Investing in banks: brilliant or bunk?
Pension schemes should invest €30bn worth of pension money in illiquid bank assets,
according to a recent proposal presented to the Dutch finance minister, Wouter Bos. A great idea? Pension luminaries Jean Frijns and Dick de Beus believe it is, and explained their views to Mariska van der Westen
Pension schemes should set up joint investment funds to buy up illiquid bank assets. Doing so would allow schemes to earn a nice return over time, and at the same time save the banking industry.
The government would have to create the conditions to make this possible by, among other things, allowing a less restrictive discount rate for future pension liabilities: this in a nutshell is the proposal that Albert Röell, chairman of the board at Kasbank, has presented to the Dutch ministry of finance.
The proposal has won support from pension czars Jean Frijns - former chief investment officer of civil servants scheme ABP - and Dick de Beus, former chairman of the board at PGGM. According to the proposal, the considerable pension savings stashed away in the Dutch second pillar should be utilised to combat the credit crisis. This ‘slumbering capital' can help fuel the recovery of the Dutch banking sector and economy if invested in illiquid debt paper, which in turn might generate a healthy return for the pension sector in the long run. That way, the pension industry can bail out the banking sector and be better off for it to boot.
Jean Frijns says: "Investors are presently restricted in so many ways that they can barely do their natural part - which is investing in a diversified portfolio of risky assets. This causes severe problems in the market. What we're seeing is a vicious downward cycle: the price of these kinds of products is artificially lowered because of plummeting demand, and if there is no demand, financial institutions' solvency is damaged even further."
As a result, banks are stuck with debt paper they cannot sell because there are no takers. The solution is clear, says Frijns: create demand. "In the US, for instance, the government encourages investors to take a chance and invest in these types of assets."
In the Netherlands however the government seems hell-bent on doing the exact opposite. Frijns says: "The trouble is that investors in the Netherlands are not allowed to take a chance. Or at the very least the supervisory regime, as implemented by the Dutch central bank De Nederlandsche Bank and social affairs minister Donner, gives pension funds the strong impression that they aren't allowed."
Frijns adds that to an outside observer it isn't always clear to what extent the supervisory regime is being determined by De Nederlandsche Bank (DNB) and to what extent it is really minister Donner who calls the shots. Frijns says: "Precisely because politics and supervision are so closely entwined, I am not very optimistic about the chances of this proposal being accepted. When it comes to investing the tendency is to impose rules, allow less and push for more caution."
Blown to smithereens
This tendency could do some serious damage to the Dutch pensions system, warns Kasbank's Roëll. If over time inflation should rise, the value of pension assets will melt away. The current supervisory regime leaves pension funds precious little room to invest in ways that might counter the risks of inflation. Roëll: "Regulation regarding solvency ratio was intended to safeguard our pension system, but in this crisis the rules unintentionally have the opposite effect."
The strict supervisory regime, with its focus on nominal, short-term certainty, forces pension schemes to scale-back their risks and invest increasingly in long-term government bonds, at the expense of equity investments that might generate much-needed returns in the future. Pension fund investments in the banking sector also fall victim to this de-risking trend, even though pension schemes benefit from well functioning banks.
"This way, in a worst case scenario our beloved pension system could be blown to smithereens by a combination of rising inflation and insufficient regulatory room for inflation-proof investments," continues Röell.
"Pension regulation in the Netherlands has indeed gone overboard, particularly with regard to market valuation of pension liabilities. This creates a lot of unrest," agrees De Beus. He also feels Roëll is right to call attention to the problem of inflation. "Inflation poses a very important potential threat to pension funds. The damage from a wave of inflation cannot easily be undone."
Frijns, too, agrees with Roëll's call to reconsider the interest rate that presently serves as discount rate for pension liabilities. "It is safe to say that by now we have learned that this kind of long-term liabilities should not be discounted based on a daily rate showing potentially gigantic daily fluctuations. Besides, one cannot possibly defend the validity of a discount rate generated in a completely obscure sub-market of paper that isn't even publicly traded."
Switching to a substantially higher discount rate is not the answer, though, says Frijns. "I do think we need a fairly strict pensions supervisor. We should not try to solve the problem simply by picking a conveniently high discount rate."
