viii) analysis of the borrower's capacity to repay;

(ix) identification of a second and third method of recovering the loan if the borrower failed to repay; and

(x) partial discharge conditions.

(b) Details of the Borrowers and Principals

This section required details on the borrower's background and current exposures, including reputation and experience with the particular type of real estate transaction. Much of the information in this section was gathered by interviewing the proposed borrower. Details of "Principals" were required because the actual borrower was often a private company, in which case Beneficial Finance's practice was to obtain guarantees from the owners and directors of the company.

(i) a description of the site, including its zoning;

(ii) a valuation of the property;

(iii) details of the use of the property, including its tenancy;

(iv) construction details; and

(v) environmental issues.

(d) Account Monitoring Details

The account manager was to list specific account management trigger points and client reporting requirements. "Trigger points" are particular features of the loan that are subject to contractual terms or covenants which, if breached, entitled Beneficial Finance to take action to recover the loan. Examples include the periodic payment of interest on the loan, and the maintenance of the loan to security ratio.

The supporting information section of the standard form credit submission for real estate lending was intended to include any significant information not included in the summary section. It comprised six parts:

(a) Security documentation, insurance and settlement details.

(b) Further details of the borrowers and principals, including Beneficial Finance's past credit experience with the borrowers and principals, their corporate structure, credit references and details of their banking arrangements.

(d) Financial Data - Capacity to Pay. This included the summation of three years' financial data of applicant, and the calculation of certain financial ratios, in a standard format. Account Managers were required to comment on "trends in financial condition and performance, seasonal fluctuations, adverse ratios, adequacy of working capital, and cash flow from operations".⁽⁾

(e) Risk Summary, Account Management and Attached Supporting Proposal. With regard to the Risk Summary, the policy stated that Beneficial Finance "should not consider an exposure where our resources are not adequate to either understand or manage the risks".⁽⁾

(f) Credit Approval, which required the documentation of any pre and post-settlement conditions, and sign off by the relevant approving authority.

As part of the process of preparing the credit submission, the account manager was required to interview the prospective borrower. An exception was allowed in the case of Level B officers proposing to approve loans up to $0.25M as a general rule, or up to their lending limit provided that the specific grounds for dispensing with an interview were noted on the submission.⁽⁾ The requirement that interviews be conducted was first introduced following a Credit Policy Committee meeting on 19 November 1987.

It was a policy of Beneficial Finance that all transactions be guaranteed by directors/principals and their associated companies and/or trusts.⁽⁾

All security was to be inspected prior to processing the credit application. Specific policies applied to the level of seniority of persons performing the inspections.⁽⁾

A key policy applicable to the initiation of real estate loans was the maximum ratio of the loan to the value of the security, called the Advance Security Ratio "ASR". This policy set a maximum loan for a particular real estate asset determined by reference to the lower of the cost or current valuation of the asset. The maximum ratio of cost or current value which might be advanced varied according to the type of asset being financed. In the case of second mortgage security, the Advance Security Ratio was to be 5 per cent lower.⁽⁾ Level B officers could increase ratios by 5 per cent to a maximum of 90 per cent if justified by the borrower's credit rating.⁽⁾

A property valuation was to be obtained for all loans from a panel of valuers or, for residential properties only, a Level B approved officer.⁽⁾ The Chief Manager National Credit and Chief Manager Credit Control were responsible for reviewing and approving the panel of valuers annually. Valuers were restricted according to the level of professional indemnity cover held. Valuations were to be addressed to Beneficial Finance, and marked "for mortgagee purposes". A standard letter of instruction to valuers, detailing Beneficial Finance's requirements, was used.⁽⁾ The reliability of property valuations was to be assessed using a "Valuation Report Assessment Guidelines Matrix" in the Attachments section of the Policies and Procedures Reference Manual.⁽⁾

A number of important policies relating specifically to construction and development finance were contained in the Policies and Procedures Reference Manual, including:

(a) "Developers must have adequate experience in the type of development we are being asked to finance unless they meet all the following criteria:

. Previous experience in the industry working for someone else, or previous management experience.

. Sufficient business acumen (in our opinion).

. Adequate asset backing and cashflow." ⁽⁾

(b) "For larger, more complex projects, construction costs to be estimated by an independent quantity surveyor, architect or valuer." ⁽⁾

The risks in financing tourism developments were recognised and communicated to staff in a Management Information Bulletin No 222 dated 10 August 1987. Tourism developments were to be fully analysed in terms of both the project and the experience, character and capacity of the sponsor.⁽⁾ Although no specific policies were stipulated for tourism developments over and above those generally applicable to real estate loans, a number of risk factors were identified as requiring particular consideration:

"High Risk

. Developer relies on optimistic "end valuations", and seeks a high ASR on cost.

. Developments which expand capacity in areas not yet proven as tourist destinations.

. Complex projects, or developments on new sites, where the risk of construction over-runs, particularly in infrastructure, are greatest.

. Projects seeking to sell large volumes of units in developing locations.

. Over building in capital cities such as Darwin, Perth and Adelaide which are not yet on major international tourist routes.

. Broad area land developments away from established tourist destination areas which lack integrated marketing strategies.

. Large time-share projects.

. A combination of all, or part, of an inexperienced owner, manager or builder.

Low Risk

. Central Business District and suburban hotels in Sydney and Melbourne.

. Acquisitions of existing hotels; but care is needed in small country towns.

. Transport infrastructure (with experienced operators).

. Upgrading/recycling of well located properties (with experienced operators)." ⁽⁾

Following a Credit Policy Committee meeting on 20 July 1990, the Policies and Procedures Reference Manual was amended to ensure that a number of specific matters were addressed on all construction and development proposals, in light of the rapidly deteriorating property market, increasing scarcity of finance for property development, and high interest rates. The matters were:

". Cashflow (Project and Client generally)

. Pre-letting (Legally enforceable)

. Financial strength of Sponsor

. Equity contribution from Sponsor

. Strength and enforceability of pre-sales contracts". ⁽⁾

In regard to financing construction of shopping centres, a number of specific conditions were stipulated:

". The centre must be located in a major metropolitan area.

. Project must cost more than $2m (i.e. do not undertake smaller projects at this level).

. Project must provide for a major acceptable supermarket (eg Coles/Myer) with tenancy pre-let and documented on a written agreement.

. 60% of total floor space (including the supermarket) is to be pre-let." ⁽⁾

30.4.1.3 Approval of Loans

The loan approval process and authorities were described in Section 30.2. Speed and efficiency in the processing of credit applications was given a high priority at Beneficial Finance. The minutes of a meeting of the Credit Policy Committee held on 23 October 1989 record that the "philosophy regarding credit processing was confirmed, with all submissions given absolute priority and a target turnaround time of 24 hours in place (48 hours for the Structured Finance and Projects division in view of the general level of transaction complexity.)"

30.4.1.4 Settlement of Loans

Settlement of loans denotes those processes following credit approval through to the time when Beneficial Finance's funds are actually advanced to the borrower.

Following approval, the applicant was sent a standard form letter of offer. The Account Manager was responsible for preparing this letter, and for ensuring that all approved terms and conditions and standard requirements for the type of loan were included.

The Account Manager then handed the letter of offer to the signing authority, who was required to check the letter before signing both it and a file copy. The face value of the loan determined which officer had authority to sign the letter of offer, as follows:

Signing Authority	$M Loan

Branch/Sales Manager	Less than 1.0
Securities Manager	1.0 to 2.0
Senior Officer Nominated by Sales Manager	More than 2.0

Approvals remained current for only thirty days from the date of approval. If the client did not settle within that time, the approval was referred back to the approving party for extension for a maximum of a further thirty days.⁽⁾

When the applicant's acceptance of the letter of offer was received, the Account Manager was required to complete forms called "FRS Loan Up-Take" forms, and pass to them to an operator for entry into Beneficial Finance's computer system. The file was then passed to the State Securities Department, which was required to insert the Securities Checklist, and to check the file to ensure that:

". the loan amount is within approving officer's limit.

. repayment calculations have been checked and initialled by two responsible officers.

. Computer Uptake/Worksheet is complete and correct. Security must be described in full, including details of collateral security, collateralised accounts, guarantors etc.

. Progress Payment details are shown on the front cover (if applicable)." ⁽⁾

The Securities Officer was then required to prepare a standard letter of instruction to the solicitors acting on the conveyance of the property. If the amount to be advanced exceeded $2.0M, the letter of instruction was required to be countersigned by a Senior Officer nominated by a State Manager. The Securities Manager was responsible for ensuring that all pre-settlement conditions of approval had been complied with. Those conditions having been complied with and that process of satisfaction having occurred, the file copy of the loan schedule was required to be stamped and signed.

Cheques were authorised by way of the Securities Manager signing the FRS Up-take form. The authorising officer was generally not permitted to be a signatory to the cheque. Both cheque signatories were required to ensure that the cheque had been authorised at an appropriate level of authority, to be satisfied with the validity of the transaction, and to ensure that the loan had been set up on the computer system.

30.4.1.5 Management of Loans

Management of loans denotes the ongoing monitoring and control by Beneficial Finance of loan accounts which are being conducted in accordance with approved terms and conditions, together with those loans which have been identified as "non-performing" by Beneficial Finance. Beneficial Finance's basic policy in relation to the degree of monitoring of loans was:

"A Lender needs to monitor a Loan to protect its interests (ie. asset) and provide on-going flexibility to the Borrower to meet changing circumstances. The degree of monitoring depends on the quality of the borrower, its ability to meet all on-going commitments and type of security supporting the loan (eg. an unsecured arrangement - negative pledge - clearly requires frequent and close monitoring)." ⁽⁾

In terms of financial monitoring of Beneficial Finance's customers, the policy was that:

"An accurate assessment of our client's financial position is required at all times. The level of on-going monitoring is dependent on the accuracy and completeness of financial statements - whether monthly, quarterly, half yearly or yearly. If possible have balance sheet and P&L statements on hand for the most recent period. Up-to-date, signed Assets and Liabilities statements are required." ⁽⁾

For property transactions of more than $0.5M, and in the case of loans to "cyclical industries", provision of regular reports was a condition of approval. It was noted that Account Managers should ensure that financial reports were readily obtainable, since borrowers require such information themselves in order to survive.⁽⁾ Despite the apparent importance of this requirement, Level B officers could waive it. Clauses conferring upon Beneficial Finance the right to inspect client accounts and to require clients to provide regular financial information were standard in all loan and lease documents. Again, however, Level B officers could authorise the deletion or modification of these clauses.

With respect to cash flow forecasts, the policy was to call for these only "if necessary".⁽⁾

A system of credit risk grading of customers was introduced at Beneficial Finance in late 1990.⁽⁾ This coincided with the introduction of a similar system at the State Bank.⁽⁾

The responsibilities of Account Managers with regard to the risk grading system were clearly identified:

"The Account Manager is responsible for:

. The continued safety of the risk asset under personal supervision. If the Account Manager detects a material deterioration at any time, downgrade the customer to reflect the deteriorated credit risk. The appropriateness of the grading is to be closely monitored in the light of developments.

. Recommending and implementing a course of action to improve and strengthen the company's position and/or reduce company exposure.

. Make efforts to rectify the conditions giving rise to the adverse grading or, in appropriate circumstances, reduce the relationship through an orderly repayment program." ⁽⁾

Apart from the credit risk grading system, there were "Credit Warning Indicators" designed to indicate potential problem accounts. Two types of accounts were distinguished:

". Irregular Accounts - Exposure where the customer is in breach of one or more conditions of the loan agreement but loans income is still being credited to profit and loss.

. Credit Watch Accounts - Exposures where there is inferential or non-quantifiable information which indicates material adverse implications for future credit risk grade. Such information could include adverse developments in the client's industry including economic conditions, changes in regulations, failure of suppliers etc." ⁽⁾

There were no policies evident in the Policies and Procedures Reference Manual regarding the frequency or method of reporting the credit warning indicators, nor were the persons with responsibility for such reporting identified.

One basic process relevant to the management of loans process was the preparation by Account Managers⁽⁾ at varying intervals of an Account Management Control Report.

Not all accounts were required to be reported by way of an Account Management Control Report. Only those accounts under which the principal outstanding exceeded a specified minimum were required to be reported in this way. The minimum varied from division to division. The General Manager of each division was responsible for setting the minimum level of transactions to be subject to an Account Management Control Report. Equally, not all Account Management Control Reports were required to be reviewed by superior officers. Only a nominated percentage or, in the alternative, reports generated in particular nominated periods were required to be reviewed. Again, the percentage of Account Management Control Reports to be reviewed or, on the alternative basis, the frequency with which they were to be reviewed was set by the State Credit Manager in liaison with the State Manager. The State Managers were responsible for the correct conduct of all account management activity.⁽⁾

Procedures for management of loans also included the classification of certain accounts as "Watchlist Accounts" which were subject to additional scrutiny including the preparation of a Watchlist Report each month. Watchlist Accounts included accounts that were or were encountering:

". regular delinquents.

. farmers with annual payments.

. clients experiencing adverse seasonal conditions.

. security reduction or loss.

. current or potential cash flow problems or re-writes to assist cash flow.

. securities geared to provide cash flow (eg. funding interest) or interest financed on projected increases in security value from using our funds (subdivisions).

. paying but under receiver/manager.

. further advances for increased construction costs, etc.

