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The Actuary The magazine of the Institute & Faculty of Actuaries
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Banking: Mind the gap

Lord Turner of the Financial Services Authority spoke in a recent radio interview of the “knowledge gap” perceived between banks and their institutional customers, such as insurance companies. But does such a gap exist and, if so, why? More importantly, can it be closed?

First, let us consider whether banks really do know more than their institutional customers. This question has become particularly relevant in the wake of the banking crisis with the impact on banks’ customers, especially when we think about some of the more complex products we have bought from banks in recent years and the effect on the investment portfolios of insurance companies.

If we think about products such as asset-backed securities that have turned out to contain so-called toxic assets, did the banks that sold them know more about the potential dangers of these products than their customers? The answer to this is no, as surely if they did they would not have found themselves holding such long positions on their own books. This, though, is missing the point. The question we should focus on is whether institutional investors were able to know and understand as much as their banking counterparts.

Acquiring this knowledge hinges on two things — an understanding of the products and marketplace and the availability of information. For the first part, if we ask whether banks have better, more knowledgeable staff than their institutional customers, the answer must again be no. If we look at the individuals working on the buy and sell side of a trade, we are likely to find very similar profiles at the point of execution. Both sides want to hire numerate, intelligent individuals with an understanding of cashflows and an appreciation of risk. Given the nature of the insurance industry, I do not think we would be wrong to argue that the buy side may well have a better appreciation of this than their opposite numbers on the sell side.

They are likely to have the same level of education; it is only in terms of professional qualifications that they may differ, depending on the requirements set out by the regulator for different job functions and the commitment of the firm to providing market training, which is not uniform on either the buy or the sell side of the industry. Whether the depth of understanding through the firm is the same on both sides of the trade is more debatable. Remember, it is the institutional investors who are left holding the assets, so it is on this side of the fence that we should see greater attention paid to managing and understanding the risks and cashflows of these deals. Yet in many cases this is not in evidence.

A clearer view
In terms of transparency, the question here is whether banks have access to more information. The answer is probably no and yes. If the institutional investors are buying publicly issued products, then the same information should be available to both sides, at issue at least. Both sides have access to the prospectus for the deals or to the summary information provided by the data vendors in the market. However, there may well be an imbalance here — just because the information is readily available does not mean that it is always taken. While the sell side has always consisted of steadfast customers of the data vendors, this is not always true of the buy side. Sometimes they choose not to invest in these products at the cost of not having easy access to data.

Looking at the secondary market, this choice can be even more significant as we have to consider transparency of values. Despite the efforts of regulators, there are many gaps in value transparency for over- the-counter products. This gives the sell side a distinct advantage if they are lucky enough to see trade flows, the ultimate measure of value where actual buyers meet actual sellers. However, we should remember that, for many of the more complex products, there is little or no trade flow, so a lot of the judgment on value will come not from transactions, but more from market reaction to the asset. This, in turn, can lead to the sort of erratic price movements that we see in some products, often as a result of defensive trading.

From the investor’s perspective this can be difficult to understand, which brings us to the next point in our potential knowledge gap — a lack of understanding of the market.

Irrational behaviour
If markets were completely rational this would not be a point of debate — but they are not. As stated, we sometimes see erratic price movements, and investment strategies are sometimes formed around the search for assets trading away from fair value. If we accept that the sell side has a broader view of the financial products, in that they not only look at the asset as a series of cash flows and risk but also work with the perception of the asset from their broader client base, this is an area where the institutional investor will be disadvantaged.

Perhaps they are also guilty of not understanding or appreciating the significance of this? A lack of understanding of how banks may have to react to changes in liquidity or credit perception, exactly as we saw in 2008, can mean that investors are taken by surprise by these price changes. Since we often rely on price feeds input by the banks for the valuation of investment portfolios, this can be very significant. We can argue that these are transient values but, ultimately, if an insurance company has to value its portfolios on given dates, it is at the mercy of these vagaries of price movements. Too often institutional investors do not really understand why banks react the way they do, and banks do not necessarily understand the impact of this on their institutional customers. This is a gap that should be closed from both sides.

It seems that there are knowledge gaps between the two sides of the market, so how can they be closed, and who should take responsibility? On an industry level, perhaps the regulators should look again at the required minimum standards of knowledge. The problem with this is that minimum standards offer exactly what they say. I am sure that they would argue that the content covered in the required examinations is of a level to give the examinees a firm base onto which more knowledge can be built. Therefore they would feel that their responsibility is fulfilled and it should instead pass to the individual institutions.

Better data
Assessing the situation from an institutional perspective, we identified the three areas of concern: transparency, product knowledge and market knowledge. If we believe that the banks are better-armed with information about the market, then surely the investors should do all they can to improve their own overview. Maybe this will mean more investment in data as well as improving communication with their bank counterparts.

Often the thing that distinguishes one bank from another is not pricing, but rather dialogue; research, ideas and the relationship between the fund manager and the institutional salesperson. Perhaps this dialogue should include more questioning about the flows and views of the bank. We know that sometimes this may need to be taken with a pinch of salt, but often the trick will lie in knowing the questions to ask. This leads us to understand the product and market.

Too often, institutional investors and the banks themselves buy the training solutions that providers want to provide. While off-the-shelf courses, be they classroom or online-based, can certainly have a place, in many cases they will not provide the solutions that are needed. Perhaps it is time for investors to become more demanding and require the training content to be designed to fulfil these needs. Of course, this does depend on identifying and understanding these needs in the first place.

Addressing these issues will not be quick, easy or inexpensive, but the benefits of trying to align the two sides can only improve performance in the long run and better equip the insurance industry to manage its relationship with the financial markets.

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Gail Rolland has worked in the financial markets for more than 25 years. She currently runs her own investment banking and financial markets consultancy