The European Financial Review August/September 2017 by EBR MEDIA

The Renegotiation of NAFTA

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The Future of Bank Risk Management

August - September 2017

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Macron Effect:

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The European Financial Review empowering communication globally AUGUST - SEPTEMBER 2017

Emmanuel Macron, A New Dawn for France? p.7

France 7

Emmanuel Macron, A New Dawn for France? Ariane Bogain

The Macron Effect: Taking France by Storm Joseph Downing

Global Trade

The Renegotiation of NAFTA David Bartlett

Brexit 20

Brexit and Beyond: How Businesses Can Survive and Flourish in Uncertain Environments Martin Reeves

Policy 25

The Limits of Central Banks’ Emerging Policy Shift Jack Rasmus

Society 29

The Crisis of Trust in Democracy and Globalisation Graham Vanbergen

Digital Transformation

The World-Class Performance Difference: Digital Transformation and Finance in 2017 and Beyond Gilles Bonelli

Technology 36

How Technology Impacts Execution for Portfolio Managers Irene Aldridge The Dawn of Assistive Technologies Fiachra O’Brolcháin

71 75

Investment

A Companion Guide to Exploring the Subtleties of Asset Management Hugues Langlois and Jacques Lussier Young Professionals and Impact Investment Marguerita Cheng

Retirement

What’s Your Retirement Strategy? Mary Sterk

Banking

Strategic ALM and Integrated Balance Sheet Management: The Future of Bank Risk Management Moorad Choudhry

Tax

What Europe’s Big Soccer Tax Evasion Cases Should Teach All Taxpayers Robert Wood

Innovation

Conquering Europe Through a Joint Innovation Strategy: How Huawei Blends Cultural Revolution and CustomerCentric Principles Manuel Hensmans

Leadership

Open Source Leadership Rajeev Peshawaria

Insurance

Not So Sure About Insurance Morten Strange

Production & Design: Angela Lamcaster Print Strategy: Stefan Newhart Production Accounts: Lynn Moses Editors: Elenora Elroy, David Lean Group Managing Editor: Jane Liu Editor in Chief: The European Financial Review Publishing Oscar Daniel READERS PLEASE NOTE: The views expressed in articles are the authors' and not necessarily those of The European Financial Review. Authors may have consulting or other business relationships with the companies they discuss. The European Financial Review: 3 - 7 Sunnyhill Road, London SW16 2UG, Tel +44 (0)20 3598 5088, Fax +44 (0)20 7000 1252, info@europeanfinancialreview.com, www.europeanfinancialreview.com No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without written permission. Copyright © 2017 EBR Media Ltd. All rights reserved. ISSN 1757-5680

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France

Emmanuel Macron, A New Dawn for France? BY ARIANE BOGAIN

Emmanuel Macron’s victory in the French Presidential election was a stunning event. This article analyses the political and economic landscape Macron is now facing, how he might navigate this new landscape as well as some of the lessons his victory taught us.

ho would have predicted a few months ago that the relatively unknown Emmanuel Macron, the candidate with no party

to his name, would become the new French president, with an absolute majority in Parliament to boot? Now that the dust has somewhat settled, where does this most astonishing election in recent time leave France? Macron’s victory has radically overhauled the political landscape in so many ways. “Dégagisme” or “get the old guard out” dominated the 2017 French electoral cycle. The Presidential election saw the demise of two former presidents, François Hollande and

Nicolas Sarkozy, and the elimination of the two giants that have shaped France for the past 50 years, the Republican Right and the Socialist Party. It also witnessed the end of the traditional fault line of French politics, the divide between the Left and the Right, with the self-styled “beyond the Right and the Left” Macron winning and a second round fought over openness versus closure, liberalism versus protectionism. In June, the parliamentary election ended with a radically new Assembly, with 424 brand new MPs, the absolute victory for a party that didn’t exist a year ago and the most feminised Lower House in history. Macron is now in full charge of his destiny, with an absolute majority that owes him everything and much weakened opposition parties. In 2012, the Socialist Party held all the levers of power: the Presidency, an absolute majority in the National Assembly, all the regions bar one, the vast majority of départements and most of the large

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France

towns. It even secured the majority in the Senate for the first time ever. Now, after losing all the elections held for the past five years, it has been reduced to a mere 30 MPs, its worst result since its creation in 1969, and is facing a bleak future, squeezed between Macron, who appeals to the moderate wing of the party, and Mélenchon’s hard left intent on luring its more “radical” wing. The Republican Right is faring only slightly better. It does have 125 MPs but it has experienced its worst result since the inception of the Fifth Republic in 1958. To make matters worse, Macron has succeeded in torpedoing it through the masterstroke of appointing as Prime Minister someone from its own rank. As a result, the Right is now split between its “Macron-compatible” side prepared to support him and a dwindling “antiMacron” wing determined to show full opposition.

With various polls showing a very high level of distrust against politicians, Macron will have to proceed with caution. After all, the French street has a habit of standing up to governments.

The more radical parties on the Far Right and Far Left are not in good shapes either. Marine Le Pen might have attracted the highest number of voters ever for her party in the presidential election but the stark reality is that she failed dismally in her secondround campaign, with a car crash of a presidential debate and a major U-turn over one of her central planks, leaving the Euro. Her party’s fortune has taken a turn for the worse in the parliamentary election, with a score lower than in 2012 (13.2% of the vote against 13.6% in 2012). The number of MPs from her party might be higher this time round but having 8 MPs pales in comparison to the 80/100 Le Pen was aiming to get following the 10.6 million of votes she received in the presidential election. The scale of the defeat has left a very bitter pill for the National Front, with current infighting over its programme and its future seriously weakening it. Mélenchon’s hard left might be very vociferous but his excellent result in the presidential election did not turn into a massive number of MPs and his party remains behind the Socialist Party. Mélenchon

The European Financial Review August - September 2017

will certainly have a platform to rail against Macron in the National Assembly but then again the new President won’t mind having him in the system rather than opposing from the outside. It is therefore clear that, politically speaking, Macron holds all the cards. This doesn’t mean, however, that he has a boulevard in front of him. It would be a folly to assume that the country has fallen to a Macronmania wave. The record high abstention rate in the June Parliamentary election indicates that the French electorate did not give him a blank cheque. With various polls showing a very high level of distrust against politicians, Macron will have to proceed with caution. After all, the French street has a habit of standing up to governments. Furthermore, Macron might have reshaped the political landscape but political ideas and ideologies don’t just die at a stroke. They might lie low for a while but they tend to come back. History has taught us to be careful in predicting the end of parties or political ideas in France. The SFIO, the predecessor of the Socialist Party, might have died in 1969 after receiving only 5% in the presidential election but that didn’t stop the Socialists from forming a new party with a new programme and to go on winning elections after elections less than 3 years later and dominating the French Left for years. Macron might have reshaped the political landscape but he needs to take full advantage of the situation now rather than later. Politically, Macron is in a very strong position. His future, however, is directly linked to what has left successive French Presidents and Governments come unstuck for decades, unemployment and the state of the French economy. According to a French saying, luck smiles on those who dare. Macron did dare and won and it very much looks like he also got the economic luck. Back in 2012, his predecessor, François Hollande, found a French economy mired into the Eurozone crisis, with an anaemic growth, a high unemployment rate that kept growing and a high level of business closures. Fast forward to 2017 and Macron is finding himself in a sweet economic spot: growth has resumed at a stronger pace, unemployment is down, the Eurozone as a whole is growing, the PMI indicators are on the increase, the business sentiment has reached new heights and, crucially, a general sense of optimism has come back. It is always easier to reform a country

He is a good illustration of how a new leader can bring renewed optimism and a sense that a new start is possible. However, Macron is not some kind of messiah who will solve France’s divisions and anxieties with a magic touch.