. as a condition of approval." ⁽⁾

An independent review process known as "Review of Buying" was conducted by the Internal Audit and National Credit departments. Review of Buying guidelines were developed which provided the following definition of the process:

"Review of Buying is a post event review of approved transactions where the risk characteristics and business rationale of a specific transaction are assessed by the Reviewer who makes a subjective evaluation as to whether a particular deal is considered to be a sound credit risk and an appropriate account management process has been put in place for subsequent monitoring of performance and control." ⁽⁾

Mr T Siegele said in evidence to my Investigation he was informed that the Review of Buying process was carried out almost exclusively in respect of the Australian Business division. There were no formal review processes in place for the Structured Finance and Projects division.⁽⁾

In about September 1989, a procedure known as "Risk Asset Review" was introduced. A Risk Asset Review was required to be carried out in respect of selected loans considered to be non-performing or to have the potential to become non-performing. The purpose of the review was to identify:

(a) whether or not the loan should have been entered into in the first place;

(b) what events or circumstances have caused the loan to become (or to be likely to become) non-performing; and

As noted, the policies and processes relevant to the raising of adequate provisions for losses are described in Chapter 42 - "Bank and Bank Group Provisioning" of this Report.

30.4.2 APPLICATION OF THE POLICIES AND PROCEDURES IN PRACTICE

As a result of my Investigation's examination of the core business real estate loans, included in the twenty-one non-performing loans that I have analysed, I am generally satisfied that the policies and procedures were observed and applied in practice. There were some departures from the policies and procedures, and more particularly, some judgments were made that, with the benefit of hindsight, were unwise. In particular, in my opinion too little attention was paid to the risks associated with a downturn in the property market in a number of the transactions investigated. These were, however, generally judgments made within the discretions provided by the policies and approval procedures. Overall, I am prepared to give the core business divisions a satisfactory rating.

Having reached this conclusion, it is not necessary for me to describe in detail the transactions that were investigated. It is, in my opinion, sufficient to briefly describe one transaction examined by my Investigation that illustrates that, despite the general observance of the policies and procedures, losses could and did occur. That was the loan made to Stemin Pty Ltd, a trustee company for a property development joint venture.

30.4.3 A CASE STUDY IN CREDIT RISK MANAGEMENT: STEMIN PTY LTD

30.4.3.1 Introduction

This Section briefly describes the results of my examination of the management of credit risk in respect of a $16.193M loan provided to Stemin Pty Ltd, including the initiation, approval and subsequent management of the loan. This transaction is illustrative, in my opinion, of the risks associated with loans to real estate developers in an overheated property market. It resulted in losses despite the apparent care taken, and despite general adherence to policies and procedures, in respect of the loan.

Stemin was a joint venture between a property developer and a construction company. The joint venturers have a continuing association with the Bank, and accordingly I will refer to them as White and Black, to protect the confidentiality of the affairs of the Bank's customers.

30.4.3.2 Initiation of the Facility

Stemin Pty Ltd was incorporated in South Australia on 16 May 1989 to act as trustee for the Stemin Unit Trust, formed for the purpose of a joint venture to acquire and develop the Hallett Nubrick industrial site at Allenby Gardens.

In June 1989, Stemin contracted to purchase the land, with settlement to occur on 2 April 1990. Before settlement, Stemin was to rehabilitate the site by filling a pug hole which covered approximately 60 per cent of the area. Stemin proposed to subdivide the property into fifty allotments for sale, comprising forty one vacant allotments and nine improved allotments, including an office building and eight strata titled warehouse units.

In about September 1989, Stemin made an application to Beneficial Finance for the provision of a loan to fund the acquisition and rehabilitation of the land, and for the subsequent sub-division and development of the land.

The application made by Stemin was for an amount of $20.96M. Stemin proposed that:

(a) the joint venturers would not provide any equity for the project; and

(b) interest would not be paid periodically, but instead would be capitalised and paid at the time that the loan was repaid.

At the time of making this application, Stemin was negotiating with Australia Post for the purchase by that party of a significant portion of the subdivided property. Stemin had also lodged development plans for the proposed sub-division with the relevant local government authority.

Jones Lang Wootton provided a valuation of the property as at 30 September 1989 on three separate bases:

(a) value of property as inspected, excluding works completed by the joint ventures up to date of valuation and assuming settlement of the purchase contract: $9.0M;

(b) estimated value as at the proposed date of settlement of the land purchase in April 1990, assuming that the site works were completed according to schedule: $14.5M; and

(c) estimated end value, following the sub-division and obtaining of certificates of title in accordance with the proposed plan of sub-division (with an escalation of sale prices during the sale period, and no allowance for costs or sale as a single holding): $24.46M.

Each of these valuations assumed that Australia Post would pre-commit to purchase Allotment 11.⁽⁾

In support of the loan application for the loan, the joint venture parties provided information regarding their respective financial positions.

White provided a statement of affairs from its financial advisers and auditors, Ernst & Whinney, in which a partner in the firm stated:

"I have acted in the above capacity for White for many years, and I am of the opinion that he is an astute businessman who is very capable in the area in which he conducts his business. In my opinion, White is unlikely to enter into any business arrangements whereby he is unable to support any commitments he may incur.

The assets and liabilities listed below have been provided to me by White. I consider that the valuations as indicated by White are reasonable." ⁽⁾

The statement of affairs revealed that White had a net worth of $9.047M as at 20 September 1989, based upon White's valuations of the real estate holdings of the White Group of companies.

White also provided details of the White Group's budgeted cash flow for the period October 1989 to September 1990, which indicated that both the White Group, and the joint venture, were expected to operate with a monthly cash deficit throughout the period. The White Group's projected deficit was to be funded from the proceeds of two property sales during that period. The joint venture deficit was to be funded from the proceeds of five property sales, also anticipated to occur during the period. Of nine properties identified for sale in White's cash flow document, however, only four were the subject of sales contracts.

The information provided by White did not include the financial statements of the companies that comprised the White Group. As noted, the statement of White's net worth was based on White's own valuation.

The other joint venturer, Black, provided financial statements which showed that Black had net assets of $4.77M. Cash flow projections for Black anticipated a cash flow surplus from construction projects, including estimated future contracts, of $0.5M over the period from October 1989 to September 1990. The projections of the joint venture's cash flow deficit were consistent with those provided by White.

Following a credit review of the Stemin application, Mr D Teroxy, Beneficial Finance's General Manager, Credit Audit and Procedures, expressed concern that there was "no real feasibility or demand analysis of the project", and that "the financial profiles of both sponsors raises substantial queries".⁽⁾ He noted the failure of White to provide financial statements, and stressed that "special attention to asset sales" was required, having regard to the importance of those sales to White's cash flows.⁽⁾ Mr Teroxy also expressed concern regarding the lack of experience, and of a demonstrable track record of success, by the joint venturers in the project this size and type.

He concluded that he would be pleased to reconsider the proposal provided that the following conditions were met:

(a) the joint venturers agreed to contribute a realistic level of equity;

(b) the sale of part of the site to Australia Post was firmly committed;

(d) a proper, sensitised financial evaluation of the capacity and financial quality of the joint venturers, predicated on current data, was prepared and was satisfactory." ⁽⁾

On 25 October 1989, Mr S Osborne, a Manager of Beneficial Finance's Real Estate and Business Loans division, met with White and Black who agreed to contribute equity to the joint venture of 10 per cent of the rehabilitation costs, and to make periodic interest payments on the loan. They advised Mr Osborne, however, that Australia Post was not prepared to enter into any contract in relation to the site until January 1990, and that it was, therefore, planned to further sub-divide the land. Mr Osborne noted that this further sub-division would favourably affect the valuation of the land, which had been prepared on the assumption that Australia Post would purchase part of the site.⁽⁾

In order to address the concerns raised by Mr Teroxy in respect of the financial position and capacity of White, Mr R A Garrett, Beneficial Finance's Senior Manager, Credit Analysis, conducted an interview with White on 31 October 1989. In his notes relating of the interview, Mr Garrett reported that:

"White is primarily a trader in commercial and industrial property acting alone or in partnership with Black, as in the Hallett Brick joint venture currently being considered, or with Brown of Brown Constructions. The philosophy is to negatively gear all properties to the maximum extent, and to generate cash for the debt servicing shortfall (against rental income) from sales of properties." ⁽⁾

Mr Garrett also noted that White's failure to provide financial statements for the White Group was due to White's concern that the financial statements would show negative net worth, because the Group's "assets are in the books at cost." ⁽⁾

As to the nine properties shown in the cash flow document to be sold during the period to September 1990, Mr Garrett sighted contracts for the sale of three of them. He noted that there were offers on another two, and that a third was being progressively sold.

Two of the properties that were shown in the White's cash flow projections to be sold in June 1990 and August 1990 respectively, to provide cash surpluses in those months, were not owned by White at the time when the cash flow document was being reviewed by Mr Garrett. These two properties were the subject of contracts for purchase by White, but completion of the purchases depended upon White obtaining necessary finance.

Mr Garrett, relying upon inquiries made of parties who had previously lent to White and upon Beneficial Finance's own experience, concluded that White had "a good credit reputation", and that he had "gained the impression that White is competent in commercial property, is proud of his achievements and reputation, wants to protect that image and track record, and is prepared to take whatever steps are necessary to achieve that." ⁽⁾

30.4.3.3 The Credit Submission

Mr Osborne and Mr S Smith, another employee in the Real Estate and Business Loans division, prepared a credit submission and supporting information and summary document in relation to Stemin's request for funds. The credit submission, dated 3 November 1989, sought approval for a facility of $16.193M, to be used as follows:

	$M
Land rehabilitation	8.168
land acquisition/legal fees	6.800
Contingency fee	0.433
Establishment fee	0.162
Risk participation fee	0.630
	16.193

The submission stated that progress payments for land rehabilitation were to commence in November 1989, and settlement of the land purchase to occur on 2 April 1990. The facility was for a term of twenty months. Stemin was to contribute $1.0M in equity, payable as 10 per cent of development costs up to a maximum contribution of $0.5M, and $0.5M towards the purchase price of the land. Stemin was, however, to be given the option to elect not to make the second $0.5M contribution, but instead to borrow that amount from Beneficial Finance, provided that repayment of the amount was supported by a bank guarantee. Interest was payable monthly.

The equity contribution and interest payments, totalling an estimated $3.156M, were to be paid from the financial resources of the joint venturers. The principal amount was to be repaid from the proceeds of the sales of allotments, following completion of the sub-division. The credit submission stated that projected sales of forty allotments within a fifteen month period, in accordance with the timing schedule prepared by Jones Lang Wootton, would provide sufficient proceeds to repay the debt within the term of the loan.

The submission referred to the 30 September 1989 valuation of the project prepared by Jones Lang Wootton and stated that, because Australia Post would not be making a decision in relation to taking up a portion of the land until early 1990, the sub-division plan had been revised and a new valuation obtained, which resulted in the property being valued as follows:

(a) property as inspected, excluding works that had been completed up to the date of valuation, but assuming purchase on 2 April 1990: $9.5M; and

(b) estimated end value, following sub-division and the issuance of certificate of title in accordance with the sub-division plan: $27.0M.

The credit submission identified a second and third method of recovering the loan if the borrower did not repay the loan. In the event that the borrower defaulted prior to completion of the sub-division project, an agent would be appointed by Beneficial Finance as mortgagee to complete the project from funds held on a "cost to completion" basis, following which the sub-division would be sold either as a single holding or as individual lots. It identified a surplus of $6.592M arising from this course of action, based on an estimated end value of $27.0M. In the event that the above alternative should result in a deficit, the submission referred to the combined net worth of the joint venturers, who were to provide guarantees, of $13.74M.

The credit submission showed two figures for the Advance Security Ratio for the loan: 99 per cent, calculated using the project cost of $16.401M, and 60 per cent, calculated using the valuation on completion of $27.0M. This presentation accorded with the format specified in the Policy and Procedures Manual, which required that both calculations be shown.

The policy relating to the Advance Security Ratio for industrial sub-divisions required that this ratio be calculated using the lower of cost or valuation. Accordingly, 99 per cent was the relevant Advance Security Ratio for the purpose of assessing this facility. The 99 per cent Advance Security Ratio used for the assessment of this credit facility far exceeded the 70 per cent Maximum Advance Security Ratio set out in the Policies and Procedures Reference Manual.

The credit submission stated that final planning approval for the proposed development was expected in mid December, and that Beneficial Finance had received an indication of general support for the design concept from the Planning Office of the Woodville Council. Further, the Submission stated that:

"We have discussed the possibility of the plan not being approved with Jones Lang Wooton, and with John Kenny, Beneficial Finance's in-house valuer. Both indicate that as the land has correct zoning, lot sizes are above the required minimum, and the land is above the 200 year flood level, there is no basis on which a plan of subdivision for industrial use can be refused." ⁽⁾

The supporting information and summary document and attachments contained details of:

(a) security documentation and land settlement details;

(b) the corporate structure of the joint venture parties;

(d) the land proposed rehabilitation works;

(e) the financial capacity of the borrower; and

(f) the proposed sales programme.

The information provided in the credit submission indicated that the concerns expressed by Mr Teroxy, following his initial credit review of the application, had been addressed.

Several aspects of the facility as outlined in the credit submission departed from policy relating to this category of facility.

First, the facility as proposed did not comply with the policy requirement that planning approval must be obtained before the advancement of funds. Beneficial Finance's personnel had, however, made inquiries to satisfy themselves that the planning approval would be granted, and a requirement as to planning approval was set down as a condition to be met prior to land purchase settlement.

