Letter number 112 of April 2018
- QUESTIONS & COMMENTS
The French Association of Corporate Treasurers (AFTE) asked us to deliver a paper at its conference in November 2017 on 2007-2017-2027, 10 years of crisis and what’s next? Below follows the second part of a transcription thereof with the first part appearing in the Vernimmen Newsletter.com of March 2018.
5/ The financial system
The financial system is characterised by banks that are not as profitable but are much more solvent and so a lot less risky than they were 10 years ago. Do we need reminding that in 2007, the Bank of England authorised RBS to acquire ABN Amro with 2% core equity? The rest of the story is well known: in order to prevent RBS from going under, the British government injected a massive £45bn of equity. Today, consensus is at 12% of equity as a percentage of average weighted outstanding loans, which may rise to 13-14% tomorrow. Moreover, average leverage has gone from 50 to 20.
With hindsight, we could say that the increased equity requirement is probably the most effective way of avoiding having to inject emergency equity into banks when the next crisis occurs.
This won’t mean that crises will cease occurring, but it should prevent massive public bail-outs. It would be naïve to believe that we could get rid of crises, as crises are how capitalism and its excesses are regulated.
So, treasurers would do well to heed the words of St Matthew when going about their business: “Watch ye therefore, because ye know not the day nor the hour.”
And what is rather reassuring today is that there are regular announcements from all sides of the imminence of a crisis, when historically crises have rarely been announced.
The development of the financial market, to make up for the relative fall-off of bank financings in Europe from €4,700bn to €4,300bn, i.e. €400bn, is ironic to say the least, when we remember that the financial crisis originated with and was spread through the financial markets.
But the most striking element is of course the existence of negative interest rates. In this area, we’ve gone from a theoretical impossibility (if not we would never have emerged from the caves), to a fleeting appearance in autumn 2008 (-0.01% over 3 months in December 2008 in the USA), followed by a long period (since June 2014 in the eurozone for deposit rates at the ECB) at a very low rate (-0.4 % for these deposits today).
Treasurers have suffered, but very few of them made mistakes, like investing in March 2016 at 1% at 3 months in pounds sterling compared with 0.01% for a deposit in euros, without having debts in pounds sterling. The greedy or the incompetent lost 13% when they woke up on the morning of 24 June following the Brexit referendum.
Finally, it is likely that we will see a return to banking consolidation in Europe over the next five years. For France, €85bn is a lot (market capitalisation of BNP Paribas) and for Spain, €90bn is a lot (market capitalisation of Santander) but on the scale of the eurozone (which is now the banking regulator, it’s not very much. JP Morgan has a market capitalisation of $280bn, Wells Fargo $250bn, BoAML $220bn. In China, the four leading banks have market capitalisations of between €150 to 225bn.
The strategic argument has already been identified: stand up better to GAFAM, generate synergies so that profits exceed equity and even stand up to the Fintechs that have succeeded.
This is not an area in which the authors of the Vernimmen excel! But it is clear that the automation of tasks that reduce the unit cost of processing or of transactions is here to stay, especially given that most of the banks in the eurozone do not earn their cost of capital. Practically all foreign exchange transactions are machine-processed, factoring is automated on platforms, Orange is working on a platform to process NEU CPs .Tomorrow, most market transactions (placement of investment grade bonds) will certainly be automated as well.
And dematerialisation (much less paper), which has changed the lives of financial directors, also looks set to continue.
Students are not all that interested in finance in the interests of entrepreneurship and strategy. Fortunately for France, this disaffection is more than made up for by an influx of international students attracted by the finance courses given in France. Five French courses are ranked among the top 10 of the Financial Times Best Master in Finance Programmes worldwide. So at HEC Paris, where we teach, 44% of students are international students, including 111 Germans, 90 Italians, 85 North Americans, 201 Chinese, 121 Indians, etc. You won’t have to look far if you want to hire young financiers who have been well trained and exposed to French culture for your international subsidiaries!
But managing this generation (millennials, generation Y) is not the same as managing the previous one. You’ll be aware of this if you have children of this age. They’re looking for a mission, not a job, a mentor, not a boss and they want to have an impact and meaning in what they do. This generation is the fruit of its era of social networks and immediacy.