France's newly elected president Emmanuel Macron (R) is welcomed by his predecessor François Hollande at the Elysee presidential palace in Paris for the handover and inauguration ceremonies May 14 © Stephane De Sakutin, AFP

when the main economic indicators are heading in the right direction. Macron brings with him youth, optimism, and a belief that France can benefit from globalisation. He aims to bring unemployment down through reforming the labour market, making France a more business-friendly country and unleashing entrepreneurial spirit. He wants to prove, to Germany in particular, that France is capable of reforming itself and bring its deficit below 3% of GDP, as per the rules of the Stability and Growth Pact. That would then enable him to push forward a greater Eurozone integration, with its own parliament, budget and finance minister. It would be wrong, however, to be carried away at this point. The French economy might be in a better health but its problems have not magically gone away. Unemployment is still very high and above the EU average, at 9.6%, with youth unemployment a particular concern. French companies might have improved their profit margins but exports remain a major weakness of the French economy. The mood amongst the French might have improved but many remain very fearful of the future. The high number of votes for both Marine Le Pen and Jean-Luc Mélenchon shows that a large section of the French electorate rejects unfettered globalisation and economic liberalism. Macron cannot take anything for granted and he will have his work cut

out if he wants to reform the French economy all the while giving hope to all those who feel left behind by globalisation. Macron has shown that the narrative of voters shunning globalisation, openness and progressive values, devised after the British referendum and Donald Trump’s victory in 2016, can be broken. He has shown that the rise of populism can be stopped, that it is possible to campaign on an openly pro-EU and liberal platform and win, and that promoting “experts” is not necessarily a turn-off for voters. He is a good illustration of how a new leader can bring renewed optimism and a sense that a new start is possible. However, Macron is not some kind of messiah who will solve France’s divisions and anxieties with a magic touch. He has reshaped the political landscape, he is facing a better economic situation than his predecessor ever did but he also knows that changes, in France, are never easy. He will have to tread very carefully in order not to face the third round of the electoral cycle, the social round of protests and demonstrations that has undermined or brought down so many French governments. The political path has been cleared and the economic horizon is slowly improving. Macron has everything to play for. Whether he succeeds or not will be fascinating to watch. Featured Image: Emmanuel Macron with interviewers © Sky News

Ariane Bogain is a Senior Lecturer in French and Politics at Northumbria University in Newcastle, UK. She has been teaching for 20 years. Her research interests include French Politics, France and the EU, Terrorism and Critical Discourse Analysis.

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France

The Macron Effect: Taking France by Storm BY JOSEPH DOWNING

Macron has burst onto the global political scene as an upstart who took not only the French executive but also a majority in the parliamentary elections. However, three key challenges could yet derail his nascent presidency. Corruption in French politics, labour market reform, and finally, dealing with the security puzzle that has haunted France for the best part of a decade. Together, these present challenges to the young president present a hard slog for a country already fatigued by decades of broken promises from both the right and left.

French President Emmanuel Macron © Getty Images

mmanuel Macron emerged from one of the most brutal and eventful election campaigns in recent European history as France’s next president and has also managed to do the unthinkable and achieve a landslide victory in the recent parliamentary elections. For a man without the support of a conventional party structure in a major European democracy this is unprecedented and demonstrates the fragility of traditional politics in the face of decades of slow growth, rising inequality and growing instability. However, much of this has been overlooked because of Macron’s reputation as a centrist – but the fact remains that he has disrupted French politics and set a precedent which while difficult to repeat, opens the door to individuals with possibly shadier political views and credentials to mount successful runs at the office of the president of the republic. There remains, however, three key issues which could work to destabilise the Macron project, which at present seems invincible because

For a man without the support of a conventional party structure in a major European democracy this is unprecedented and demonstrates the fragility of traditional politics in the face of decades of slow growth, rising inequality and growing instability.

of it’s clear parliamentary majority and his statesmen like behaviour as the executive. Corruption in French politics is unfortunately nothing new, but it still has the power to derail political careers – as seen with Fillion’s fall from grace during the election campaign. Importanty, Macron’s appointments have been far from immune to these problems and he will have to be extremely careful that dirty hands do not squander the good will of the French electorate. Additionally, reform to the labour market has been something central to both Macrons campaign and his work in his previous incarnation as minister of economy. However, such reforms have proved to be explosive for this predecessors, and further reform has the potential to derail not just his presidency, but the country as a whole as general strikes can effectively shut down France – the unions remain a key veto player on the political landscape. Finally, while relatively quiet since the campaign ended, the security problems that have dogged France for the past several years remain lurking in the shadows and conspicuous by their absence from the campaign manifestos. The true nature of France’s engrained security problems could also be a problem for Macron. Corruption has blighted French politics for decades – be it the very public tribulations of figures like Jupé of Fillion, or the sentiments expressed in the corridors of power that the true scope of corruption by French politicians is bigger in both reach and magnitude than is conventionally known.

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France

But solving the riddle of France’s recent security woes is going to require wide-ranging action and reform. This will present the new president with one of the biggest challenges of his presidency. There is no doubt that Macron hugely benefitted from Fillion’s fall from grace and he was able to capitalise on the reputation as a relative newcomer not tainted by financial misdemeanors. However, already members of his nascent government have fallen due to corruption problems – Francois Beyrou being the most notable victim. He was appointed by Macron as Minister of Justice and paradoxically begins his tenure with promises to put morality back into French public life.1 However, allegations that his party misused EU funds quickly led to his fall from power and demonstrated the fragility in Macron’s policy of reaching out cross-party to bring in a wide range of political actors into his government. Clearly, the further one reaches, the less sure we can be of the problems behind political figures. Additionally, the fact that many of those elected to parliament under the “en marche” banner are political novices that have never held office.2 This is a stratergy that is also prone to similar problems in that no one can be sure what these individuals have on record, and indeed what they will do during their time in office. This could be a serious cause of instability for Macron, and sufficient scandals could even bring down his government. Reform to the labour market will perhaps be one of Macron’s biggest headaches. Previous successful efforts at doing this have been problematic for two reasons. Firstly, they have been extremely unpopular with rank and file voters, worried about the loss of working conditions and social benefits that they see after years of reform across the channel in the UK. Secondly, the reforms that have been pushed through so far have not delivered the economic miracle that politicians quickly promised that they can deliver.3 For over three decades France has been a slow growth economy with structural unemployment issues and a growing sense that the standards of living for the middle and working classes have slowly been eroded. It is important to note that this is by no means specific to France – and neither is France alone in having no substantive answers to re-deliver high growth figures in a post-industrial service based economy. However, France does stand out in terms of a political landscape in having an extremely powerful veto player in the unions. Recent attempts at reform have demonstrated that they can effectively shut down the country and the prospect of summers, and maybe even indeed winters, of discontent is something that no incoming president wants. For Macron