Second, the policy in force at the relevant time set the maximum Advance Security Ratio for lending in relation to real estate sub-divisions at 70 per cent, and required that the Advance Security Ratio be calculated using the lower of cost or valuation. Although the credit submission set out two Advance Security Ratio figures in accordance with the required format, 99 per cent was the relevant figure for the purpose of assessing this submission. The submission made no comment about the fact that the relevant Advance Security Ratio for this facility exceeded the maximum level of 70 per cent.

Third, the industrial sub-division project to be undertaken by Stemin, being in excess of forty allotments, was significantly larger than the twelve lots set down in Section 1123 of the Policy Manual as a guide to maximum project size. The submission did not comment on this aspect of the Stemin project.

30.4.3.4 Approval of the Facility

Because the Stemin facility was not, in the first instance, to be secured by a first mortgage over real estate, the limits in the "Other Secured" category of the delegated loan approval authorities applied for the purpose of determining the appropriate approval authority for this facility. Within the category, a facility for an amount of $16.193M required approval by two directors.

In accordance with the required procedures, the credit submission was successively reviewed and recommended by the State Credit Committee, the Credit Sub-Committee and the National Credit Committee before being submitted to two directors for approval.

The credit submission was approved by two directors, Mr R P Searcy and Mr T M Clark. In giving his approval, Mr Searcy imposed three conditions. A letter dated 10 November 1989 from Mr P Fleming to Mr Clark stated:

"Mr Searcy has advised an approval subject to:

i) a Geotech clearance on completion of land fill by an engineer appointed by Beneficial Finance, and instructed by the Chief General Manager of the Structured Finance and Projects division;

ii) All rectification work, if required, to be at the borrower's sole cost; and

iii) Stemin's Unit Trust structure to be vetted by solicitors." ⁽⁾

This letter carries the handwritten notation "Approved", and is signed by Mr Clark.

In accordance with policy requirements, a summary of credit transaction detailing the facility, as approved, was supplied to the Beneficial Finance Board of Directors for ratification of the approval at the Board meeting held on 24 November 1989. The minutes of this Board meeting record the concern of the Board that the land rehabilitation aspect of the project be properly controlled, and that "those controls should be included as a condition of the deal." ⁽⁾

30.4.3.5 Security

The circumstances of the Stemin facility were unusual, in that although Stemin was to commence land rehabilitation work in November 1989, settlement of the purchase of that land by Stemin was not to occur until April 1990. It was, therefore, not possible to obtain the security of a registered first mortgage on the property at the commencement of drawdowns on the facility.

After taking legal advice, Beneficial Finance lodged a caveat over the property pending settlement, at which time a registered first mortgage was to be obtained. The following forms of security were also obtained:

(a) A registered debenture over the whole of the assets and undertakings of Stemin Pty Ltd.

(b) A Deed of Assignment over the contract for purchase of the site, the construction and development contracts, and all plans and specifications in relation to the site. A consent was obtained from the vendor of the site, J Hallett & Son Limited, for the assignment of the contract of purchase.

In addition, pursuant to a guarantee executed on 15 February 1990, Kabani Pty Ltd ("Kabani"), an off-balance sheet company, guaranteed to Beneficial Finance the payment of all amounts due from Stemin in relation to the facility. Stemin provided an indemnification to Kabani in respect of any amounts which Kabani might be required to pay pursuant to the guarantee given to Beneficial Finance. A guarantee fee of $100 was payable by Stemin to Kabani. The performance of Stemin's obligations under the indemnity was guaranteed by the joint venture partners.

30.4.3.6 Settlement of the Facility

On 14 November 1989, a letter of offer was sent to Stemin outlining the terms and conditions pursuant to which Beneficial Finance was prepared to make the $16.193M facility available. The letter took into account the conditions upon which Mr Searcy and Mr Clark had approved the facility, including conditions designed to ensure the quality of the rehabilitation work undertaken on the site, a matter that had been of concern to the Board. The letter of offer required the $1.0M equity contribution to be contributed in two tranches. First, the borrower was to contribute 10 per cent of all progress payments, up to a maximum of $0.5M. Thereafter, the claims would be met by drawdowns on the facility. The second $0.5M tranche was to be contributed by the borrower towards the purchase price of the land at settlement of the purchase on 2 April 1990, subject to Stemin's right to borrow that $0.5M from Beneficial Finance upon the provision of a bank guarantee.

On 22 December 1989, following an extension of the original offer period, a further letter was sent to Stemin. The offer, as outlined in the letter of 14 November and amended by the letter of 22 December, was accepted by Stemin on 22 December 1989 by the signing of the Memorandum of Acceptance clauses included at the foot of each of these letters.

An Agreement, together with documentation relating to the guarantee and indemnification in respect of this loan, was executed on 15 February 1990.

30.4.3.7 Management of the Facility

Management Information Reports relating to the loan were prepared, and meetings with the borrowers were held on a regular basis. Regular reports as to the progress of the project and the quality of the land rehabilitation work were received from the engineering firms involved, and progress payments were made in accordance with policy requirements.

Within three months from the date of the first drawdown on this facility, however, it came to the attention of Mr Osborne, the Account Manager, that White was experiencing financial difficulties, related to the two other properties which White had contracted to purchase. The contracts had long settlement periods, and the property market having declined somewhat since the contract date, White was finding it difficult to finance the purchases, and so was facing the possibility of legal action from the vendors and a loss of up to $1.0M.⁽⁾

Upon becoming aware of this, Mr Osborne took action to enable Beneficial Finance to assess its position, and to monitor the account more closely. He requested from the joint venture parties:

(a) updated cash flows from White and Black;

(b) an estimate of drawdowns for the ensuing four months, to enable an estimate of interest payments which would need to be met; and

In March 1990, Stemin elected to borrow the $0.5M needed for settlement from Beneficial Finance, supported by a guarantee from the National Australia Bank. The White Group's cash flow projections had anticipated that, during the period October 1989 to June 1990, nine properties would be sold, providing net cash inflows to the White Group totalling $4.249M. As at June 1990, however, none of these property sales had eventuated.

In view of these problems, Beneficial Finance decided that, from 1 June 1990, all progress payments for the rehabilitation work would be made directly to the two major contractors, and not to the joint venturers.

In July 1990, a further report was obtained from Jones Lang Wootton, which noted that the market for commercial and industrial property had taken a severe downturn in the previous eight months. The report estimated the gross proceeds of the proposed sub-division at between $19.0M (calculated on the basis that there would be no increase in sale prices throughout the selling period) and $21.0M (assuming a 7.5 per cent annual increase in sale prices).

Interest on the loan continued to be paid until October 1990. From the August payment onwards, however, it was apparent that the capacity of the borrowers to meet their commitments was limited. The account was subjected to close monitoring, and became the subject of a weekly Problem Loan Report to Management.

On 23 September 1990, Mr J Kenny, Beneficial Finance's in-house valuer, expressed the view that a forced sale of the property under prevailing market conditions could be expected to realise a maximum of between $13.0M and $13.5M, and that even then a buyer may be very difficult to find.⁽⁾

Stemin failed to meet the October 1990 interest payment, and Beneficial Finance issued Notices of Demand. When Stemin also failed to meet the November 1990 interest payment, Beneficial Finance took steps to enable mortgagee possession of the property. By December 1990 Kabani, as Mortgagee, had entered into possession of the property.

The $0.5M bank guarantee provided by Stemin at the time of land settlement was called, and the proceeds applied to meet interest arrears and penalties, bringing the account up to date. The balance of $0.183M from the guarantee funds was applied to reduce the principal of the loan.

In a report to the Board for November 1990, the Stemin account was shown as a major addition to reported arrears. In the December Board report, as a consequence of the National Australia Bank guarantee being called, the account was reported as having been brought up to date. To claim that the account was regular in the light of all the surrounding circumstances was to deny the reality of the situation that existed, and the advice to the Board that the account had been brought up to date was, in my opinion, misleading. The Stemin facility was, however, included as a non-performing loan in the December 1990 Board reports, and a Monthly Status Report, identifying the status of the facility as "non-accrual" and showing interest foregone on the facility, continued to be prepared monthly for inclusion in the Board Papers.

As at April 1991, the account was still being reported as "non-accrual" in the Monthly Status Reports. The report for April 1991 reported that interest foregone was $0.559M.

30.4.3.8 Summary and Conclusions in respect of the Stemin Facility

In my opinion, the deficiencies in the management of the loan to Stemin are the result of an over reliance on the continuing strength of the property market. The success of the transaction depended entirely upon continuing high real estate values. In particular:

(a) The financial capacity of White to meet its obligations depended on its ability to sell other properties, and in respect of two of those properties, to obtain finance to complete the purchase of the properties by White. When property prices fell and the ready availability of finance for real estate investment ended in late 1989 and early 1990, White's financial position deteriorated rapidly. The business strategy of White, as described by Mr Osborne's interview notes, was the classic 1980's strategy of maximising debt, and relying on ever increasing real estate prices to meet the debt obligations. That strategy collapsed along with property values.

(b) The financial capacity of Black depended on its business activities in the construction industry.

(c) The funds to repay the loan to Stemin were to come from the proceeds of sale of the project. By agreeing to a loan to security ratio of 99 per cent based on the cost of the project, Beneficial Finance was reliant on at least the maintenance of property values to recover its loans.

The changes to Beneficial Finance's policies and procedures in 1990, referred to earlier, were introduced to ensure that this sort of reliance was not repeated.

30.4.4 SUMMARY AND CONCLUSIONS

I am satisfied that, in general, the policies and procedures applicable to the real estate lending of Beneficial Finance's were adequate and appropriate. I am also satisfied, from my review of individual loan files and from other documents and evidence, that those policies and procedures were generally observed and applied in practice.

The losses associated with the real estate loans of the core business divisions were the result of the economic conditions of the time, that saw a large rise, and an equally large collapse, in the market. Those economic conditions directly influenced the exercise of judgments within the discretions provided by Beneficial Finance's policies and procedures.

Beneficial Finance's losses in respect of the real estate lending by its core business divisions were caused principally by:

(a) an over reliance on the continuing strength of the property market in making judgments in respect of loan applications; and

(b) the excessively large exposure of the portfolio to the real estate sector.

30.5 BENEFICIAL FINANCE'S "NON-CORE" BUSINESS: THE STRUCTURED FINANCE AND PROJECTS DIVISION

30.5.1 INTRODUCTION

As described in the introduction to this Chapter, after 1984 Beneficial Finance expanded its business activities beyond its traditional, core businesses. It did so both as a response to the increased competition in its core businesses following deregulation, and to take advantage of the particular opportunities provided by deregulation and the economic conditions of the time. Beneficial Finance's ownership by the Bank from 1984 significantly enhanced its ability to obtain both capital and loans to fund its expansion. The report of my Investigation of Beneficial Finance's funding is provided at Chapter 34 - "The Funding of Beneficial Finance".

These non-core businesses were carried on principally by the Structured Finance and Projects division, and its predecessors, the Investment Banking and Corporate Services divisions. I will use the name Structured Finance and Projects division to apply to all three manifestations of the division, each of which was headed by Mr Reichert.

It was the Structured Finance and Projects division that was responsible for most of Beneficial Finance's extraordinary growth after 1984. Established in March 1986, the division grew to the point that, by 30 June 1989, its exposures of more than $5.0M to clients totalled $1,039.1M, which represented 78 per cent of Beneficial Finance's large exposures. The division's average client exposure at the time was $18.2M, or almost 14 per cent of Beneficial Finance's shareholders' funds. The division's total assets represented about 40 per cent of Beneficial Finance's on and off-balance sheet assets. The assets of the operating joint ventures were a further 18 per cent.

Broadly stated, the Structured Finance and Projects division's businesses can be regarded as falling into three broad categories:

(a) Loans to corporate borrowers, very heavily concentrated on commercial property development.

(b) Equity interests in, and lending to, commercial property development projects, usually in the form of project-specific joint ventures.

(c) Initiating and managing Beneficial Finance's equity participation in operating joint ventures with small, specialist financiers. These joint ventures, which were an extension of Beneficial Finance's core business activities, are described separately in Section 30.6 of this Chapter.

30.5.2 THE BUSINESS ACTIVITIES OF THE STRUCTURED FINANCE AND PROJECTS DIVISION

The Corporate Services division was established in March 1986 following a review of Beneficial Finance's operations by a finance efficiency consultant. A Management Information Bulletin at the time stated that the "growth and diversification of Beneficial Finance necessitates that we change our organisation to focus on the opportunities that exist."⁽⁾ The role of the Corporate Services division, headed by Mr Reichert, was to "to handle the larger and more complex transactions requiring specialised staff and sophisticated systems" involving single transactions in excess of $2.0M.⁽⁾ It was also to pursue opportunities in joint ventures, financial packaging and syndication servicing, "the middle tier of the corporate market, and providing some merchant banking type products to this middle market." ⁽⁾

Beneficial Finance's 1986 Strategic Plan, for the financial year 1987-1991, stated that:

"The establishment of a separate division to handle corporate transactions facilitates the continued thrust by the company away from its traditional markets, into a sector of the corporate market which is considered to be inefficiently serviced by existing financial institutions." ⁽⁾

The Strategic Plan expressly stated that part of the new division's strategy was to take risks that were unacceptable to other financial institutions. It said:

"The company has the capacity to act as a quasi-finance arm for a number of banks and merchant banks ... The rationale for the above proposition reflects the willingness of these institutions to act as wholesalers with relatively high facility sizes, and also their perceived reluctance and/or inability to take risk positions which may be acceptable to Beneficial - whether that risk relates to credit, product or security." ⁽⁾ [Emphasis added]

Reflecting the highly specialised nature of the transactions that the division was to pursue, the Plan stated that the need to appoint "adequately qualified staff cannot be over-emphasised".