Such a higher discount rate, however, is exactly what Roëll proposes. He suggests choosing a more ‘real' discount rate and proposes a switch to a moving average over multiple years, or a discount rate of 4-4.5%.
In addition, DNB should grant an exemption of capital requirements to encourage pension schemes to take on banks' illiquid debt, which would allow banks to clear their balance of troublesome, ‘toxic' debt paper so they have their hands free to once again start lending to credit-starved companies.
After all, banks cannot afford to hold on to troublesome debt until faith in the markets is restored, whereas pension schemes, given their long term investment horizon, can. This also allows pension schemes to plug into a very interesting asset category, since these debts can be expected to appreciate quite a bit once markets recover. "At the very least this investment category seems more lucrative than large scale direct investments in banks the government has a stake in," says Röell, referring to earlier suggestions to this effect made by the Dutch finance ministry.
Investments in toxic bank assets could be arranged via so-called ‘bank funds', dedicated investment vehicles set up by pension schemes specifically for this purpose. Creating multiple bank funds would encourage healthy competition and stimulate market valuation of the assets.
According to Röell some 5% of Dutch pension assets, amounting to over €30bn, might be invested in illiquid bank assets. He adds: "If the government were to follow the example of the US by matching this €30bn investment with additional financing, possibly paid out of the existing €200bn ‘liquidity fund', such bank funds would be sufficiently large to effectively support the Dutch financial industry."
Insurance companies might play a role as well, since a recalculation of future yields with regard to their pension business would create some extra breathing room, allowing them to participate in a bank fund.
Röell points out that his proposal is neither new nor outrageous. "As a matter of fact pension funds would apply the same construction that the Dutch state has used in the case of ING. The main difference is that in this proposal the state would be involved indirectly rather than directly. This way the state would not be subject to possible criticism from Brussels about state support or insufficient neutrality, and the state's credit rating remains fully guaranteed."
In addition, the proposed solution might establish the Netherlands internationally as a leader in the pensions and finance arena. "The proposed joining of forces between pension industry, banking industry and government is unique to Europe and effectively bolsters the position of the Netherlands as a financial center of expertise," claims Roëll.
Investing in bank assets may be good for the Dutch economy and society at large, but so far, pension schemes have shown little interest in establishing such ‘bank funds'. Frijns says: "Given its size, the pensions industry plays an important part in society, and the industry is aware of this. But it is no easy task to find the right model that allows the industry to fulfill this societal role while also staying true to its investment mandate - which is to diversify risks and generate good returns."
It would take targeted incentives to encourage pension funds to make the intended investments. Presently, however, the policy seems to be one of discouragement instead. Frijns notes: "On one hand pension funds are told to take a more active role as shareholders, but on the other hand shareholders are told that their influence should be curbed." This strikes him as odd. "If you invest a lot of money in something, you should have a lot of say in the matter."
De Beus agrees that if pension funds are to invest in bank assets, regulation needs to change to make it worth their while. "Presently it doesn't do pension funds any good to take on illiquid debt from banks, because the present regime requires them to offset these assets with sizable capital buffers."
He sees other pitfalls as well. "The implementation of this bank fund proposal does pose a few problems. It takes extensive due diligence to get a good view of the bank debt portfolio a pension fund would take on. That is not easy to do, and there will always be some debts that remain doubtful," he explains.
In addition De Beus doesn't agree with Roëll's suggestion that a bank fund debt portfolio should be run by managers of the banks involved. "If one takes on a bank's debt portfolio, you really do not want that same bank to manage this portfolio. I would keep those things well separate."
Although both Frijns and De Beus appreciate the concept of bank funds, they are not particularly optimistic about the proposal's chances of success. "Pension funds are hesitant to take on these types of portfolios from banks unless they have a clear incentive. I doubt that there is enough political support for the regulation changes that would take. The finance ministry, at least, has not responded with a great deal of enthusiasm," says De Beus. "However, the proposal does help start a debate and so may lead to results indirectly. In any case, somebody went out on a limb and that is to be appreciated."
Frijns says: "It is a sympathetic proposal because of the idea that financial institutions and pension funds can come together and can jointly come up with constructive solutions. That might provide just that bit of momentum we need." Despite his doubts regarding the political feasibility of the proposal, he remains positive: "One should keep trying, and keep thinking. Because pessimism is not going to do anyone any good."