The European Financial Review August - September 2017

there seems to be no easy way out of this bind where he is faced with inaction or direct confrontation with organised labour. Successive governments have chosen the former, with good reason, as it will be a high risk, potentially low gain, option to Macron to take on extensive labour reforms. Security has been a major issue on the French political landscape in recent years, however it received surprisingly thin coverage in the election campaign. Macron promised to increase security spending,4 strengthen internal security services and introduce new centres to integrate people returning from fighting for so-called Islamic State.5 But solving the riddle of France’s recent security woes is going to require wide-ranging action and reform. This will present the new president with one of the biggest challenges of his presidency. The complex, bureaucratic and disjointed French intelligence services need reform. Macron has remained fairly silent on specific proposals to change the way they work, promising instead to increase defence spending in more abstract terms.6 This will not deal with the ineffective and overly complex “S-list”7 a system for monitoring security threats. Over its history, the list, created in 1969, has contained over 400,000 names, including organised crime figures, anarchists and ecologists, as well as terror suspects. Being placed on this list, however, does not come with automatic obligations for the authorities to monitor or sanction a particular individual. Policing the Banlieues Reforms are also needed to French policing, particularly in the banlieues, the poor suburban estates that ring French cities. These suburbs are not hotbeds of Islamic extremism as some have claimed but rather are in the grip of their own security crisis.8 While France has extremely well-equipped police forces, their practices in policing the banlieues is an Achilles heel. Macron has promised an extra 10,000 police jobs but without a change of tactics this will make little difference to the day-to-day realities of insecurity.9 From my reseach in urban and suburban areas in France,10 I’ve seen a pattern emerging where the police are seen as an “all or nothing” presence. On a daily basis, the police are markedly absent from the cités, the large housing blocks in the banlieues. Petty crimes go unreported, and when reports are made to the police – if the victim lives in the “wrong” area – they are unlikely to turn up.11

When the police do show up, it is to carry out raids with heavily armed special forces and helicopters.12 But without the everyday security and regular policing, these one-off raids mean very little to improving day-to-day security. After one highprofile raid of drugs outlets in the La Castellane area of Marseille, for example, the trade moved seamlessly across town to the Felix Pyat estate.13 Neglected for decades, the drugs trade is often the most powerful social organisation in these estates, providing jobs and status for generations of young men. The international “French connection” system of transit trafficking has been replaced with “narco-banditisme”.14 This supplies domestic demand: France has the largest per capita consumption of cannabis in the EU.15 Cannabis resin is the staple of this trade, known colloquially as le shit, and is brought in via organised crime from Morocco to Spain and then sped across the border into France on what’s called the “go fast” route.16 This trade is dependent on weapons, which has led to a proliferation of guns on the streets of French cities. Weapons like the AK-47 (colloquially “la kalach”) have become the go-to-tool for petty robberies across France.17 Coming via organised crime networks stretching into the Balkans, this trafficking route has been linked to the way the guns used in the Charlie Hebdo and Paris in 2015 attacks were sourced.18 Without effective policing of the daily grind of drugs trafficking, heavy weapons will remain in demand in France and present any potential terrorist with a plentiful and available stockpile from which to operate. The thread that runs through these problems is the need for an integrated and coherent approach to the political problems facing France. However, in conditions of perpetual austerity and low growth, the options for Macron seem limited. Additionally, the paradox of widespread corruption in political life yet the continued insistence on the need for voters to swallow the bitter pill of labour market reform is a

Macron will need to tackle the chronic, daily, security issues France faces and overcome the institutional atrophy and social marginalisation which are such powerful drivers of insecurity.

recipe for turning increasing numbers of voters not just off of politics, but also possibility into the arms of radical left and right parties which accounted for over 40% of votes in the French presidential primaries. Additionally, it is not practical to concentrate on security only when it becomes an emergency, after a terrorist strike and lives are lost. Rather, Macron will need to tackle the chronic, daily, security issues France faces and overcome the institutional atrophy and social marginalisation which are such powerful drivers of insecurity. There is a reason, however, that previous administrations have not tackled these issues: they are politically explosive and economically costly. In a presidency that is already looking crowded with political challenges and policy promises, there is a risk that these issues will be once again be pushed to the back of the queue.

Dr. Joseph Downing received his PhD from the European Institute, London School of Economics in 2014. He has been awarded a Marie-Curie individual fellowship to conduct a research project on social media by Muslim organisations and individuals to de-securitise Muslims in the UK and France, based at the School of Oriental and African Studies and the CNRS. References 1.www.huffingtonpost.fr/2017/06/01/presentee-par-bayrou-ce-jeudi-la-loi-sur-lamoralisation-de-la_a_22120897/ 2. www.politico.eu/article/emmanuel-macron-gambles-on-novices-for-parliament/ 3. www.lemonde.fr/les-decodeurs/article/2016/02/18/droit-du-travail-ce-que-contientl-avant-projet-de-loi-de-myriam-el-khomri_4867746_4355770.html 4. www.esjnews.com/security-priorities-of-macron-and-le-pen 5. en-marche.fr/emmanuel-macron/le-programme/securite 6. www.ft.com/content/fb0ac974-2909-11e7-9ec8-168383da43b7 7. www.lemonde.fr/les-decodeurs/article/2015/08/31/terrorisme-peut-on-sanctionnerles-personnes-faisant-l-objet-d-une-fiche-s_4741574_4355770.html 8. www.cbsnews.com/news/paris-banlieues-seeds-of-terror-isis/ 9. www.telegraph.co.uk/business/2017/04/30/emmanuel-macrons-bid-haul-franceeconomic-malaise-will-harder/ 10. journals.sagepub.com/doi/abs/10.1177/1468796815587007 11. www.aljazeera.com/indepth/opinion/2017/02/justice-theo-protect-police170216085902545.html 12. www.theguardian.com/world/2015/sep/16/marseille-drug-trial-la-castellane 13. www.20minutes.fr/marseille/1284822-20140130-quartier-plus-pauvre-france 14. www.leparisien.fr/faits-divers/le-vrai-visage-du-narco-banditisme-a-marseille-02-052016-5760745.php 15. www.telegraph.co.uk/travel/maps-and-graphics/mapped-the-countries-that-smokethe-most-cannabis/ 16. www.bfmtv.com/police-justice/une-centaine-de-kilos-de-cannabis-saisis-lors-d-un-gofast-1116953.html 17. www.bfmtv.com/societe/paris-braquage-a-kalchnikov-une-filiale-sncf-598572.html 18. www.spiegel.de/international/europe/following-the-path-of-the-paris-terror-weaponsa-1083461.html

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Global Trade Photo: (Left) President of Mexico, Enrique Peña Nietro, (Centre) President of the United States, Donald Trump, & (Right) Prime Minister of Canada, Justin Trudeau

The Renegotiation of NAFTA BY DAVID BARTLETT ECONOMIC ADVISER AND WRITER FOR RSM

Recent actions by the Trump Administration are altering the structure of international trade. In this article, the author examines the revamping of the North American Free Trade Agreement. Is an amicable renegotiation of NAFTA probable in the near future?

n July 17, 2017 the Office of the United States Trade Representative (USTR) released its “Summary of Objectives for the NAFTA