The Strategic Plan presented to the Board of Directors in 1987 said:

"The major strategic initiative for the Corporate Services Division will be a redirection of business activity. Corporate Services Division will concentrate on large, complex and specialised transactions with an emphasis on fee based activities and equity participation, rather than product-driven income.⁽⁾

On 1 July 1988, a further re-organisation was undertaken to facilitate a greater focus on Beneficial Finance's expanding joint venture investments, and "to optimise opportunities in the rapidly changing and highly competitive Australian financial environment." ⁽⁾ The Corporate Services division's name was changed to the Investment Banking division, and was again headed by Mr Reichert. Its role was to handle all receivables-based lending in excess of $10.0M, and all tax-based transactions.⁽⁾

A separate strategic plan was prepared for the Investment Banking division, which was distributed to directors in October 1988. The Investment Banking division's plan referred expressly to its willingness to take risk as a competitive advantage, stating:

"An advantage Investment Banking Division has over many competitors is the ability to provide funds (equity or debt) or take risk by way of guarantees in addition to providing the services of structuring and managing financial transactions. This differentiates Investment Banking Division from many competitors who are reluctant to take risks of any note. Flexibility to quickly refocus provides Investment Banking Division with the unique advantage to optimise profitable opportunities." ⁽⁾

Among the perceived weaknesses of the division identified in the Plan were:

". Inadequate management information systems, which hinder improvements in portfolio planning, strategic and financial planning, and management controls;

. Confused market image;

. Inadequate and unstructured approach to staff training;

. Level of industry experience and business acumen below optimum requirements in some instances." ⁽⁾

Among the threats identified by the Plan was that of a "downturn in the Australian or International economies or specific market segments (eg real estate sectors such as tourism related real estate)".⁽⁾

As its meeting on 24 June 1988, the Board of Directors of Beneficial Finance questioned whether the company was "growing too quickly in view of the volume and complexity" of the transactions written in 1988. Mr Reichert, who was present at the meeting representing Mr Baker who was overseas, is recorded as having told the Board that:

"... there had been a major change in the product range with higher unit sales in the business finance products, equity funding and unit trust financing. These covered a much lower number of transactions, although it was recognised that they were more complex and required strong and detailed account management. On the other hand, the higher volume account activity in equipment finance, commercial hire purchase and leasing directed through the State Bank Reverse Principal and Agency arrangement was well below budget. The need for an effective control of growth was a matter of continuing review by Management." [Emphasis added]

By July 1989, Mr Reichert's division had grown to represent almost half of Beneficial Finance's total assets. Of the company's exposures in excess of $5.0M, which totalled $1,327.8M, the Structured Finance and Projects division accounted for $1,039.1M, or 78.3 per cent of the total.⁽⁾

In July 1989, the Investment Banking division was renamed the Structured Finance and Projects division. Still headed by Mr Reichert, the division was responsible for "all structured facilities, client exposures of more than $10 million, overseas operations, and selected major customers' accounts." ⁽⁾ The fastest growth of the Beneficial Finance Group in the previous twelve months had been in large structured transactions relating to major construction and property development projects, which typically involved exposure risks in excess of $10.0M.⁽⁾ A new Investment Banking division was formed at the same time, headed by Dr R N Sexton, to manage Beneficial Finance's strategic investments and joint ventures.

On 1 May 1990,⁽⁾ the organisational structure was changed to "re-focus the Company on its core business, which has been very profitable in the past," ⁽⁾ to "reflect the changing business focus of Beneficial in a tough market", and to "ensure we focus, even more strongly, our efforts towards improving customer service." ⁽⁾

Most significantly, the Structured Finance and Projects division was disbanded, and an Asset Management division was created to manage all non-performing loans, focusing on the account management of larger real estate and project transactions, and investments.⁽⁾ Mr Reichert was re-assigned to head an internal service department. The Northern and Southern Business divisions were merged to form an Australian Business division "concentrating on commercial and business finance", and handling "only positive cash flow business".⁽⁾ The Australian Business division assumed the responsibility to manage most of the large financing transactions that had been the responsibility of the Structured Finance and Projects division.⁽⁾

Beneficial Finance's 1990 Annual Report announced the company's intention to "refocus the Company on its core business", noting that Beneficial Finance had been affected by the finance industry being "too aggressive", and by the rapid growth in property development funding. The larger structured property business in particular was causing most concern. The Report attributed Beneficial Finance's problems to "over aggressiveness, particularly in the area of structured property finance".

30.5.3 CREDIT RISK MANAGEMENT POLICIES AND PROCEDURES

The Structured Finance and Projects division did not regard itself as being bound by the credit risk management policies, procedures and guidelines that applied to the core business divisions of Beneficial Finance.⁽⁾

In his submission to my Investigation, Mr G L Martin, who as Business Development Manager was a senior manager of the Corporate Services division,⁽⁾ said that Beneficial Finance's Policies and Procedures Manual did not need to be observed if the submission was to be approved by the Board of Directors.⁽⁾ He said that "as a matter of practice, as the submission was subject to Board approval, it did not have to comply with the guidelines" Having regard to the size of the transactions undertaken by the division, which meant that almost all required the approval of directors, that meant that the policies and procedures effectively did not apply. He acknowledged too that there was no "formal assessment of joint venture projects".⁽⁾

Beneficial Finance's policies and procedures did not expressly provide any formal exemption for the Structured Finance and Projects division from their application. In practice, however, the division's business activities were perceived as being very different from those of the core business divisions for which the policies and procedures were written. The specialised and sometimes complex transactions of the Structured Finance and Projects division were regarded as being beyond the purview of Beneficial Finance's established policies. The division perceived its role to be that of highly skilled "financial engineers" involved in large and complicated transactions, where success required flexibility, innovation, entrepreneurial flair, and a willingness to take risks, including equity positions, that other financial institutions would not accept.

Such credit risk evaluation procedures as were in place in the Structured Finance and Projects division were frequently overridden by senior management, who acted on the view that its business could not flourish if it was constrained by the policies and procedures of the core businesses. The Structured Finance and Projects division would, instead, depend very heavily upon the technical and business skills and judgments of its senior management.

30.5.4 CREDIT RISK MANAGEMENT IN PRACTICE

30.5.4.1 Introduction

The fact that there were no formalised and obligatory policies and procedures applicable to the business activities of the Structured Finance and Projects division does not necessarily mean its management of credit risk was deficient. Although I regard the lack of policies as a serious deficiency, it is theoretically possible that the division could have adequately managed the risk exposures of the non-core businesses if its personnel had been sufficiently skilled, experienced and diligent to adequately and properly perform that task without the guidance of mandatory policies and procedures.

The absence of established policies in respect of Beneficial Finance's non-core business activities required my Investigation to closely examine the actual conduct of its risk management. As I have said, part of that examination involved a detailed analysis of individual non-performing facilities. I have reported the results of my examination of two Structured Finance and Projects division facilities in Chapters 31 - "Case Study in Credit Management: East-End Market" and Chapter 32 -"Case Study in Credit Management: Mindarie Keys" of this Report.

30.5.4.2 Initiation of Loans

My examination of the problem loans granted by the Structured Finance and Projects division identified a variety of deficiencies in the evaluation of the credit risk associated with credit proposals.

The single most fundamental and important failing of the Structured Finance and Projects division's assessment of credit risk was the apparently complete faith in, and reliance on, the profitability of property development and construction projects. The division's business was very heavily concentrated on financing such projects, which were a principal area of growth in the second half of the 1980's.

The reliance upon the perceived value of property development, and the failure of the division to observe the policies and procedures that applied to the core business divisions, manifested itself in the form of a variety of deficiencies in the evaluation of loan applications:

(a) There was a tendency to base the evaluation of the proposal upon essentially subjective judgments of the value and merits of the project, to the exclusion of a detailed independent and objective financial analysis of the project. Beneficial Finance's financing of the East End Market project is a good example of the reliance on the perceived value of a development without undertaking any analysis of the economics of, or problems associated with, bringing the project to fruition. Simply stated, the basic essentials of financial evaluation and credit risk analysis were neglected in favour of judgments based on essentially subjective perceptions of the merits of the project being financed.

(b) There was a general lack of attention to the financial strength of the borrowers. Reliance was placed instead upon the profitability of the particular use to which the borrowed funds were to be put. The result was that Beneficial Finance was often totally reliant on the success of the project to recover its loan. Shortly stated, if the project was successful, both the borrower and Beneficial Finance would profit. If it was not, Beneficial Finance stood to bear the loss. In that sense, even those facilities notionally structured as loans, with a commensurate rate of return, involved the down-side risk of an equity investment.

(c) Too much reliance was placed upon the value of security for a loan, to the exclusion of a detailed analysis of the project and its cash flows. There was a recurring tendency to justify the making of a loan on the basis solely of the appraised value of the property held as security.

(d) Further, the basis of the valuation of the security was often inappropriate for lending purposes. Rather than insisting upon a valuation for mortgagee purposes that assumed a forced sale of the project at any time, Beneficial Finance commonly relied upon valuations that were based on the assumption that the project would be successfully completed in accordance with the developer's plans. Beneficial Finance's Structured Finance and Projects division too often failed to consider the implications for the value of its security if, for one reason or another, the project did not proceed as planned. The result was to effectively commit Beneficial Finance to continue funding the project after problems developed, in the hope of mitigating its loss by taking the project to completion.

(e) In a number of cases, the evaluation of credit risk was subsumed to the prospect of earning substantial profits from a direct equity participation in the project. The credit risk management case studies in Chapter 31 - "Case Study in Credit Management: East End Market", and Chapter 32 - "Case Study in Credit Management: Mindarie Keys", provide particular examples of Beneficial Finance's participation being influenced by the anticipation of receiving large profits from part ownership of the developments.

30.5.4.3 Approval of Loans

My Investigation of the problem loans granted by the Structured Finance and Projects division disclosed a number of important deficiencies in the procedures for the approval of loans:

(a) Perhaps as a reflection of the perceived specialised and complex nature of its transactions, the loan approval procedure in the Structured Finance and Projects division was characterised by a domination of the evaluation and decision making procedure by the division's senior management. The credit risk evaluation and approval procedures were too often overridden or bypassed by senior management, thereby eliminating the possibility of a detailed quantitative financial evaluation of the borrower and the project. Senior management placed far too much reliance upon their own judgment, upon the expertise and capabilities of the borrowers, and upon the long-term profitability of property development projects.

The dominance of senior management of the division over the evaluation and approval process was particularly dangerous, having regard to the imperatives of management to increase the division's assets and profits. Shortly stated, management faced an inherent conflict between approving a loan to meet budgets, and subjecting the proposal to a critical and objective evaluation. In my opinion, the imperative for new business was by far the dominant factor, at the expense of adequate or proper credit risk evaluation and management.

(b) Reflecting that imperative, there was a tendency by senior management to structure submissions and presentations to the Board of Directors essentially as a sales pitch to the Board, rather than as incisive and objective summaries of the benefits and risks associated with the proposal. In very few of the submissions examined by my Investigation was there any effort to identify and evaluate the downside risks associated with a credit facility. The submissions were designed to obtain the approval of the Board, not to fully inform it of the substantive risks associated with the loan or equity investment.

(c) In my opinion, the Board of Directors was too willing to approve submissions put to it by senior management of the Structured Finance and Projects division. The Board's task in this respect was not an easy one. That division was regarded by the Board as a specialist division, with particular skills and expertise in the large and often complex financial transactions. For example, in the core business division loan to Stemin described earlier in Section 30.4.3 of this Chapter, Mr Searcy made his approval of the loan conditional upon the land rehabilitation work funded by Beneficial Finance's loan being reviewed by Mr Reichert.

Nevertheless, by retaining to itself the ultimate authority to approve loans, the Board of Directors assumed a responsibility to bring to the process the degree of expertise required to adequately discharge that function. Whatever the nature of the proposed facility, it was not beyond the capabilities of the directors to insist that the basic principles of credit risk analysis, which the directors had insisted be observed by the core business divisions, should also, at least, be addressed, and departures from policies justified, in respect of facilities proposed by the Structured Finance and Projects division. With the Structured Finance and Projects division operating outside the scope of Beneficial Finance's policies and procedures, the evaluation of submissions from that division was a role for which the Non-Executive Directors were ill-equipped.

30.5.4.4 The Structuring of the Facilities

My Investigation of the structuring of the problem loans of the Structured Finance and Projects division disclosed a number of deficiencies in the way that the credit facilities were arranged, that had significant implications for Beneficial Finance. The principal deficiencies identified were:

(a) In a number of cases, Beneficial Finance took an equity interest in the project, essentially providing its financial backing to the project in return for a share of the profits from the project. These ventures cast Beneficial Finance in the dual role of property developer and financier, resulting in a failure to adequately analyse the real risks associated with its financing of the project. Beneficial Finance's exposure as the financier of the project meant that its interests did not always coincide with those of its partners in the venture, upon whom it was reliant for the expertise to bring the project to fruition. The almost inevitable result was that Beneficial Finance was obliged, in order to protect its position, to effectively buy out its partners and become the sole owner of the project, as was the case in the East End Market and Mindarie Keys projects.

