The Barings aftermath continues to have repercussions in the financial markets. The major factor to manifest itself following the bank’s fall from grace is the question of credit risk management, an area which many fear is not being handled effectively.
Up until recently, there has been no viable alternative for institutional investors in Europe to obtain a good return on their cash investment with 100% guaranteed security. That is, until the relatively recent introduction into the UK market of institutional cash funds (ICF).
An alternative to the bank deposit, ICFs were conceived in the US over 20 years ago. Now the big US providers are launching offshore-domiciled funds to access the European market.
ICFs are built on a balance of three elements: security, yield and liquidity, with a target market comprising pension funds, insurance companies, custodians, trustees and, in fact, anyone with a large amount of disposable cash.
The security aspect - which is by far the most attractive to the UK institutional investor, though perhaps not so important to other Europeans - derives from the Triple A rating given by Standard and Poors’ and Moodys’ rating services.
“Our fund is triple A,” says Anthony Myers, director at AIM Global Advisors, “because of the quality of its underlying activity which is in gilts and commercial paper. It hasn’t got the risks that banks have of lending your overdraft and your mortgage.”
Consequently the fund is only allowed to invest in the market instruments which are deemed “safe” enough by the ratings agencies to qualify it for the highest rating. No UK banks currently hold such a rating.
AIM’s $550m dollar portfolio, established in 1995, currently holds approximately 40% of an estimated $1.2bn worth of Lloyd’s of London’s liquidity. Myers views this as a virtual stamp of approval on the concept of funds. “If a market as conservative as Lloyd’s of London insurance market can use money market funds, then it’s got to be all right for everybody else.”
The yield on the funds depends on the charges and interest earned. Fees charged by the provider do not vary significantly – Fidelity, who currently hold $118bn in cash funds under management, mainly in the US, carry the lowest fee of 0.15%, with Liberty at 0.25%, and Chase and AIM variable depending on the class. Chase is in fact launching a sterling and deutsche-mark portfolio priced at 30 basis points, on the back of their dollar fund. The portfolios are expected to come out at the end of March.
The yield offered on an ICF is attractive, but by no means exciting, as high yield comes at the expense of security. Liberty, who has recently launched a sterling and dollar portfolio, stated the annual yields, net of fees, of internally managed sterling fund was in the range of 5.65-5.95% and on the dollar portfolio 5.10 - 5.30%. Fidelity’s average return for 1996 on the sterling portfolio was 5.85%, five points over the overnight London interbank bid rate (LIBID), and on the US dollar fund 5.28% compared to LIBID’s 5.23%.
The deutschemark underperformed at 3.09%, 0.09% lower than the benchmark, which, says Peter Knight, head of institutional cash funds at Fidelity, has a lot to do with the fact that due to the small size of the fund, Fidelity was more interested in going for security “rather than chasing yield”.
Yield has to be effectively managed to take advantage of the size of the fund, to get the highest yield in the market and be competitive with London money market overnight rates. But, says Myers, “security and yield must be balanced. If you lose that balance you get a BCCI situation.”
The third selling point of an ICF is the liquidity aspect. Most providers are offering same day settlement, which means they need to ensure a certain percentage of their portfolio matures on any given day should investors want to withdraw cash.
However, while the top banks have no problems concerning liquidity - they are relatively flooded with cash - this in turn means lower interest rates. In Europe, there are billions of dollars worth of cash simply sitting in comparatively unsecured banks - while a handful of European banks sustain a top rating, all of the “top four” banks in the UK remain at double A status. Not only that but they are sitting on a balance sheet earning “very low rates of interest and attracting a poor service for their clients”, says Knight.
When banks default, which mainland Europeans seem to have no fear of at the moment, it is questionable to what extent their compensation guarantees can deliver. Knight is skeptical of the compensation schemes put forward by European banks, seeing them of limited use. “If you’ve got $50-100m with a German bank that goes into liquidation, how quickly can you get your money back? By the time you’ve got it back, you could have been forced into liquidation anyway.”
After Barings, the “fear aspect” is inherent in the UK investor, so the security appeal is the driving force behind the funds’ popularity in the UK and ICF providers are more than happy to step in with the ideal alternative right at the point where institutions are changing their investment habits. Banks, who are have been the target of criticism and used as the main selling pitch by fund providers, are of course now launching their own ICFs - Citibank have dollar, sterling and deutschemark portfolios, Chase, the world’s largest global custodian with $3.5 trillion assets under administration, will soon be launching sterling and deutschemark after the success of their dollar fund and BZW are yet to expand on its sterling and dollar funds.
The growing insecurity with banks is also likely to hit the way pensions funds are invested. The impending Pensions Act, where trustees will become increasingly liable for their decisions, is obviously going to impact a pension fund manager’s portfolio, particularly concerning cash.
“Soon trustees are going to be sitting in a very hot seat” says Mark Doman, director at AIM Global Advisors. Typically 5-10% of a pension fund portfolio is cash, and has up until recently been left in a bank. There will now be growing pressure on all pension fund trustees to relook at all the cash elements and rethink their investment choices.
“Cash has never really been regarded as an investment, which is extraordinary” says Andrew Jenkins, portfolio manager at Fidelity. Fidelity has already approached a number of pension fund custodians, pointing out the risks they may be taking with their own cash.
“Custodians should already bear a responsibility for that” says Knight, “but changes in legislation will encourage them to think even deeper about that.”
While the UK seems to be sitting up and realising there is life beyond banks, the case in Europe continues to be a sustained reliance on bank deposits or the retail money market funds which have been popular, especially in France for some years and which are also available to the institutional investor.
“Institutional money market products are something of a slightly difficult sell” says Mark Connolly, director or Rothschild Asset Management in London, “With companies like Siemens who have masses of amounts of reserves, have quite strong treasury teams, and have a very large and professional team managing the money, they’ll get pretty good interest rates themselves.”
Rothschilds, incidentally have just launched the Five Arrows Cash Management Fund, with a minimum investment of $500,000.
Markus Hammes-Jenkins, fund manager at Deutsche Bank’s DWS division in Frankfurt, cannot foresee the introduction of ICFs in Germany from a security aspect, as Germans traditionally have had a strong banking system and have a sustained confidence in them. Yet only recently Deutsche Bank was downgraded and Dresdner was put on the watch list for possible downgrading, though presently remains at Triple A status. Few other banks in mainland Europe carry the top rating.
Commerzbank, with DM10bn invested in institutional money market funds, is one of the very few fund providers in continental Europe to cater for the institutional investor, and currently holds a deutschemark and dollar portfolio. The bank has a sterling portfolio, which director of product development, Peter König describes as “sleeping”, as “there are not too many customers out there.”
However, König agrees with Jenkins’ prediction that Germany won’t catch on to ICF fever - the demand is not yet strong enough and the fear factor has not swept through mainland Europe as it has done in the UK.
Accessing Europe, a relatively undeveloped market would seem the next logical step, but as Bill Semmes, director at Chase Manhattan says, it’s not that easy. “It’s not like the field’s wide open and we’re going to grab it”.
Semmes feels an accumulating share class will be important, but the ICF trend is going to take time to grow. “A lot of people don’t understand it and aren’t used to it” he says.
Education, agrees Knight, appears to be the key with ICFs, not only in mainland Europe but also in the UK; “There must be heightened awareness of cash. If custodians were forced to look at this and trustees and pension funds, then I think it’s a good thing and not before time””