Renegotiation” detailing the Trump Administration’s goals for “NAFTA 2.0”. The eagerly awaited document reveals the Administration’s opening position in the forthcoming talks between Canada, Mexico, and the US to revamp the North American Free Trade Agreement. The USTR document signals an easing of the Trump Administration’s stance on NAFTA. During the 2016 presidential candidate, then candidate Donald Trump declared his intention to exit what he called the “worst trade deal”

in US history. During the early months of the new administration, President Trump continued his strident rhetoric about NAFTA, which he claims has decimated US manufacturing. But following personal appeals by Canadian Prime Minister Justin Trudeau and Mexican Prime Minister Enrique Peña, on April 27 Trump withdrew his threat to scuttle NAFTA. On May 18, the Administration formally notified the US Congress of the launch of a trilateral renegotiation of the 23 year old trade agreement. Supporters of NAFTA in all three countries agree on the need to modernise the agreement, whose formation in 1994 preceded the emergence of the digital economy, the expansion of global value chains, and other shifts in the economic and technological landscape that have transformed international trade. Many of the measures needed to upgrade NAFTA had already been settled in a separate regional trade agreement: The Transpacific Partnership (TPP), the 12-member pact that was concluded in February 2016 after seven arduous years of negotiation. TPP has been heralded as the gold

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Global Trade

Figure 1: NAFTA in International Trade Global Exports of Goods and Services by NAFTA, 1994-2016 (USD Million)

Source: WTO World Trade Statistics

standard in international trade agreements, featuring chapters on cross-border data flows, intellectual property rights, environmental protection, labour standards, and other provisions aligned with the 21st century world economy. Canada and Mexico belatedly joined TPP, offering concessions to the United States (also a TPP signatory) on NAFTA-related trade to expand their access to a huge Asia-Pacific market representing one-third of global trade. But President Trump’s announcement on January 23, 2017 (three days after his inauguration) of the US withdrawal from TPP altered the strategic calculus of Canada and Mexico, which must now negotiate regional trade issues within the trilateral framework of NAFTA. Ironically, the decision of Donald Trump (who prides himself as a master dealmaker) to withdraw from TPP weakens the US bargaining position with Canada and Mexico, which will prove less willing to compromise on NAFTA-specific trade than on accessing the $28 trillion TPP market. The renegotiation of NAFTA thus promises to be a highly contentious affair, with the two smaller members poised to resist efforts by their larger neighbour to craft regional trade rules hewing to Trump’s “America First” project. NAFTA in the World Economy With a total merchandise trade turnover of $5.4 trillion, NAFTA is the world’s second largest trading block behind the European Union ($10.7 trillion).

Between 1994 and 2016, global exports of goods by the three NAFTA countries grew from $738 billion to $1.7 trillion. During the same period, NAFTA’s global service exports grew from $220 billion to $480 billion. (See Figure 1) Intra-regional commerce represents one-half of NAFTA’s global exports, illustrating the expanding role of regional production networks operating across the three member countries. Among restof-world trading partners, Asia and Europe receive the largest shares of global NAFTA good exports (20.4 and 15.6 percent respectively). Machinery and transport represent the largest share (43.4 percent) of goods exported by NAFTA. Within NAFTA’s increasing stock of service exports, travel (29.2 percent), financial services (15.2 percent), and use of intellectual property (15.2 percent) comprise the biggest categories. (See Figure 2). In addition to boosting intra-regional and extraworld trade, NAFTA has stimulated foreign direct investment in North America. Between 1994 and 2015, inbound stock FDI in NAFTA rose from $901 billion to $6.8 trillion (UNCTADstat). Canada and the United States (which entered a bilateral free trade agreement in 1987) were already leading destinations of foreign direct investment by the time of NAFTA’s formation in 1994. The accession of Mexico (heretofore not a major FDI site) prompted economic/legal/regulatory reforms that enhanced that country’s attractiveness to foreign investors.

Figure 2: Structure of NAFTA Trade Destination and Composition of NAFTA Exports, 2015

Source: WTO World Trade Statistics

The European Financial Review August - September 2017

The growth of foreign trade and investment in NAFTA has accelerated the rise of multinational value chains in advanced manufacturing, with extensive movement of raw materials, semiprocessed goods, components, and finished products across national borders. Multinational Value Chains in NAFTA The bulk of foreign investment in NAFTA comes from multinational corporations in key global industries (aerospace, automotive, chemicals, energy, telecommunications, etc.) enlarging their North American footprints. The local content requirement for duty-free access to the NAFTA market (62.5 percent) has incentivised foreign multinationals to boost value-added production at their North American subsidiaries. To meet the local content threshold, Japanese car manufacturers that first entered North America in the 1980s (Honda, Nissan, Toyota) upgraded their regional subsidiaries from simple assembly plants to engine manufacturing, research and development, and other high value added functions. The growth of foreign trade and investment in NAFTA has accelerated the rise of multinational value chains in advanced manufacturing, with extensive movement of raw materials, semi-processed goods, components, and finished products across national borders. Intermediate inputs account for 50 percent of trade between the US, Mexico, and Canada. A large share of intermediate input trade in NAFTA stems from intra-company transfers (related party trade and majority-owned affiliate trade), demonstrating multinational control of complex North American supply chains. Volumes of cross-border intermediate trade are particularly high in US states that rely on Canadian and Mexican imports: e.g., Washington State in aerospace components, Texas in energy products, Michigan in automotive parts.1 Regional production networks play an especially critical role in the NAFTA automotive industry. Since 2011, Mexico has received 9 of 11 new automotive assembly plants announced for North America. In addition to US-based automotive companies (Ford, General Motors, Fiat Chrysler), leading foreign car manufacturers (Audi, Daimler, Honda, Kia, Mazda, Nissan, Volkswagen) are expanding production capacity in Mexico. A major share of cars assembled in Mexico is exported to the United States, contributing to a large merchandise trade deficit that underpins the Trump Administration’s claims about unfair trade in NAFTA. However, the imbalance in gross trade neglects the high import content (nearly 20 percent) of US-manufactured, value-added components (drive chains, electronic systems, etc.) embedded in Mexican-assembled cars destined for the American market.2

Trade Balances in NAFTA The automotive case illustrates President Trump’s fixation on trade deficits as a measure of the economic damage supposedly inflicted by international trade deals consummated by previous US administrations. The very first item in USTR’s summary of objectives is “to improve the US trade balance and reduce the trade deficit with the NAFTA countries”. As shown in Figure 3 on the next page, the US does indeed run trade deficits with both Canada and Mexico ($20.8 billion and $63.9 billion respectively in 2015). But these deficits emanate from imbalances in goods trade between the US and its NAFTA partners, which illustrate the relative positions of the three countries in regional production networks. The US runs bilateral surpluses in service-related trade, demonstrating the country’s comparative advantages in high value services (design and engineering, research and development, etc.). Moreover, as noted above the gross trade figures (which report the full value of final assembled products exported from Canada and Mexico to the United States) obscure the high import content of intermediate goods manufactured on the US side. The Trump Administration’s preoccupation with trade deficits betrays other fallacies regarding the NAFTA renegotiation: • Economists broadly agree that regional trade agreements like NAFTA have little impact on global balances of exports and imports. Trade deficits and surpluses are chiefly the result of macroeconomic factors, namely (1) the balance between domestic absorption and domestic production and (2) the relationship between savings and investment. The long-standing US trade deficit reflects the propensity of Americans to consume products in volumes surpassing domestic production capacity, driving demand for foreign imports.3 • While large in absolute terms, the US global trade deficit is not particularly big relative to GDP (2.7 percent). Furthermore, as the world’s largest economy that holds the principal reserve currency, the United States is uniquely positioned to finance its trade deficit via inflows of foreign capital. • Canada and Mexico are not the leading sources of the US global trade deficit. China is by far the biggest contributor to that deficit ($347 billion in 2016, equivalent to 40 percent of the US current account deficit worldwide). American trade deficits with Japan and Germany also exceed the bilateral imbalances with Canada and Mexico.