(b) The credit facilities provided by the Structured Finance and Projects division too often did not involve the payment of periodic interest by the borrowers. Interest was instead capitalised into the loan, with the division reporting profits on the basis of the income entitlement, but without receiving cash flow. The most important consequence for the purpose of credit risk management was the difficulty thereby created for monitoring the performance of the borrower, and taking early action to protect Beneficial Finance's position. In the absence of regular interest payments, there was no default "trigger" allowing Beneficial Finance to take action to protect its position when the financial position of the project deteriorated.

(c) There was a general failure to make the drawdown of funding for a project conditional upon the provision of reports from construction engineers and architects of the satisfactory progress of the project. The tendency was to continue to provide additional funding in the hope that, with sufficient support, the project would ultimately be successful, particularly as Beneficial Finance would bear the cost of the failure of the project.

30.5.5 A HINDSIGHT REVIEW BY BENEFICIAL FINANCE

At its meeting in September 1990, the Board of Directors was provided with a report prepared by Management titled "Lessons Learned from Problem Loans". Although the Report did not expressly say so, in my opinion, based on my review of Beneficial Finance's business activities, the deficiencies in Beneficial Finance's management of credit risk that were identified in the Report related principally, although not wholly, to the non-core business conducted by the Structured Finance and Projects division.

The Report described the analysis involved in its preparation as:

"... an evaluation of the major lessons learned as a consequence of the losses and problems which have emanated from Beneficial Finance Corporation's non and under performing portfolio. The report, derived in the main from contributions made by Asset Management's line and credit staff, is a distillate of the major issues and conclusions, and attempts to identify the root causes of the problems, the corrective action already in train and items which are to be addressed in conjunction with a revamp of the Group's composite credit process."

The minutes of the Board of Directors' meeting record in respect of the report:

"Lessons Learned from Problem Loans: The meeting discussed the evaluation of the lessons learned from large problem loans. It was concluded that the business culture, the search for tax based deals and failure to adhere to the existing credit procedures were the main contributors to the problems. The evaluation detailed remedial actions taken. The credit process had since been separated from line management to a more independent function and tax based deals were no longer applicable to the company's tax position. Other corrective actions had been taken and these were detailed in the paper. It was agreed that the information in the evaluation be condensed and issued to line management to convey the lessons."

The Report provided a frank analysis by Management of the shortcomings of the management of the credit risk associated with the non-core business activities, detailed positive remedial action being taken, and identified further remedial action to correct the situation. It included a checklist of the principal credit risk management deficiencies in respect of ten problem loans, all of which were facilities granted and managed by the Structured Finance and Projects division.

A copy of the "Lessons Learned from Problem Loans" Report is included as Appendices D1 and D2 to this Chapter.

Generally speaking, my examination of Beneficial Finance's non-core business has reached similar conclusions to those identified in the Report, although in a submission to my Investigation, Mr

Reichert strongly disputed the conclusions of that Report. Of particular importance, in my opinion, were the features of Beneficial Finance's "Business Culture" identified in the Report as having severe implications for the company. These were:

(a) Beneficial Finance was driven by a desire for additional business volume and balance sheet growth;

(b) there was an imperative to make all proposals "bankable", which means finding a way to do a deal rather than reject it;

(c) an attitude that obtaining higher profits necessitated the taking of higher risks;

(d) a focus on providing positive responses, and to do so rapidly;

(e) a belief that business based on real property was essentially recession-proof; and

(f) a belief that sharing in the profits of property development projects could result in sustainable fees and profits.

30.5.6 SUMMARY AND CONCLUSIONS

The business activities of the Structured Finance and Projects division were, in my opinion, a principal cause of the financial position of Beneficial Finance as reported in February 1991.

The division was formed in March 1986 to pursue business opportunities outside the scope of Beneficial Finance's experience and expertise in its core business activities. The division undertook transactions of a size and type not undertaken previously by Beneficial Finance. Accordingly, it operated not only outside the area of Beneficial Finance's business experience, but also outside the scope of Beneficial Finance's credit risk management policies and procedures.

The division's assets grew quickly, and by June 1989 represented almost half of the total on-balance sheet assets of Beneficial Finance. It was responsible for 78 per cent of Beneficial Finance's exposures in excess of $5.0M.

A key plank in the division's business strategy was its willingness to accept risks that were not generally taken by other financial institutions. The division would provide advice to clients on how to structure the financing for a project, including a mixture of equity and debt, and then commit itself to provide the equity and debt finance.

The overwhelming majority of the Structured Finance and Projects division's exposures were to commercial property developments. This was a major area of investment growth in the 1980's, and it abounded with opportunities for a financier, like Beneficial Finance, that could provide large facilities, and which was prepared to accept both equity and debt exposures.

The most important failing of the Structured Finance and Projects division was its failure to pay regard to the basic principles of credit risk analysis. Too often, the division's sole criteria for the evaluation of the credit risk associated with a project appeared to be the adequacy of the security available to it over the development site, valued on the assumption that the project would proceed to completion in a buoyant property market.

The credit risk management in respect of the facilities granted by the Structured Finance and Projects division was inadequate and short-sighted, ignored the basic principles of credit risk evaluation, and the facilities were structured in a way which committed Beneficial Finance to fund the projects to fruition, regardless of the continuing interest, financial or otherwise, of the sponsor of the project, and regardless of the state of the property market. The inadequacies of the credit risk management of that division meant that debilitating losses were inevitable.

30.6 BENEFICIAL FINANCE`S OPERATING JOINT VENTURES

30.6.1 INTRODUCTION

An increasingly significant part of the business development strategy of Beneficial Finance from 1985 was its participation as a joint venture partner in joint ventures carrying on specialised financing businesses in niche financial markets, including motor vehicle leasing, real estate financing and bloodstock leasing. For present purposes, the importance of these joint ventures is that, in their conduct of lending activities, they involved the creation and management of credit risk outside the operation of Beneficial Finance's credit risk management policies and procedures, and by staff who were not employees of Beneficial Finance.

Beneficial Finance's objective in entering into the joint ventures was to expand its business activities into new areas which, although they were an extension of its core businesses, were outside the scope of its experience and expertise. Usually formed with a small financier with whom Beneficial Finance had some previous experience, the joint ventures were essentially a partnership between Beneficial Finance's financial strength, and the business expertise and contacts of its partner.

In the course of giving his evidence in respect of the Pegasus Leasing joint venture, the Managing Director of Beneficial Finance, Mr Baker, outlined the strategy that Management pursued in establishing these joint ventures. Mr Baker's evidence highlighted the reliance placed by Beneficial Finance on the expertise of its joint venture partner, and the need for Beneficial Finance to carefully assess that expertise. Mr Baker said:

"The philosophy was that the joint venture partner would put up its equity and Beneficial would do so, but Beneficial really ultimately understood that it would pick up any loss ... the Beneficial Board would have been quite aware, with all the joint ventures, whether or not there was a guarantee from the other party in relation to credit losses ... those people, we knew, could not stand up ... they were small entrepreneurs but we were prepared to go into joint venture business with them because they had skills and access to business. We weren't asking them to guarantee credit losses." [Emphasis added]

In a submission to my Investigation⁽⁾, the former Non-Executive Directors of Beneficial Finance disputed Mr Baker's assessment of the nature of the company's relationship with its joint venture partners. They said that:

(a) there was a standing direction from the Board of Directors that all joint venture partners of Beneficial Finance were to provide guarantees in respect of the liabilities of the joint ventures in which they participated; and

(b) Beneficial Finance's funding of any joint venture had to be assessed using the same criteria, and subjected to the same policies and procedures, as applied to its general lending business.

In his submission, Mr Baker disputed the suggestion that there was such a standing direction, and no such direction has been found in any documents provided to or reviewed by my Investigation, including minutes of Board of Directors' meetings. There was a general policy that required guarantees to be provided by the principals and owners of private companies to which Beneficial Finance made loans. That policy did not, on its terms, have application to operating joint ventures in which Beneficial Finance participated as a partner. Certainly, Mr Baker and Mr Reichert did not regard the taking of guarantees as either required or necessary.

Whether or not such a standing direction was given, the reality of the operating joint ventures in which Beneficial Finance participated was that, in practical terms, the joint venture partners lacked the financial resources to meet anything like one-half of the potential losses of the venture.

The operating joint ventures included:

(a) Asset Risk Management Limited, which was originally a joint venture and became wholly owned by Beneficial Finance in 1989;

(b) Mortgage Acceptance Nominees;

(d) Leasefin Corporation;

(e) Pegasus Leasing;

(f) Allied Westralian Finance;

(g) First Pacific Mortgage; and

(viii) First Pacific Insurance Brokers.

I have reported the results of my examination of two joint ventures in Chapters 33 - "Case Study in Credit Management: Pegasus Leasing", and Chapter 39 - "Mortgage Acceptance Nominees Limited".

30.6.2 RESPONSIBILITY FOR MANAGEMENT OF BENEFICIAL FINANCE'S PARTICIPATION

Until 30 June 1989, the responsibility for the initiation of the operating joint ventures, and for managing Beneficial Finance's participation, lay with the Structured Finance and Projects division, headed by Mr Reichert. Thereafter, responsibility for the joint ventures was split between the new Investment Banking division headed by Dr Sexton, and the core business divisions. The Investment Banking division was responsible for Beneficial Finance's equity participation in the businesses, and the core business divisions were responsible for overseeing the operations of the joint ventures, and for their funding.

A Joint Venture Committee was established in 1987, which among other things attempted to formalise the process of initiating and managing the operating joint ventures. The purpose of the Joint Venture Committee was to:

(a) establish criteria for forming new joint ventures;

(b) review monthly results of each joint venture;

(d) review budgets and forecasts.

It was agreed that any new joint venture must be approved by the Joint Venture Committee prior to execution of documentation. The Committee, however, lacked power and authority, and its advice and recommendations were largely ignored. For example, a new Pegasus Leasing joint venture was established in January 1988 by Mr Baker, despite the express recommendation of the Joint Venture Committee that it not be established. Although the Committee developed and updated, on several occasions, a checklist of matters to be considered in evaluating joint venture proposals, that checklist was not used. In 1988, the Structured Finance and Projects division established a separate joint venture department to assess and manage the joint ventures, which were seen by that division as being "the ideal vehicle for Beneficial Finance to diversify into new market niches with an associated high level of specialisation." ⁽⁾ The Joint Venture Committee was formally disbanded when the newly established Investment Banking division assumed responsibility for the Investment Banking division.⁽⁾

30.6.3 THE INITIATION, FUNDING AND MANAGEMENT OF THE JOINT VENTURES

30.6.3.1 Initiation

The operating joint ventures were usually established with a joint venture partner with which Beneficial Finance had some previous business relationship. For example, the case of both Pegasus Leasing and Mortgage Acceptance Nominees joint ventures, Beneficial Finance had provided loans to the joint venture partner, and, more importantly, the partners had both introduced new business to Beneficial Finance, and made loans on behalf of Beneficial Finance as its agent pursuant to Principal and Agency Agreements.

The initiation and approval of the joint ventures was conducted and controlled by Mr Baker and Mr Reichert. It was they who identified joint venture opportunities, and directed their establishment. Indeed, the Mortgage Acceptance Nominees joint venture was established and commenced operations before a submission was presented to the Board for approval of the joint venture, and effectively continued after the Board rejected the submission. They, and the staff of the Structured Finance and Projects division, were responsible for the negotiation of the terms and conditions of the proposed joint ventures including the structure of the joint venture, the financial arrangements, and the management and accounting arrangements. As noted earlier, Mr Martin acknowledged that there were no formal assessment procedures in respect of joint venture proposals.

This "top-down" initiation, structuring, and approval of the joint ventures, without established review procedures, policies or criteria, was, in my opinion, consistent with the general nature of the Structured Finance and Projects division's method of carrying on business.

The processes for establishing and structuring the joint ventures involved little more than the exercise of Mr Baker's and Mr Reichert's judgment. The establishment of the joint ventures did require the approval of the Board of Directors. Based on their submissions to my Investigation, however, I doubt that the Board ever really understood the risks associated with the ventures until too late.

As previously noted, a Joint Venture Committee was established in July 1987. Although its role included the formulation of guidelines with respect to the establishment and management of the joint ventures, the Committee's recommendations with respect to some joint venture activities, including Pegasus Leasing, were ignored.

30.6.3.2 Funding of the Joint Ventures

Funding for the activities of the joint ventures was provided by Beneficial Finance, either directly, or by providing guarantees for loans from third party financiers. The basic premise of the joint ventures was, as I have said, a partnership of Beneficial Finance's financial strength, with the business expertise and contacts of the other joint venture parties.

In practice, Beneficial Finance's funding of the operating joint ventures was essentially uncontrolled. There are two important aspects of funding arrangements which had that result:

(a) First, no individual exposure limits were established in respect of Beneficial Finance's exposure to particular operating joint ventures. Although there was a policy which limited the total size of the assets of the joint ventures to no more than 20 per cent of Beneficial Finance's total assets, no prudential exposure limits were established for individual ventures.

(b) Second, no procedure was established for undertaking formal credit risk reviews of the joint venture partners whose interest in the joint venture assets was essentially being funded by Beneficial Finance. The procedures for advancing funds to the operating joint ventures were limited to the provision, by the joint venture partners, of reports detailing the loans made by the joint venture, and the funding needed to support those loans.

The result was that the joint ventures were able to grow their assets very rapidly, unconstrained by funding limits, including those related to gearing ratios. For example, Beneficial Finance's loans to Pegasus Leasing grew to $62.0M in June 1989, and amounted to $85.0M in early 1990.