We’re not management gurus, but is seems clear to us that this generation is going to carry on resigning on a regular basis and to provide companies with 87% of employees who are only moderately involved in their work, if the company does not adapt working methods to today’s way of living and change its architecture. The emphasis needs to be put on working in a network in order to give individual talents the opportunity to express themselves, rather than having a system of managerial and hierarchical control. The future authority of today’s leaders will not be linked to their hierarchical position, but will depend on their ability to mobilise and to bring consensus. This will apply to finance as well.
And this generation is going to have to learn all about patience, which is a fine quality, just as impatience is.
But there’s not just the new generation. And treasurers are not just specialists of a technique. Some of them are managers and, in this regard, they cannot remain indifferent to the fact that only 13% of company employees feel motivated and engaged by what they do. Imagine how efficient teams would be if this figure rose to 26% or 52%!
For professionals wishing to go over the basics, update their knowledge or acquire new knowledge quickly, at a lower cost and by creating professional links with other participants, digital training has been a reality for over three years. While we were privately lamenting the lack of significant improvement in our productivity in the classroom, digital tools have enabled us to multiply it in one go by 14. We have already trained or retrained some of you or your colleagues, 2,200 in three years, thanks to the ICCF@HEC Paris programme, which English version is ICCF@Columbia Business School. But companies are slow on the uptake, not individuals who forge ahead, because they’re more concerned about their human capital than about their employer. We ourselves continue to follow training courses on a regular basis. Which just goes to show!
In conclusion, we’d like to look at shareholder activism.
As has been shown by Michael Jensen, whom we’re predicting will win the Nobel Prise for Economics awarded to a researcher in Finance, takeover bids function efficiently as a means of discipline for small- to medium-sized groups that are underperforming (ABN Amro, Club Med or more recently Gemalto). But they are impossible to implement for groups that are controlled or too big (worth more than €100bn), which raises questions about their discipline in the event of a lasting underperformance.
In fact, shareholder activism is the missing tool for improving the governance of controlled listed groups (Lagardère) or too big to be the object of a takeover bid (Nestlé).
And whether we like it or not, it’s going to continue to develop in Europe.
And the best defence against shareholder activism is for the company to engage in activism itself, by not shying away from disposing of assets, changing managers or even strategy, in short, depriving activist shareholders of arguments. This is how it came about that L’Oréal sold The Bodyshop, bringing an end to a failed attempted incursion into retailing.
They have reached a historic high since 2003, when Coface began to compile them:
The increase of 2017, after that of 2016, brings them to 76 days. The proportion of Chinese companies with delays exceeding 120 days has thus increased from 19% to 26%, but those with deadlines greater than 180 days on at least 2% of their turnover reach 47% in 2017 against 35% in 2016. As for those for whom these ultra-long payment periods exceed 10% of turnover, their proportion has increased from 11% to 21%. Coface estimates that only 20% of unpaid claims after 180 days will ultimately be honored.
The worst-paying sectors are energy and construction, where the largest over-investment seems to have taken place.
It will be reminded to our novice readers that payment periods that are growing, here 36% since 2015, are rarely a sign of good economic health, and the longer they are, the greater the danger of domino effects - the bankruptcy of unhealthy companies that contaminate initially healthy businesses that can no longer afford to pay, and in turn experience difficulties, is important. For this reason, working capital in days of sales or the payment deadlines appear by the most discriminating factors of the score functions (as can be seen in chapter 6 of the Vernimmen).
Research has shown that deregulation of banking markets across the globe increases competition between banks, with many associated advantages. In Hombert and Matray’s study into the effects of deregulation on innovation, however, they found an apparent disadvantage for small firms, who were seen to lose out in terms of funds and talent.
In the 1970’s, the world saw the beginning of banking market deregulation. This liberalization saw an increase in competition between banks and their subsequent growth, alongside wider growth of industry and individual firms. The authors, meanwhile, set out to investigate the effects of this deregulation on innovation, asking: “How has the financing of innovators been affected by the arrival of these large, competitive banks?”
The two authors decided that the USA would be a good laboratory for their financial experiment. Here, banks are regulated at the state level, rather than federal. This means that in some states, banks were deregulated in the 1970’s, while others were still being regulated into the 1990’s. The authors say, “It was a bit like a biology lab, we looked at data from regulated states and those that were deregulated, and compared them over a timeframe of about 15 years.” To understand how deregulation might affect innovation, he needed an innovation indicator and decided to look at patents. Patent activity is a good measure of the amount of innovation that is occurring and data on patents in the USA is publicly available, making this easy to analyze. By comparing the number of patents over time, the results show a drop in patenting by small firms in states with deregulated banking markets. “Banking deregulation has been proven to provide many benefits, but it does not seem to be good for the innovative activity of small firms,” he explains. “This does not necessarily mean the system is bad, but it is different.”