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Global Trade

The long-standing US trade deficit reflects the propensity of Americans to consume products in volumes surpassing domestic production capacity, driving demand for foreign imports. • Canada and Mexico are themselves deficit countries in international trade. In fact, as a share of GDP the global trade deficits of Canada and Mexico exceed that of the United States. It is therefore unlikely that the two countries will yield to American browbeating to reduce their bilateral surpluses with the US, which would merely increase their global deficits. Rules of Origin The USTR document calls for a strengthening of rules of origin “to ensure that the benefits of NAFTA go to products genuinely made in the United States and North America”. This statement is a red flag for companies undertaking cross-border operations in North America, which already confront high costs of compliance with NAFTA Chapter 4 Rules of Origin. The purpose of these rules is to certify that products and services entering the NAFTA zone actually originated from Canada, Mexico, or the US. Enforcement of such rules is difficult in an era when multinational corporations source thousands of intermediate inputs across complex global supply chains, with value-added operations undertaken at multiple points in the transnational value chain. Figure 3: Trade Flows within NAFTA Intra-Regional Trade in Goods and Services, 2015

Sources: UN Comtrade Database; WTO World Trade Statistics

The European Financial Review August - September 2017

To qualify for duty-free treatment, multinationals operating in NAFTA must present detailed documentation of the country origin of imported products. If they still fall short of the local content threshold, these companies are forced to replace externally imported inputs with costlier regionally sourced inputs, raising production costs and creating welfare losses for consumers. The burden of rules of origin compliance has proven onerous for small and medium enterprises active in NAFTA, which increasingly opt to pay WTO tariffs on imported products (ranging in the low single digits in many industries) rather than endure the paperwork and administrative costs of certifying North American content.4 NAFTA’s status as a free trade agreement and not an EU-type customs union further complicates enforcement of Chapter 4 Rules of Origin. The three member states apply their own rest-of-world tariffs governed by the World Trade Organization. Canada, Mexico, and the US are also members of an assortment of bilateral trade agreements with countries outside NAFTA. Lacking a common external tariff on extra-regional imports, companies operating in NAFTA must undertake complex calculations on the source and destination of intermediate inputs. The Transpacific Partnership presented an important opportunity for the three NAFTA countries to streamline and simplify their rules of origin. By cumulating rules of origin across the 12 member states and reducing local content requirements, TPP would have lowered the costs of regulatory compliance within NAFTA and facilitated the extra-regional operations of North American-based companies. But the US withdrawal from TPP has removed this option, leaving Canada and Mexico with the challenge of negotiating with an administration intent on devising rules of origin aimed at advancing Trump’s “Buy American, Hire American” campaign. Trade Disputes The USTR document also provides ominous signs of the Trump Administration’s intentions regarding trade disputes with Canada and Mexico. In the

NAFTA renegotiation, the Administration seeks to: • “Preserve the ability of the United States to enforce rigorously its trade laws, including the antidumping, countervailing duty, and safeguard laws.” • “Eliminate the NAFTA global safeguard exclusion so that it does not restrict the ability of the United States to apply measures in future investigations.” • “Eliminate the Chapter 19 dispute settlement mechanism.” Commensurate with NAFTA’s standing as a preferential free trade area, Chapter 19 was designed to reduce friction and expedite resolution of intra-regional trade disputes. North American companies contesting AD (anti-dumping) and CVD (countervailing duties) cases can appeal to binational expert panels to undertake independent, impartial reviews. This mechanism provides an alternative to costly litigation in domestic courts and lessens dependence on the cumbersome multilateral procedures of the World Trade Organization. NAFTA has also exempted Canadian and Mexican companies from applications of two trade remedies in US federal law: (1) Section 232 of the 1962 Trade Expansion Act, which authorises the US Secretary of Commerce to investigate foreign trade matters affecting national security; and (2) Section 201 of the 1974 Trade Act, which empowers the US President temporarily to impose duties and non-tariff barriers to protect American industries threatened with import competition. These provisions succeeded in limiting the application of trade sanctions within NAFTA. While the three countries have initiated a number of AD/CVD/201/232 actions against extra-regional countries (with China the most frequent target), intra-regional disputes have proven infrequent (affecting just 1.3 percent of U.S. and Mexican imports from NAFTA and 0.1 percent of Canadian imports from NAFTA). The election of Donald Trump signals a major shift in U.S. policy on intra-regional trade disputes. Within the first 100 days of Trump’s presidency, the share of Canadian/Mexican imports covered by US trade sanctions jumped to 6.4 percent. That share will doubtless rise if the administration achieves its declared goal of eliminating NAFTA Chapter 19, which will expose Canada and Mexico to AD/CVD actions previously limited to extra-regional countries. Equally worrisome, Trump’s removal of the NAFTA global safeguard exclusion would allow

the US to apply Sections 232 and 201 to its North American partners. This raises the spectre of Canada and Mexico’s inclusion in the Administration’s invocation of the “nuclear option” declaring rising steel imports a threat to US national security – a development that stems less from steel trade in NAFTA than from excess steel capacity in China.5 Conclusion The USTR’s list of NAFTA 2.0 objectives includes several reform proposals for which common ground between the three countries already exists, and for which the prior agreements of the Transpacific Partnership (and also the recently completed EU-Canada Comprehensive Economic and Trade Agreement) provide useful models. This includes proposals on customs and trade facilitation, sanitary and phytosanitary measures, technical barriers to trade, labour and environment, and digital trade. However, the Trump Administration’s pronouncements on the “hard” issues noted above (trade balances, rules of origin, trade disputes) do not bode favourably for an amicable renegotiation between the three NAFTA countries in coming months.

The Trump Administration’s preoccupation with trade deficits betrays other fallacies regarding the NAFTA renegotiation.

David Bartlett is an Economic Adviser and Writer for RSM. He is Executive in Residence in the Department of Management at the Kogod School of Business, American University in Washington, DC. Bartlett’s research, teaching, and consulting focus on International Corporate Strategy with special attention to emerging markets and emerging technologies. He has published widely on these topics while leading interdisciplinary research projects on the global economy. References 1. Joseph Parilla, “How U.S. States Rely on the NAFTA Supply Chain”, Brookings Institution, 30 March 2017. 2. Filippo Biondi, “The Mexican Automotive Industry and Trump’s USA”, Bruegel, 27 February 2017. 3. C. Fred Bergsten, “The U.S. Agenda: Trade Balances and the NAFTA Renegotiation”, Peterson Institute for International Economics, July 2017. 4. Caroline Freund, “Streamlining Rules of Origin in NAFTA”, Peterson Institute for International Economics, June 2017. 5. Chad Bown, “Trump’s NAFTA Renegotiation and Trade Law Enforcement”, Peterson Institute for International Economics, 17 July 2017.