The control over the funding to the joint ventures was further weakened by the use made of the Bank's Reverse Principal and Agency Agreement to fund those ventures. That Agreement appointed Beneficial Finance as an agent for the Bank in granting tax-effective financing leases, funded with loans from the Bank. In substance, the Agreement had the hallmarks of a funding arrangement, and was treated as such by Beneficial Finance. By appointing the joint venture partner as its sub-agent under the Principal and Agency Agreement, Beneficial Finance was able to arrange funding for the joint ventures which did not appear on its balance sheet, since the loans from the Bank, and the receivables funded with them, were "netted off". The details of this Agreement are described in Chapter 33 - "Case Study in Credit Management: Pegasus Leasing".

30.6.3.3 Management of the Joint Ventures

The joint venture agreements governing the operating joint ventures contained terms which were intended to provide a measure of control for Beneficial Finance over the joint ventures operations. For example, Beneficial Finance would have equal representation on the Board of Directors of the nominee company that conducted the joint venture operations, and in most cases, other than Pegasus Leasing, the joint venture's accounting was performed by Beneficial Finance. Further, Beneficial Finance was required to approve major loans made by the joint ventures, above pre-determined limits.

In practice, however, these controls were ineffective. There were two reasons for that:

(a) First, the very basis of the joint venture was that Beneficial Finance lacked the experience and expertise in the particular specialised finance business being undertaken. In that circumstance, it was inevitable that Beneficial Finance would place heavy reliance upon the judgments of its joint venture partners.

(b) Second, the actual conduct of the lending activities, including the management of the loan portfolio, was conducted by the joint venture partner. Beneficial Finance did not require that its own core business credit risk management policies and procedures be adopted by the joint venture partners, and did not evaluate those of the joint venture partners.

The combination of effectively unlimited funding, unrestrained even by gearing ratio considerations, with the reliance on the joint venture partners' credit risk management systems and skills, created a highly dangerous situation. In the operating joint ventures examined by me, those businesses grew rapidly to a size that was beyond the experience of Beneficial Finance's joint venture partners, and beyond the ability of their credit risk management systems to adequately manage.

The ready availability of funding inevitably placed downward pressure on the credit standards of the businesses. In normal circumstances, the lack of funding places an in-built restraint upon new lending, as applicants for loans are "rationed" by the limits on the lender's ability to make new loans. Without that limit, the joint ventures were free to pursue ambitious growth targets by making loans that, in normal circumstances, they would not. The nature of the joint ventures was such that the cost of the failure of their credit risk management was borne by Beneficial Finance.

30.6.4 TERMINATION OF THE OPERATING JOINT VENTURES

Beneficial Finance re-organised its divisional structure on 1 July 1989. As part of the re-organisation, the responsibility for the monitoring and management of Beneficial Finance's participation in the operating joint ventures was taken away from the Structured Finance and Projects division. The newly created Investment Banking division, headed by Dr Sexton, was given responsibility for managing the equity participation in the joint ventures, while the core business divisions were given responsibility for monitoring their operations.

As a result of the work of the new Investment Banking division, Beneficial Finance took action, for the first time, to impose proper control over both the operations of the joint ventures, and over its funding commitment to them. A draft letter dated 2 October 1989, prepared by the Investment Banking division stated in part:

"On 1 July 1989, Beneficial Finance Corporation implemented a top level restructure to provide stronger divisional focus in strategic and major business areas.

A new division, Structured Finance and Projects, was formed to control all of the company's structured facilities, overseas operations and major property accounts. This division is headed by Erich Reichert.

The Investment Banking Division is now headed by Roger Sexton and, inter alia, will focus on Beneficial's strategic equity investments. The Investment Banking Division is now responsible for strategic and policy issues relating to Beneficial's Joint Ventures [JVs] while the Business Divisions are responsible for the day to day operations of the JVs.

The Investment Banking division has appointed an account manager for each JV. This person will be involved in the strategic direction of the JV and will assist with policy issues as they arise. Roger Sexton will be appointed to the board of each JV, with the appropriate account manager being the alternate board member."

A draft letter of the same date from Dr Sexton to the Beneficial Finance personnel responsible for its various joint ventures stressed the need to place greater emphasis on the monitoring and control of joint venture operations. The letter identified a number of factors for "consideration and implementation":

"(a) One of the most critical areas that needs to be addressed is Credit Standards. Attached is a summary of the Approval limits which apply to your company, and it is essential that these limits are adhered to.

In particular, Group exposure to clients must be closely monitored, and as a matter of procedure, no credit approval should be given without first confirming the extent of Beneficial's exposure, if any, to the client.

The level of Beneficial exposure, or, if applicable, the fact that no exposure exists must be included as part of the approval process. Information concerning Beneficial's client exposures can be sourced through the joint ventures account manager in the relevant Business Division.

(b) Any major variation in expenditure by the joint venture outside of the approved budget, must be referred to the Board of the Venture.

(c) In order to ensure that Beneficial is fully informed of the performance of each joint venture, and can therefore provide the necessary support, it is essential that all financial and secretarial reports are prepared in a timely manner.

It is appreciated that the responsibility for day to day running of the business is that of the Joint Venture Manager. However, the level of Beneficial's capital and funding commitment to the Venture necessitates the provision of regular information to Joint Venture Accounting, the Business Divisions and Investment banking Division. The provision of this information on a timely basis will assist in Beneficial's continued support to the venture.

Secretarial matters should be referred to Beneficial's Company Secretary, who is joint company secretary for all Joint Ventures.

There is no doubt that the financial climate has changed, and that the successful companies will be those that adapt to the changing environment and place more emphasis on monitoring and control.

Adherence to the above criteria will assist with the continuing strength of our Joint Venture operations."

A Joint Venture Status Report dated 16 October 1989, stated in respect of the funding of the joint ventures, that:

"Currently, Beneficial provides the bulk of the funds for most joint ventures, acting as Banker, achieving banker's margins but without the benefit of bank cost of funds. The provision of funds has an opportunity cost attached. A review of the shareholders' agreement for each of the joint ventures suggests that Beneficial's original intention was only to interim fund. In addition, non-recourse funding arrangements with external lenders are impacting on Beneficial/State Bank's limits in some instances.

The environment which prevailed when the joint venture arrangements were first entered into has changed. While the premise that Beneficial has the financial strength and the joint venture parties have the expertise has not changed, the market requirements have since altered such that Beneficial's capital is now a scarce resource. In addition, the strong growth of some of the joint ventures was not anticipated and given that none of the joint venture partners have the financial capacity to support the growth they were achieving through continual capital injections to maintain gearing at acceptable levels, there has been an expectation that Beneficial will provide the additional funding required. Whilst Beneficial can choose to limit the funds lent, as there is no legal requirement to provide all funding, it is our objective to not restrict profitable growth of the joint venture. However, notwithstanding this objective, considerable difficulty is being experienced in attracting non-recourse external borrowings with existing joint venture gearing levels ...

Our current efforts are being directed mainly towards reducing Beneficial funding to joint ventures to the minimum required to secure non-recourse funding, thereby maximising both the joint venture profitability and Beneficial's overall ATROE from the joint venture involvement."

As the Investment Banking division and the core business divisions moved to take control of the joint ventures, the inadequacies in the previous management by the Structured Finance and Projects division began to become apparent. In a memorandum dated 14 December 1989 to Mr Baker, Beneficial Finance's legal officer, Mr G L Yelland, provided a recommended framework to separate the responsibility for managing the joint ventures from the responsibility for protecting Beneficial Finance's interest as a lender to the joint ventures. Mr Yelland wrote:

"Subject: Conflicting roles of Managers and Directors

John, I note your comments about the apparent `arbitrary' appointment of John Malouf to Mortgage Acceptance Nominees, and secretarial control generally.

I have investigated, and find that there is, as yet, a little confusion between the Investment Banking division and the Business divisions about their various areas of authority and responsibility.

Ideally, those two must always perfectly match. Further, in view of the Board's desire to gradually be represented on all the Boards of all joint ventures and other affiliated companies, and the dangers which account managers face when caught in the conflict of interests arising out of director's responsibilities compared with creditor rights, we would recommend as follows:

1. That the function of protecting exposures, and looking after its interests as creditor, rest squarely with the business division, acting within the terms of the `loan' transaction controls and supervision of the recovery of those funds. The account manager should have no directorship responsibility/authority, only rights as a prudent lender.

2. That the implementation of policies, protection of Beneficial Finance's equity, and normal directive decisions from a board level, secretarial and administration of the business of the joint venture as an on-going concern, be the responsibility of the Investment Banking division. An Investment Banking division representative may be appointed an alternate director.

3. The Joint Venture partner will then deal on a day to day basis with the business division manager who, as a representative of Beneficial Finance as sole or major creditor, will insist on maintaining control on how its loan funds will be spent and managed.

4. Using the daily/monthly management information provided by Beneficial Finance's accounting procedures, the Joint Venture Partner then reports on a regular basis, i.e. monthly to `the Board' comprising himself and the Investment Banking division representatives, who hold delegated power from Beneficial Finance Board to protect the equity position.

Without such a separation of functions in a legal sense, not only are we opening the flood gates to confusion and the `divide and conquer' syndrome, but leaving the Beneficial Finance participants with potentially conflicting roles." [Emphasis added]

In February 1990, the Credit Policy Committee was informed of "a recent problem concerning approval authority required for lending to joint venture partners." ⁽⁾ As a result, policy was altered to require, for the first time, that:

"Any loan to joint venture partners, whether by Beneficial, the joint venture itself or any of Beneficial's other operating joint ventures, is to be subject to the approval of Beneficial's Credit Committee, irrespective of amount and subject to standard credit assessment criteria." ⁽⁾

Until June 1990, there was no policy requiring the operating joint ventures to adhere to Beneficial Finance's credit policies and procedures. The attitude adopted within Beneficial Finance was that it was the responsibility of the joint venture partners to establish the policies and procedures to be applied to the management and operations of the joint venture, since the joint ventures' businesses were within the other partner's areas of expertise. On 20 June 1990, the Credit Policy Committee resolved that all operating joint ventures should adopt Beneficial Finance's procedures.

Shortly afterwards, Beneficial Finance decided to end its participation in, and funding of, the operating joint ventures. The minutes of the meeting of the Board of Directors held on 31 August 1990 record that:

"The meeting was advised that specific plans were in place for the withdrawal from all joint ventures, and a report on these plans would be prepared for the September Board meeting."

At its meeting on 30 November 1990, the Board resolved that:

"Following a review of Beneficial Finance's involvement in various joint ventures, action was being taken to withdraw or wind down all joint ventures as quickly as possible within the constraints imposed by the joint venture agreements."

30.6.5 A HINDSIGHT REVIEW BY BENEFICIAL FINANCE

At the November 1990 meeting, the Beneficial Finance Board was presented with a report titled "Lessons Learned from Joint Ventures".⁽⁾ This report, which was prepared at the request of the Board of Directors, summarised Management's own evaluation of the deficiencies in Beneficial Finance's involvement in joint ventures. The report included a review of the principal deficiencies identified in respect of nine operating joint ventures, which, it was said, "clearly demonstrate where we went wrong in each relationship".

A copy of the paper is provided as Appendices E1 and E2 to this Chapter.

My Investigation of the operating joint ventures has generally confirmed most of the problems identified in the "Lessons Learned from Joint Ventures" report. That report does however identify a variety of deficiencies in the joint ventures that were not obvious to my Investigation. In part, that is probably a consequence of the scope of my Investigation, which, being constrained by the limitation of my Terms of Appointment to the activities of the members of the Bank Group, did not examine the business records of Beneficial Finance's joint venture partners.

30.6.6 SUMMARY AND CONCLUSIONS

The operating joint ventures in which Beneficial Finance participated effectively involved the creation and management of credit risks by parties other than Beneficial Finance, applying their own policies and procedures. Despite that, the financial structure of the joint ventures was such that Beneficial Finance bore the risk of loss. Shortly stated, Beneficial Finance was subject to credit risks that it did not effectively control.

The very nature of the joint ventures exacerbated the problem. The funding provided to the joint venture partners by Beneficial Finance, unrestricted by credit reviews, prudential limits or gearing ratios, both:

(a) enabled the joint ventures to make loans unrestrained by funding limits; and

(b) resulted in the joint ventures growing beyond the scope of the experience and capacities of the joint venture partners to adequately manage.

In my opinion, the basic strategy of Beneficial Finance in establishing the joint ventures was flawed, and an invitation to disaster. The "Lessons Learned from Joint Ventures" Report correctly identified the key elements of the approach of Beneficial Finance that were at the heart of the problems:

(a) Joint Ventures were perceived to be prestigious, enhancing market awareness and image.

(b) Beneficial Finance was a volume driven company striving for growth.

(c) The joint ventures, being held off-balance sheet, were not restricted by the gearing constraints of Beneficial Finance's trust deed.

(d) The financial strength of the joint venture partner was regarded as being unimportant.

In my opinion, it is Mr Baker and Mr Reichert who are primarily responsible for the deficiencies in Beneficial Finance's participation in the operating joint ventures. It was those officers who initiated and established both the strategy, and the individual joint ventures.

The reports I have provided in this Report of my examination of two of the joint ventures show that:

(a) In the case of Pegasus Leasing, Mr Baker established the new joint venture in January 1988 despite the recommendation of the Joint Venture Committee not to do so.