Big banks work in a different way to small banks. In the past, banks would have been localized to a particular area or region. These smaller banks had strong relationships with local businesses and borrowers. Bank loan officers would not only have a customer’s financial details, and the business books, but they would have personal or ‘soft’ information about the individual. They would know if they were trustworthy and reliable and use this information when they decided on the loan application. With big banks, there is no knowledge of personal information. Instead they rely on an algorithm. They feed in the businesses’ financial information and this will calculate its credentials and tell the loan officer what to do. These algorithms are based on credit scoring models and are efficient and economic. They have also been shown to be very effective in allowing for competition between banks. “This is the root of the problem for small innovators,” explain the authors. “It is not easy to look at the finances of a small company and decide if a project is going to be successful. More soft information is needed to decide if the idea is good. The big, sophisticated banks are not good at dealing with this type of information, so small businesses lose out.”
Through additional analysis, the authors tracked individual inventors over time. By looking at their job history, they found that inventors who started in small firms generally move to bigger firms after deregulation. As such, larger firms drain the innovator talent away from small firms. they note, “Small innovative firms find it harder to find funding after deregulation which corresponds to them struggling to retain talent. With less money, inventors move on to better funded, bigger firms.”
“Overall, the shift from local banks to big banks was good for many in the economy, but not for small innovators,” they conclude. The authors are unsure of whether the financial innovation advantages that big firms have over small firms in deregulated banking markets are a good thing. Governments and organizations across the globe often promote the work of small innovative firms in the form of subsidies and tax credits. But the small firms that are the target of such schemes often fail in their applications, as big firms with better administration systems in place capture the funds instead. The authors conclude by noting, “This work cannot tell us if it is a good idea to let the big firms do all the innovating or if more needs to be done to bolster small innovators. These are questions to be answered in the future.”
 J.HOMBERT, A.MATRAY (2017) «The Real Effects of Lending Relationships on Innovative Firms and Inventor Mobility», The Review of Financial Studies, vol. 30-7, pages 2413-2445.
Problem 1: A holds 49.4% of X and has 2 out of 5 directors. B holds 50.6% of X and holds 3 directorships and appoints the chairman. The appointment or dismissal of the Chief Executive Officer, the Chief Financial Officer, the adoption or amendment of the budget or business plan, as well as the decisions of indebtedness, investments, acquisitions or disposals of assets require the agreement of A.
Does B have to consolidate X by full consolidation or by proportionate consolidation under IFRS rules? And A by proportionate consolidation or equity method?
Problem 2: Company X is 50% owned by the company P, 25% by the company R and 25% by the company S.
Main decisions are taken by a majority of 70% in X.
Can P, which de facto has a right of veto over X, under IFRS, consolidate its participation according to the method of proportional integration, because it would share the control of X with another shareholder?
Answer to problem 1: A does not control X because its needs B to be able to take most important decisions in S. So for both A and B, it is the proportionate integration that is necessary.
Answer to problem 2: No, because control sharing is with well-defined partners. But here P can share control with R, or S or R and S, but nothing says that it's always with the same partner. So P will have to consolidate X by equity method.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.
Cause or consequence?
A few days ago, a financial news agency reported that: "Investors are flocking to the share of the temporary working group after the announcement of a sharp rise in its dividend."
If it were enough to raise its share price by 8.8% to increase its dividend, even strongly, many groups would regularly increase their dividends!
In fact, if the share price of CRIT, the company in question, rose 8.8% in one session, it is rather to put on the account of announced results better than expected: investors expected an EBITDA between €128m and €145m; CRIT announced €150m, i.e. + 20%. It is this growth in earnings beyond the expectations of investors that triggered the rise in prices, especially since the increase in the dividend, starting from very very low and multiplied by 11, is a signal that the managers of CRIT are at comfortable with the current outlook of their business.
Even with a payout ratio of 58%, CRIT is safe from need, as its cash net of any bank or financial debt represents 20% of its market capitalization. And it's all equity, which CRIT no longer needs, that can be reinvested by investors in companies that are in need of equity.