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Brexit

Photo: Pro-Brexit demonstrators protest outside the Houses of Parliament on November, 2016. © Getty Images

Brexit and Beyond: How Businesses Can Survive and Flourish in Uncertain Environments BY MARTIN REEVES

With current political landscapes still blanching in uncertainty, how can businesses survive and flourish? In this article, Martin Reeves elaborates on key strategies that will enable business leaders to have a fighting chance in their attempt to conquer the game amid Brexit and an insecure future.

ven as Brexit moves towards a clear and well-defined goal – withdraw of the UK from the European Union – the process’

trajectory and its consequences are far from certain. Indeed, after the British Government triggered Article 50,1 separation began without any real sense of what Brexit would mean in practice. UK Prime Minister Theresa May’s original intention was to deliver a clean separation from the EU under her “Brexit means Brexit” campaign. Yet, after her ability to deliver this was recently weakened by UK voters, the best prognosis may be a resounding “let’s wait and see”.

The European Financial Review August - September 2017

As Brexit unfolds, two significant sources of uncertainty will continue to dominate the conversation: First, given that the separation of any country from the EU is unprecedented, the legal and financial terms that will cut the UK loose are still unclear. Second, even once break-up terms are agreed, additional negotiations will be needed to define future commercial relationships, immigration, security and more. For example, on the commercial issues alone there is great unpredictability: the UK wields the slogan of frictionless trade, while the EU’s chief negotiator has made clear that “this is not possible”. While Brexit’s effects so far have been modest compared to initial concerns, it remains far too early to conclude that this will continue to be the case. What Does This Mean for Businesses? The challenge of Brexit alone should encourage leaders to develop their companies’ capabilities to deal with uncertainty. But Brexit is just the tip of the uncertainty iceberg. If we also consider the increasing pressures

against free trade and globalisation, the burgeoning populist backlash against economic inequalities, uncertain economic growth prospects, and the incessant progress of disruptive technologies, then this need to skillfully navigate uncertainty becomes even more compelling. Companies must now address the multi-dimensional uncertainties of what we might call an ABCD environment. A. Acceleration in Digital Innovations: Digital technologies have been taking an increasingly prominent role in shaping both customer experiences and the management of companies. As a consequence, digital transformation is no longer optional for businesses. Two decades ago, the basis of a digital transformation was to substitute paper with computers and faxes with emails. Today, it involves the integration of Artificial Intelligence (AI), big data, cloud computing, block chain, augmented reality and other technologies into business as usual. This acceleration also triggers the need for fundamental adjustments in the nature of work, the architecture of organisations, as well as companies’ business models. B. Borders Come Back: New narratives opposing global economic integration are currently advancing in several parts of the world, and it’s clear that our current model of globalisation will need to evolve. For example, Brexit may trigger new borders, considering that UK countries like Scotland or Northern Ireland may attempt to re-join the EU in one form or another. Also, despite the reversal of populist trends in recent voting in France and the Netherlands, pressures to reinstate controls and limit free movement within the EU are significant. While we can discern the trends shaping the evolution of the trade regime, like more bilateral commercial agreements (as emphasised by Donald Trump’s proposed approach to trade),2 greater prominence of data and services, as well as an increased localisation of supply chains, the end state and speed of development remain unclear. C. Challenges to Political Stability: As the US election, Brexit’s referendum results, and the sudden collapse of France’s two largest political parties have taught us, little is certain in the political sphere right now. Issues such as migration, inequality, and free trade are being tested in the ballots with increasingly variable outcomes. The shape of Western democracy is less clear than any time since WWII, driving overall uncertainty and increasing the weight of political and economic consideration in business decisions.

D. Disruptive Competition: In our deeply interconnected world, smaller yet digitally-enabled competitors can quickly reshape entire industries in unpredictable ways. Just as Uber reshaped the transportation industry globally in less than a decade, many industries are now vulnerable to disruption. In the UK, 50% of business executives recognise increased competition and new entrants as the main effects of digital disruption.3 If companies do not address this phenomenon with preemptive self-disruption, they will instead become the victims of disruption. This requires companies to challenge and rethink historically successful business models, and to embrace the uncertainties which this entails. As we look toward a less certain future, now more than ever before, business leaders must put emphasis on understanding, adapting to and – whenever possible – shaping their business environments. What Can Business Leaders Do to Flourish in ABCD Environments? 1. Adjust your mindset. First, a significant shift must occur in how leaders’ think about their business. Companies should stop considering themselves as stand alone entities playing in well-defined markets with long familiar competitors. Instead, they must recognise that they are parts of broader, dynamic, socio-economic ecosystems which they can adapt to, shape or be shaped by. 2. Build robustness.4 Shocks are frequent and unpredictable in ABCD environments, and pose risks to corporate longevity. However, companies can build resilience and enhance their chances of survival by fostering three properties characteristic of biological systems.5 First, redundancy, which allows a company to have buffers against risk. For example, the functional redundancy in Toyota’s supply network reduces the likelihood of network failure. Second, heterogeneity in people, innovations and endeavours positively impacts the chances of survival by having diversified sources of ideas and revenues. Fujifilm’s business portfolio included non-obvious adjacencies, giving the company multiple growth options thus ensuring its survival in the face of digital disruption. Finally, modularity prevents local shocks from becoming systemic. Canadian banks successfully applied this principle to limit their exposure to the last global finance crisis.

As we look toward a less certain future, now more than ever before, business leaders must put emphasis on understanding, adapting to and – whenever possible – shaping their business environments. www.europeanfinancialreview.com

Brexit

A scenario based approach, which only 48% of firms used in Brexit preparations,7 can equip a company with a menu of options to react swiftly to evolving circumstances.

3. Develop a scenario-based approach to decision making. Faced with an ABCD environment, firms need to constantly assess political, economic, and competitive risks. To do so, companies require new capabilities to gain a better understanding of their ecosystems and model the implications of their strategic choices. Developing macroeconomic skills is key to understanding risks and opportunities, as well as developing worst-case scenarios for taxes, trading regimes and other variables. These can serve as a stress test for the viability of their business models and are a prudent investment given current levels of uncertainty.6 A scenario based approach, which only 48% of firms used in Brexit preparations,7 can equip a company with a menu of options to react swiftly to evolving circumstances. 4. Shape the system. Companies can moderate exposure to uncertainty in an ABCD environment by building dynamic ecosystems of suppliers and customers. Creating a dynamic network of business partners enables a company to orchestrate the development of the industry as a whole, through the development of a business platform that others can access and leverage. For example, Amazon has shaped the e-commerce sector by orchestrating the activities of thousands of smaller independent players. This helped the company to simultaneously increase its intelligence, diversify its risk exposure, develop its agility and become progressively product-agnostic. As Amazon continuously develops its platform, it deals with uncertainty by proactively shaping it. 5. Adapt where needed. As new developments emerge unpredictably from the ABCD environment, firms can adapt in two ways. First, by staying tuned to new market signals and responding nimbly. Second, by proactively creating new options for future growth. For example, Google, Netflix, Amazon and Alibaba have been effective in developing a real-time understanding of their customers â&#x20AC;&#x201C; and being able to offer options that best suit their wants and needs through real time adaptive technologies. These technologies also create the opportunity for companies to simultaneously run and reinvent themselves. 6. Use uncertainty to gain competitive advantage. Under an ABCD environment, the challenge

The European Financial Review August - September 2017

is not only to remain viable. Uncertainty affects all firms, and the ability to deal with it better than others can translate into competitive advantage. Uncertainty can be grasped as an opportunity to reconsider the strategy of a firm and focus investment on future growth opportunities. American Expressâ&#x20AC;&#x2122; recovery after being hit by the financial crisis in 2008 provides a perfect example. While optimising costs, the company was able to invest in new sources of growth, and become one of the few financial companies that remained profitable through the crisis. Amexâ&#x20AC;&#x2122;s swift actions helped them to emerge from the financial crisis faster than most other financial institutions and created the basis for multi-year growth thereafter. In the end, companies must earn the right to continue playing in the ever-changing game of business, by choosing and executing the right strategic approach.8 Even as the fog of uncertainty obscures visibility, businesses must be more receptive than ever to change. And while the ABCD environment will (someday) become history, the newly developed capabilities for managing uncertainty will likely help them to cope with comes in the form of EFGH and others.