(b) In the case of Mortgage Acceptance Nominees, Mr Baker and Mr Reichert established the joint venture before seeking the approval of the Board. When the Board was considering the submission, Mr Reichert did not tell the directors that the joint venture was already operating. When the Board rejected the submission, the basic elements of the joint venture were left in place.

In my opinion, the Board of Directors did not appreciate the reality of the structure of the joint venture arrangements. It should have done so. Although the information from Management was less than full and frank, the directors had sufficient information to, in my opinion, reasonably have been expected to understand the risks being run.

30.7 FINDINGS AND CONCLUSIONS

30.7.1 BENEFICIAL FINANCE'S EXPOSURE TO REAL ESTATE

In my opinion:

(a) Beneficial Fiance's exposure to real estate generally, and commercial property development in particular, was imprudent and excessive.

(b) The Board of Directors and senior management failed to adequately monitor and control that exposure. In particular, no overall prudential limit on the exposure was set.

(c) The imprudent and excessive exposure was an important matter that contributed to the financial position of the Bank Group as reported by the Bank and by the Treasurer in February 1991.

30.7.2 THE CORE BUSINESS ACTIVITIES OF THE GENERAL BUSINESS DIVISIONS

In my opinion:

(a) The general organisation and structure of the credit risk management function in respect of the core businesses of Beneficial Finance was adequate and appropriate.

(b) The Board of Directors and Management adequately and properly supervised, directed and controlled the policies, procedures and conduct of Beneficial Finance's core business divisions.

(c) In particular, the policies and procedures applicable to the core businesses were adequate, and were generally observed in practice.

(d) The losses realised in respect of the core business real estate lending activities were the result of the rapid increase in, and subsequent collapse of, property values, and of the over-exposure of the core businesses to that over-heated market. Although the policies were adequate and generally observed, there was a tendency for judgments made within the discretions provided by the policies to be influenced by an over-reliance on the continuation of the buoyant property market.

30.7.3 THE NON-CORE BUSINESS ACTIVITIES OF THE STRUCTURED FINANCE AND PROJECTS DIVISION

In my opinion:

(a) The Structured and Finance and Projects division did not observe the basic principles of credit risk evaluation and management. Its management of the credit risks associated with the non-core businesses was wholly inadequate, being based on little more than perceptions of the inevitable profitability of commercial property development projects.

(b) Decisions regarding credit risk management were too often made by senior management, without regard to the need for observing structured and sound procedures for the identification and evaluation of risk. The division was characterised by the imperative of asset growth, without adequate attention to the risks that involved.

(c) The Board of Directors failed to adequately control, supervise and direct the business operations of the Structured Finance and Projects division. It was too willing to approve submissions that did not comply with, or even refer to, the policies established by the Board in respect of the real estate lending of Beneficial Finance's core business divisions.

(d) Mr Baker, as Managing Director, and Mr Reichert, as Chief General Manager of the Structured Finance and Projects division throughout its four year existence, failed to apply to the non-core business activities the skill and judgment reasonably to be expected of executive officers of a financial institution.

30.7.4 THE OPERATING JOINT VENTURES

In my opinion:

(a) The structure and operation of Beneficial Finance's participation in, and funding of, the operating joint ventures, meant that Beneficial Finance was subject to the risk of losses in respect of credit risks that it did not effectively control. Both the initiation and subsequent management of the credit risk was, in practical terms, in the hands of Beneficial Finance's joint venture partners.

(b) The risks associated with the operating joint ventures were exacerbated by the almost unrestricted funding provided to them by Beneficial Finance.

30.8 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

30.8.1 TERM OF APPOINTMENT A

30.8.1.1 Term of Appointment A(a)

The matters and events which caused the financial position of the Bank as reported by the Bank and by the Treasurer in public statements on 10 February 1991 and in a Ministerial Statement by the Treasurer on 12 February 1991 included:

(a) The failure of the Board of Directors and of senior management to establish a prudential limit on Beneficial Finance's total exposure to real estate generally, and commercial property development in particular. The result of that failure was that Beneficial Finance was imprudently and excessively exposed to property, and so suffered significantly when the property market collapsed in 1990.

(b) The inadequacies in the business activities of the non-core business activities conducted by the Structured Finance and Projects division and its predecessor divisions, as described in this Chapter.

30.8.1.2 Term of Appointment A(b)

The processes which led Beneficial Finance to engage in operations which have resulted in material losses or in the Bank holding significant assets which are non-performing included the lending processes and procedures of Beneficial Finance upon which I have commented in this Chapter.

30.8.1.3 Term of Appointment A(c)

For the reasons given in this Chapter, those processes were inappropriate.

30.8.1.4 Term of Appointment A(d)

The procedures, policies and practices adopted by Beneficial Finance in the management of significant assets which became non-performing include those described in this Chapter.

30.8.1.5 Term of Appointment A(e)

For the reasons given in this Chapter, those procedures, policies and practices were inadequate.

30.8.2 TERM OF APPOINTMENT C

The operations, affairs and transactions of Beneficial Finance were, in the respects identified in this Chapter, not adequately and properly supervised, directed and controlled by:

(a) the directors of Beneficial Finance;

(b) the Chief Executive Officer of Beneficial Finance, Mr Baker;

30.9 APPENDICES CREDIT POLICY COMMITTEE

APPENDIX A

MEMBERS	JULY 1987	JULY 1988	AUGUST 1989
Mr T M Siegele	Member	Member	Member
Mr R A Garrett	Member	Member
Mr J Mudge	Member	Member
Mr G A O'Brien	Member	Member	Members⁽²⁾
Mr D Copeland	Member
Mr G Hewitt	Member
Mr S Spadavecchia		Member
Mr J S Malouf		Member	Member⁽²⁾
Mr J Baker		Member⁽¹⁾	Member⁽¹⁾
Mr E Reichert		Member⁽¹⁾	Member(2)
Mr M Chakravarti		Member⁽¹⁾	Member⁽¹⁾
Mr D Teroxy			Member
Dr R Sexton			Member⁽²⁾
Mr P Fleming			Secretary

Source: Compiled from Management Information Bulletin No 214 of July 1987, No 268 of July 1988 and SS282 of August 1989.

⁽¹⁾ Ex-officio members.

⁽²⁾ These persons, or their representatives, were on the Credit Policy Committee in their capacity as Divisional Heads.

⁽³⁾ The Investigation has been unable to identify the composition of the Credit Policy Committee outside of the above tabulated period. However, those attending Credit Policy Meetings in the period July 1988 to the September quarter of 1990 have been identified and are tabulated at Appendix D.2.

MEMBERS	06/88	02/89	01/07/89	01/05/90	02/91
Mr T M Siegele	Member^{(I + B)}	Member^{(I + B)}	Member	Member	Member^(A)
Mr J Mudge	Member⁽¹⁾	Member⁽¹⁾		Member	Member^(A)
Mr G A O'Brien	Member^(B)	Member^(B)	Member
Mr M Sparrow	Secretary^(B)
Mr J Graham	Member⁽¹⁾
Mr S Spadavecchia	Member^{(I + B)}	Member^{(I + B)}
Mr J D Malouf	Member^(B)	Member^(B)	Member	Member	Member^{(A + B)}
Mr C Freeman					Member^(B)
Mr J Baker	Member^{(I + B)}	Member^{(I + B)}	Member	Member
Mr E Reichert	Member^{(I + B)}	Member^{(I + B)}	Member
Mr M Chakravarti	Member^{(I + B)}	Member^{(I + B)}	Member	Member
Mr G Martin	Member^{(I + B)}	Member^{(I + B)}
Mr P Fleming		Secretary^(B)	Secretary
Mr J Blunt	Member⁽¹⁾	Member⁽¹⁾
Mr L Kenny	Secretary⁽¹⁾	Secretary⁽¹⁾
Mr F Piovesan	Member⁽¹⁾	Member⁽¹⁾
Mr T Waller	Member⁽¹⁾	Member⁽¹⁾
Mr D Teroxy			Member	Member
Dr R Sexton			Member	Member	Member^(B)
Mr H Webster			Member
Mr R Horwood				Member	Member^(B)
Mr B Price					Member^{(A + B)}
Mr G Abbott					Member^{(A + B)}

Source:

June 1988 Mr T M Siegele document of 17.06.88 referenced A/R 3.1 to 3.3

February 1990 Special Submission SS254

1 July 1990 Special Submission SS282.1

1 May 1990 Special Submission SS305.3

February 1991 Special Submission SS340

Notes:

(1) Separate Credit Committees were in existence in respect of the Business divisions (members denoted by "B") and Investment Banking division (members denoted by "I"). Quorum for Business division Credit Committee was two members excluding secretaries and for the Investment Banking division Credit Committee, four members with certain specified attendees.

(2) Separate Credit Committees continued in respect of the Business divisions (members denoted by "B") and Investment Banking division (members denoted by "I").

(3) From May 1990, the Credit Committee was also described as "Beneficial Credit Committee". The quorum for this committee was three persons with certain restrictions imposed as to their composition.

The Beneficial Finance Credit Sub Committee comprised two groups; Group A and Group B, with the quorum being one person from each such group. The members of these Groups A and B were also members of the Beneficial Finance Credit Committee.

(4) As indicated, from February 1991 Credit Committee members were assigned to either "Group A (members denoted by "A")", "Group B (memebers denoted by"B")" or both. The quorum for the Credit Committee comprised three persons with at least one each from Groups A and B. The quorum for the Credit Sub Committee was two persons comprising one from each of the Groups.

REAL ESTATE FIRST MORTGAGE LENDING APPENDIX C

CREDIT AUTHORITY LIMITS RECORD OF CHANGES (ALL AMOUNTS ARE $000)
DATE OF CHANGE	ALL AVAILABLE DIRECTORS	QUORUM OF FOUR DIRECTORS^o	SUB-COMMITTEE OF TWO DIRECTORS^o	CREDIT COMMITTEE	CREDIT SUB-COMMITTEE	REGIONAL CREDIT COMMITTEE	NOTES
	*		7,500 S 10,000 C	6,000 S 7,500 C	3,000 S 4,000 C	- -	(1)
January 1988	*	27,000 SC	16,000 SC	7,500 S 10,500 C	3,500 S 5,000 C	1,500 S 2,500 C	(2)
June 1988	*	27,000 SC	16,000 SC	7,500 S 10,500 C	3,000 S 4,000 C	2,000 S 2,500 C	(3)
September 1988	*	31,500 SC	19,000 SC	9,500 S 12,500 C	3,000 S 4,000 C	2,000 S 2,500 C	(4)
February 1989	*	33,500 SC	20,000 SC	10,000 S 13,000 C	3,000 S 4,000 C	2,000 S 2,500 C	(5)
February 1989	*	33,500 SC	20,000 SC	10,000 S 13,000 C	4,500 S 5,000 C	2,000 S 2,500 C	(5)
May 1990	*	33,500	20,000	13,000	7,500 #	5,000 +	(7)

* All proposals above indicated limits The above information was compiled from the following sources:

S Single transaction January 1988 Special Submission SS225

C Cumulative exposure June 1988 Mr T M Siegele document of 17.06.88 referenced A/R 3.1 to 3.3

^o One SBSA representative September 1988 Credit Policy Committee meeting minute of 26.09.88

# Described as "Beneficial Credit Sub Committee" February 1989 Special Submission SS254

+ Described as "State Credit Committee" May 1990 Special Submission SS305.2

Notes:

(1) These were limits in existence as at the time the new percentage based structure was introduced in January 1988. Date on which these limits were introduced has not been identified by the Investigation.

(2) Approved by Board on 29.01.88, Minute P 02074.

(3) Approved by Board on 24.06.88, Minute P 02127.

(4) Limits applying for Credit Committee and above increased in line with Beneficial Finance's Shareholders Funds as at 30.06.88.

(5) Limits applying for Credit Committee and above increased in line with Beneficial Finance's Shareholders Funds as at 31.12.88. Increased limits for approval levels for the Credit Sub-Committee were also proposed by SS254 and approved by the Board.

(6) Changes proposed under Special Submissions SS282, in line with increased Beneficial Finance shareholder funds, to be effective from August 1989 were not approved.

(7) Special Submission SS305 notes that no overall increase in limits was contemplated. Changes proposed essentially reflected change in management structure and removal of the separate single and cumulative limits.

OTHER LENDING APPENDIX C

CREDIT AUTHORITY LIMITS RECORD OF CHANGES (ALL AMOUNTS ARE $000)
DATE OF CHANGE	ALL AVAILABLE DIRECTORS	QUORUM OF FOUR DIRECTORS^o	SUB-COMMITTEE OF TWO DIRECTORS^o	CREDIT COMMITTEE	CREDIT SUB-COMMITTEE	REGIONAL CREDIT COMMITTEE	NOTES
	*		5,000 S 7,500 C	3,000 S 5,000 C	2,000 S 3,000 C	- -	(1)
January 1988	*	20,000 SC	12,000 SC	5,500 S 7,500 C	2,500 S 3,500 C	1,000 S 1,500 C	(2)
June 1988	*	20,000 SC	12,000 SC	5,500 S 7,500 C	2,000 S 3,000 C	300 S 500 C	(3)
February 1989	*	25,000 SC	15,000 SC	7,500 S 10,000 C	2,000 S 3,000 C	300 S 500 C	(4)
May 1990	*	25,000	15,000	10,000	5,000 #	1,500 +	(6)

* All proposals above indicated limits The above information was compiled from the following sources:

S Single transaction

C Cumulative exposure January 1988 Special Submission SS225

June 1988 Mr T M Siegele document of 17.06.88 referenced A/R 3.1 to 3.3

# Described as "Beneficial Credit Sub Committee" February 1989 Special Submission SS254

+ Described as "State Credit Committee" May 1990 Special Submission SS305.2

^o One SBSA representative

Notes:

(2) Approved by Board on 29.01.88, Minute P 02074.

(3) Approved by Board on 24.06.88, Minute P 02127.

(4) Limits applying for Credit Committee and above increased in line with Beneficial Finance's Shareholders Funds as at 30.06.88.

(6) Changes proposed under Special Submissions SS282, in line with increased Beneficial Finance shareholder funds, to be effective from August 1989 were not approved.

The following is an evaluation of the major lessons learned as a consequence of the losses and problems which have emanated from Beneficial Finance's non and under-performing portfolio. The report, derived in the main from contributions made by Asset Management's line and credit staff, is a distillate of the major issues and conclusions, and attempts to identify the root causes of the problems, the corrective action already in train and items which are to be addressed in conjunction with a revamp of the Group's composite credit process.

CONCLUSIONS AND ISSUES

PRINCIPAL CONSEQUENCES

REMEDIAL ACTION(S) TAKEN

FURTHER ACTION TO BE TAKEN

BUSINESS CULTURE

. Volume/Sales driven company striving for balance sheet growth.

. Make all deals bankable.

. Higher pricing demands greater risks.

. Rapid positive responses.

. Property based business is essentially recession proof.

. Sharing development margins made for sustainable fees and profits.

. Lending activity strayed into areas where no demonstrable expertise existed.

. Credit departments tended to be technical resource units to book business and not act as an independent body of checks and balances.

. Attraction of lower tiers of sponsors without proven financial resources or staying power to weather economic downturns.

. Self created sense of urgency at the expenses of cool headed and detached analysis.

. Concentration on security cushion in lieu of cash flow and project analysis.

. Recognition of accounting profits at the expense of cash flows.

. Deferral of actual profits until project completion.

. Confusion between the distinctions, roles, responsibilities and operations of a financier versus a speculative developer.

. Back to basics lending and product policies where Beneficial Finance has a historically successful track record.

. Refocus on quality business with a sustainable long term earning stream.

. Elimination by policy directives of pioneering ventures and non-cash generating participants.

. Re-evaluation of core products within a more traditional finance company environment.

. Change in emphasis of the credit role.

. Development of more formula based and homogenous products capable of lower cost delivery.

. Development of private label finance products and portfolios readily capable of rapid securitisation.

. More direction to the business getters of what is our desired business and the acceptance parameters.

CREDIT & RISK EVALUATION

. Bias towards qualitative evaluation.

. Lack of critical financial analysis in assessing a sponsor's underlying capacity to honour commitments to all creditors.

. Acceptance without a professional critique of sponsor provided data.

. Downstreaming of acceptance authority to line management as pre-settlement rather than pre-approval conditions.

. Emphasis on credit presentation form and security ratio.

. Top down pressure to book business. Credit process not an essential component of the approval process. Could be (was) bypassed.

. Ostensible authority to grant credit as a function of job title rather than proven technical expertise and experience.

. Absence of mandatory periodic review and re-accreditation of credit facilities.

. Credit Department had process responsibility but no effective decision authority.

. Institutionalised acceptance of lower standards in quantitative analytical techniques.

. Loss of objectivity in credit and financial analysis.

. Lack of recognition of Inter-active vulnerabilities in sponsor's composite financial capability.

. Orientation towards unrealistic security margins as primary criteria for approval.

. Loss of credibility with line managers in the integrity and independence of credit personnel.

. Implicit and explicit pressure to proceed with a deal once an "in-principle" agreement reached.

. Development of new standards of credit and financial analytical techniques across the whole Group.

. Structured long term training programs for all credit personnel initiated at Group level.

. Mandated segregation of the credit/approval process from the line.

. Clear cut credit authorities commensurate with proven skills.

. Further development and Group wide standardisation of the credit process.

. Deploying credit trained specialists alongside marketing personnel to facilitate "on the spot" referrals.

. Development of industry specialists for mandatory sign off in areas of specific risk.

. Implementation of credit product programs with statistically reliable risk profiles.

. Greater access to credit data bases and research material.

ACCOUNT MANAGEMENT

. Emphasis on "deal doers" not relationship managers.

. Short term transaction focus.

. Lack of structured training in account management techniques over a full business cycle.

. Tendency to generalists rather than product or industry experts.

. Account managers too close to sponsor. Intermingling of mutual interests.

. Inadequate MIS/relationship profile records and portfolio composition.

. Evolution of salesmen and reactive order takers.

. Loss of a long term relationship development with understanding and sense of responsibility/ownership.

. Loss of detachment and objectivity.

. Risk of irreconcilable conflicts of interest.

. Production of specific account management guidelines in handbooks.

. Allocation of specific relationships to designated account managers with mandate for overall responsibility. (Specifically in AMD and Group Asset Management).

. Development of system based tools to facilitate better data collection and retrieval (eg PMS).

. Introduction of Risk Asset Reviews and hindsight reviews.

. Further training programs specifically orientated to account management techniques and negotiating skills.

. Establishment of more comprehensive research facilities and data bases.

. Career path streaming for account management specialists.

OTHER SIGNIFICANT ISSUES

. Mismatch of funding techniques.

. Prudential limits and exposures inappropriate for our capital base.

. Inadequate MIS to appreciate the growth and concentration of specific portfolios and risk assets.

. Unreasonable reliance in takeout of problem loans by other (parent) group members.

. Use of short term debt to underwrite long term equity and project orientated debt.

. Failure to recognise particular risks and vulnerabilities in the event of cyclical economic downturns.

. Involved in transactions in excess of our capacity to easily digest.

. Policy directives to cease speculative, non-cash equivalent business.

. Specific portfolio profile research through Credit Policy Committee.

. Development of a Group wide central liability system (Commitment Register).

. Reduction in prudential limit (to 20% of shareholders funds) with more conservative calculation methods.

REPORT PREPARED BY BENEFICIAL FINANCE TITLED APPENDIX D.2

"LESSONS LEARNED FROM PROBLEM LOANS"

In the evaluation of the lessons learned and the issues consequent in the problems which have been identified, specific relationships were chosen for greater critical analysis. The following table sets out the major elements of weakness evident in these accounts. The indicators, whilst by no means exhaustive, clearly demonstrate where we went wrong in each relationship. Whilst there is a degree of subjectivity in this identification process, it is evidence that had we paid greater heed to the fundaments of analysis and critical evaluation, many of these problems may have been avoided.

KEY INDICATORS	A*	EAST END	HOOKER	B*	C*	MINDARIE	D*	E*	SOMERLEY (1)	F*
. Inadequate quantative and financial analysis of composite group position	X		X		X	X	X		X	X
. Unquestioning willingness to approve.		X	X			X	X	X	X	X
. Pioneering no prior product expertise.		X				X	X		X	X
. Inadequate critical project analysis.	X	X	X	X	X	X	X			X
. Over reliance on good economic times.	X	X	X		X	X	X	X	X	X
. Substandard/inexpert sponsor.	X			X	X	X	X		X	X
. Security margin primary deterimer.			X		X	X	X	X	X	X
. Documentation skewed to client.	X					X	X
. Lack of monitoring triggers.				X		X	X			X
. Failure to recognise deterioration.	X	X	X	X	X		X	X	X	X
. Reliance on personal acquaintances.	X						X		X	X
. Focus on high rewards.		X	X			X	X		X	X
. Big ticket deal-impact as volume.		X	X		X	X	X	X	X	X
. Implied reliance on strong bank support.				X			X	X	X
. Credit evacuative process bypassed.	X	X					X

(1) Note: For Somerley, the failure of Trico in conjunction with Interwest was a critical component of our problems. We relied on Trico to underpin our exposure.

* To protect client confidentiality the entity names that have been included are those that are the subject of investigation and comment in this Report.

The following is an evaluation of the major lessons learned as a consequence of the losses and problems which have emanated from Beneficial's involvement in Joint Ventures. As a result of the experience gained, action is being taken to withdraw from all Joint Ventures as quickly as possible within the constraints imposed by the Joint Venture agreements, whilst protecting the value of Beneficial Finance's assets and interests.

CONCLUSIONS AND ISSUES

PRINCIPAL CONSEQUENCES

BUSINESS CULTURE

Joint Ventures perceived to be prestigious - enhancing market awareness and image.

Volume/Sales driven company striving for growth.

Off-balance sheet entities not restricted by Trust Deed gearing.

Financial strength of JV Partner unimportant.

Proliferation of Joint Ventures with heavy reliance on expertise and management ability of joint venture partner.

Documentation tended to favour JV partners and inadequately covered many aspects, such as gearing.

Inadequate written procedures and reporting requirements.

Inadequate prior evaluation of funding arrangements, profitability and impact on Beneficial Finance (particularly medium and long term).

Inadequate assessment and allocation of resources and priorities.

Beneficial Finance provided or guaranteed majority of funding either as sub-ordinated debt or funding loans, at concessional rates.

External non-recourse funding not obtainable. Treasury advice on independent funding lines ignored.

Beneficial committed to provide financial support to JV Partner.

Gearing relatively unrestricted.

Lending activity strayed into areas previously banned by Beneficial Finance.

Lending margins squeezed to achieve volume.

Unacceptable risk/reward structures.

Direct competition with Beneficial Finance branches evolved.

Direct competition between JVs.

Recognition of accounting profits at the expense of cash flows.

CREDIT

Large approval limits given to CEO of JV.

Unlimited funding loans provided.

Beneficial Finance's credit standards not complied with.

Review of Buying and Audit reports not adequately acted upon.

Interest capitalised on funding loans.

MANAGEMENT

Tendency of CEO to treat JV as own.

CEO reported direct to JV Board - with quarterly meetings.

Frequent change in Divisional responsibilities.

Equity investment and debt funding not clearly defined.

Insufficient Beneficial Finance resources applied in formulative period of JVs followed by split responsibilities between two divisions inhibited good account management.

Inadequate and untimely management reporting by JV.

Collection actioning below Beneficial Finance's standards.

Funding charges to JVs have not recognised the costs to Beneficial Finance of managing the JV's.

Conflict of interest in managing investment and debt facilities.

REPORT PREPARED BY BENEFICIAL FINANCE TITLED APPENDIX E.2

"LESSONS LEARNED FROM JOINT VENTURES"

In the evaluation of the lessons learned, major elements of weakness evident in the joint venture arrangements were identified. The following table sets out the key indicators which, whilst by no means exhaustive, clearly demonstrate where we went wrong in each relationship.

KEY INDICATORS	A*	B*	C*	MANL	D*	E*	*F(1)**	PEGASUS	G*
. Top down approval of JV.	X	X	X		X	X		X	X
. Limited prior experience with JV partner.		X	X		X	X
. JV Agreement/documents skewed to JV partner.				(2)		X		X	X
. Inadequate written procedures at commencement.	X	X	X	X	X	X		X
. Management directly controlled by JV partner.	X	X	X	X	X	X		X(3)
. JV Partner unable or unwilling to contribute adequate equity.	X	X	X	X	X	X		X	X
. High arrears/weak collections.	X			X	X			X
. Financial support provided to JV partner.	X	X	X	X		X		X
. Products outside Beneficial Finance's normal approved criteria.	X	X	X	X	X	X		X
. Products directly competed with Beneficial Finance's and/or other JVs.				X	X		X	X	X
. Maximum credit limits without reference to Beneficial Finance up to $1.0M.	X		(4)	X	X			X
. Credit limits and/or other authorities breached. (5)			X		X			X	X
. Significant loss write offs.			X	X	X			X	X
. Unclear, shared and frequently changed account management responsibilities within Beneficial Finance.	X	X	X	X	X	X		X	X
. Inadequate control by Beneficial Finance over cash receipts and/or expenses.		X	X	X	X			X

(1) This joint venture is directly managed by Beneficial Finance. Additionally, it has low gearing with equal capital contribution by a financially sound JV partner.

(2) No written agreement finalised.

(3) JV partner also controlled accounting and receivables systems.

(4) No prudential limits were set.

(5) The larges losses have been incurred where the JV partner has large credit limits.

* To protect client confidentiality the entity names that have been included are those that are the subject of investigation and comment in this Report.

CHAPTER 30 CREDIT AND ITS MANAGEMENT : GUIDELINES, POLICIES, PROCESSES, PROCEDURES AND DELIVERY SYSTEMS

30.1 INTRODUCTION

30.2 ORGANISATION AND STRUCTURE OF THE CREDIT RISK MANAGEMENT FUNCTION

30.3 THE MANAGEMENT OF DIVERSIFIABLE CREDIT RISK

30.4 CREDIT RISK MANAGEMENT IN THE CORE BUSINESS DIVISIONS

30.5 BENEFICIAL FINANCE'S "NON-CORE" BUSINESS: THE STRUCTURED FINANCE AND PROJECTS DIVISION

30.6 BENEFICIAL FINANCE`S OPERATING JOINT VENTURES

30.7 FINDINGS AND CONCLUSIONS

30.8 REPORT IN ACCORDANCE WITH TERMS OF APPOINTMENT

30.9 APPENDICES CREDIT POLICY COMMITTEE

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CHAPTER 30
CREDIT AND ITS MANAGEMENT : GUIDELINES, POLICIES,
PROCESSES, PROCEDURES AND DELIVERY SYSTEMS