Martin Reeves is a Senior Partner and Managing Director in The Boston Consulting Group, author of Your Strategy Needs a Strategy, and Global Director of the BCG Henderson Institute. Current research themes include growth and resilience, strategy and artificial intelligence, new bases of competitive advantage, corporate longevity, and economic complexity. Follow him on Twitter @MartinKReeves. References 1. www.telegraph.co.uk/news/0/article-50-triggered/ 2. www.reuters.com/article/us-usa-trump-trade-idUSKBN15A2MP 3. www.netimperative.com/2016/11/digital-disruption-half-uk-businesses-will-notexist-current-form-2021/ 4. www.bcgperspectives.com/content/articles/stratregy-strategic-planning-biologycorporate-survival/ 5. www.ted.com/talks/martin_reeves_how_to_build_a_business_that_lasts_100_years 6. www.bcg.com/publications/2017/globalization-strategy-reeves-levin-buildingresilient-business-inspired-biology.aspx 7. www.hoganlovellsbrexit.com/_uploads/downloads/HoganLovellsBrexometer.PDF 8. www.amazon.com/Your-Strategy-Needs-Execute-Approach/dp/1625275862

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Central banking has become an unprecedented state subsidization of private banking IT CAN BE REDESIGNED IN THE PUBLIC INTEREST Originally designed to serve as lender of last resort during banking crises, central banks globally have been transformed into cash cows subsidizing the private banking system. Today the global financial system is addicted to, and increasingly dependent on, continuing central bank infusions of significant amounts of liquidity. The US central bank, the Federal Reserve, has become “the central bank of central banks,” a conduit for redistributing wealth from wage earners to investors and capital incomes. Rescinding this artificial subsidization would almost certainly lead to a global collapse of the financial and real economy. Central banks will not be able to pull back on their massive liquidity injections any time soon. Nor will they find it possible to raise their interest rates much beyond brief token adjustments. Truly, central bankers are at the end of their rope. This book provides a comprehensive analysis of this critical impasse and proposes a road forward: a constitutional amendment that revolutionizes central banking in the public interest. ISBN 978-0-9860853-9-0 $26.95 355 pp. 2017 FROM REVIEWS OF EARLIER WORK Systemic Fragility in the Global Economy CHINESE EDITION / HUAXIA PUBLISHING

“...offers a penetrating analysis of economic stagnation in advanced economies by providing a sustained and systemic focus on the role of finance, an analysis that probes further than mainstream economic analysis. Rasmus has made a signal contribution to contemporary economics and provided a vitally important X-ray of the political economy of stagnation..” Jan Nederveen Pieterse, University of California Santa Barbara, in Journal of Post Keynesian Economics, 2017 “... a theoretically-informed, empirically-grounded diagnosis ... The case studies of the USA, Europe, Japan and China are excellent .... A major contribution is the analysis of the complexity of shadow banking, an ill-defined term of art in most of the literature.” Capital & Class, Vol. 40, No. 2, June 2016

Dr. Jack Rasmus’ latest books are Systemic Fragility in the Global Economy (2015) and Looting Greece: A New Financial Imperialism Emerges (2016). He hosts the weekly New York radio show, Alternative Visions and is economic advisor to the USA Green Party. He writes bi-weekly for Latin America’s teleSUR TV, for Z magazine, Counterpunch, and others. Dr. Rasmus teaches economics and politics at St. Marys College in California. View at http://www.claritypress.com/RasmusIII.html

Policy Photo: Building of the Eurpean Central Bank (ECB) © Getty Images

The Limits of Central Banks’ Emerging Policy Shift BY JACK RASMUS

The major central banks have a plan, but its consequences are questionable. In this article, Dr. Jack Rasmus analyses past and present factors of the global economy, from balance sheets to policy shifts, which have significant influence on the possible future of the financial industry and the global society as a whole.

s central bankers, finance ministers, and government policy makers head off to their annual gathering at Jackson Hole, Wyoming, this August, 24-26, 2017, the key topic is whether the leading central banks in

North America and Europe will continue to raise interest rates this year; another topic high on the agenda is when the three major central banks – the Federal Reserve, European Central Bank and Bank of England – might begin to sell off their combined $9.8 trillion dollar balance sheets that they accumulated since the 2008-09 banking crisis. But the more fundamental question – little discussed by central bankers and academics alike – is what are the likely effects of further immediate rate hikes and/or commencement of central banks’ balance sheet reductions? The assumption is further rate hikes

and sell-offs will have little negative impact on the real economy or financial markets. But will they? Central banks in the US and Europe were grossly in error predicting in 2008 that massive liquidity injections and zero interest rates would re-stimulate their economies and return them to pre-crisis real GDP growth rates. They are now about to repeat a similar error, as they presume that raising those rates, and retracting excess liquidity by selling off balance sheets, will not have a significant negative impact on the real economy or financial markets. The Central Banks Monetary Policy Shift Central banks’ balance sheets have been growing for almost nine years, driven by programmes of zero-bound (ZIRP) interest rates and the introduction of firehose liquidity injections enabled by quantitative easing, QE, bond and other securities purchases. After eight years, the official consensus among central bankers and government policy makers is that the 2008 shift to unlimited central bank liquidity and zero (or below) interest

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Policy

Federal Reserve Bank building in Washington DC, USA

rates is now over. The front page business press and media lead story is that central banks are now about to embark collectively in a new direction – raising their benchmark rates and selling off their massive, bloated balance sheets. But don’t bet on it. They may find sooner, rather than later, that rates cannot be raised much higher and that balance sheets may not be reduced much, if at all, without provoking a further slowdown of their still chronically weak real economic recoveries, or without precipitating a serious contraction in equity, bond and other financial asset markets. In 2008-09 the Federal Reserve quickly dropped its benchmark federal funds rate from 5.25% to a mere 0.15% by January 2009. It followed with its initial bond buying QE1 programme in early 2009. By 2013 the Fed’s net balance sheet rose to $4.5 trillion. The Bank of England promptly followed the Fed. It reduced its rates from 5% in September 2008 to 0.5% by early 2009, followed by a launch of several QE-like bond and equity buying programmes and then its formal QE “Asset Purchase Plan” in early 2009. Its net balance sheet level rose to approximately $600 billion. Lacking full central bank authority at the time of the 2008 crash, the European Central Bank lowered rates initially more slowly while injecting more than $2 trillion in liquidity by various pre-QE programmes from 2010 to 2014, eventually introducing its highly aggressive QE programme beginning early 2015. Its rate and liquidity programmes drove Eurozone sovereign nominal bond rates to negative levels, as its aggressive $2.5 trillion QE programme raised its balance sheet to more than $4.7 trillion. That’s a combined balance sheet total of roughly $9.8 trillion as of mid-2017 for the three major central banks alone. Globally, however, balance sheet totals are actually far greater than the $9.8 trillion. When other major central banks, like Switzerland’s, Sweden’s, Canada’s and others are added, it’s well more than $10 trillion. And then there’s the nearly $5 trillion balance sheet of the Bank of Japan and the more than $5 trillion of the People’s Bank of China. Worldwide, central banks’ balance sheets therefore exceed well over $20 trillion…with the total still growing.

The European Financial Review August - September 2017

Attempting to sell off such massive balance sheet holdings – even the $9.8 trillion of the three central banks in Europe and America – may prove far more daunting than those central banks now anticipate. And their coordinated raising of interest rates risks precipitating another recession – given their fundamentally weak economies with chronic low bank lending, slowing investment, stagnating productivity, contracting public investment, and lack of real wage income gains. For the global economy has undergone a major structural change in recent decades that has been rendering central bank interest rate policies increasingly ineffective with regard to stimulating real investment and growth, while simultaneously contributing to further financial fragility as well.1 The New Normal: Unstable Interest Rate Elasticity Effects In 2008-09 all three central banks quickly reduced their benchmark rates and began to add trillions of dollars, pounds and euros to their balance sheets. But real investment and GDP growth lagged, and periodically stagnated in the US and UK, and even contracted again in the Eurozone. In economists’ jargon, the elasticity of real investment to interest rate cuts was highly “inelastic” – i.e. the collapse of rates and accelerated central bank liquidity produced insufficient real investment, employment, and wage incomes necessary to restore pre-crisis GDP growth. Now that central banks are reversing those policies – with the Fed in the lead and the BOE and ECB expected to follow – a “mirror image” of the error of the past eight years may emerge: it will take very little in terms of rate hikes or balance sheet reductions (which will also raise rates) to generate a further contraction in real investment and growth, and may even precipitate a major correction in financial market prices. In other words, the negative impact of pending rate hikes on investment may prove highly elastic, just as it proved in the past that rate cuts’ positive effects on real investment were highly inelastic. This may seem anomalous – i.e. rate reductions post-2008 had little positive effect on real investment and growth, but rate hikes now will have a quick and major negative impact on investment and growth. But it is not. The same global forces and restructuring in financial, capital, and labour markets that have taken place in recent decades causally underlie both effects. The global economy crossed a threshold in 2008-09 that is still not very well understood by central bankers and economists alike. The anomaly is only apparent.2 The causes are the same. What then are the likely scenarios with regard to the three central banks – Fed, ECB and BOE – in the next six to twelve months as they attempt to shift their policies of the preceding

eight years by raising rates and selling off balance sheets? Three Scenarios: BOE, ECB & the Fed The Bank of England’s (BOE) initial QE experiment was temporarily halted when the Fed suspended expanding its QE programmes in 2013, but QE was re-introduced in 2016 in the wake of Brexit. As of mid-2017, moreover, the BOE shows no indication that it will not continue its QE programme and thereby expand its balance sheet. Embroiled an in increasing difficult implementation of Brexit, and what appears to be several more years of growing economic uncertainty, the UK economy has begun to show signs of weakening in recent months. The BOE will therefore continue to add liquidity, both by QE and traditional means, in order to prop up UK financial markets in the interim. Balance sheet sell off is thus not imminent anytime soon. On the other hand, more likely is the BOE will follow the Fed should the latter continue to raise rates, raising its benchmark marginal lending or discount rate to prevent a further decline of the UK currency to ensure much needed money capital inflows and to slow rising import inflation that comes with currency decline. So expect more rate hikes from the BOE, as well as more balance sheet accumulation. Nor will the ECB’s balance sheet be appreciably reduced any time soon. European Central Bank chair, Mario Draghi, plans to attend the Jackson Hole gathering of central bankers and friends. It will be his first appearance since three years ago, where in 2014 he signalled

Worldwide, central banks’ balance sheets therefore exceed well over $20 trillion… with the total still growing.

the ECB was planning to introduce its version of quantitative easing, QE, which it did in early 2015. But this time it is highly unlikely Draghi will signal the ECB to follow the Fed in any reduction of its own $4.7 trillion balance sheet. More likely is some ECB intent to slow its QE bond accumulation programme in 2018 – i.e. after it sees what the US Fed will do in what remains in 2017 and after it replaces current chair, Janet Yellen, with former Goldman Sachs banker, Gary Cohn, next February 2018. Meanwhile, the ECB will allow rates to drift upward from their former negative and zero levels. Like the BOE’s, the ECB’s balance sheet will therefore continue to grow, as rates are allowed to rise in coordination with the Fed. All eyes are therefore on the US central bank, the Fed, and what signals it gives, and its follow up, to the Jackson Hole August gathering, and the Fed’s policy committee in September. Will it continue to raise rates? Will it announce formally a schedule for balance sheet reduction in September? If the latter, will the announcement of sell off be so minimal and token that it will generate a mere 0.25% hike in rates by year end 2018, as some pundits predict? Or will the psychological effects on investors – who have enjoyed eight years of record equity, bond, property, and derivatives asset price and thus extraordinary capital gains – consider the announcement as the signal to “cash in” and take their money and run, given the bubble levels already attained in equities, some bond markets, and real estate? And should the Fed continue to raise interest rates at a pace of 3 to 4 a year, what will be the impact on the US real economy? Economic potholes are beginning to appear in a number of places. Bank lending to US business has declined sharply, now growing at only 2%; consumer loans for auto, mortgages and credit cards have halved over the

past year; real investment and productivity have nearly collapsed; the so-called “Trump Bump” has dissipated; government investment has contracted below 2007 levels and infrastructure spending is still but a discussion envisioned for 2019 at the earliest, if at all; and job growth has been consistently low quality, resulting in wage stagnation or worse for the vast majority of the labour force. In this unstable environment the Fed has nonetheless has announced plans to continue to raise interest rates and to begin selling off its balance sheet. The question is just how much and when? Consensus thinking at the Fed is that rates can continue rising 3 to 4 times a year at .25 basis points a crack through 2019 without serious negative effects. And that the Fed’s balance sheet can start selling off immediately in 2017, initially at a modest rate of $10 billion a month, accelerating further at a later date. But these were the same central bankers who believed their QE and zero bound rate programmes would return the US real economy to robust growth by 2010 but didn’t; who maintained the Fed’s massive liquidity injections would attain a 2% goods and services inflation rate, which it still hasn’t; who argued that once unemployment fell to 4.5% (in the US), wage growth and consumption would return to past trends and stimulate the economy, which has yet to occur; and who argued in 2008, also incorrectly, that Fed QE programmes providing bankers virtually free money would stimulate bank lending and in turn real investment and growth. The Fed’s latest predictions could prove no more correct about the consequences of further rate hikes and balance sheet reductions than they were about QE, ZIRP, and all the rest for the past eight years. It’s Not Your Grandpa’s Global Economy To assume that selling off that magnitude of securities – even if slowly and

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Policy

over extended time – will not have an appreciable impact on nominal interest rates is the kind of assumption that resulted in previous predictive errors circa 2008 since the possible effects on investors’ psychological expectations of more rate hikes and balance sheet selling are completely unknown. After eight years of treating symptoms and not the disease, the global financial system has become addicted to super-low rates and to continued central bank excess liquidity provisioning. What started in 2008 as a massive, somewhat coordinated central bank lender of last resort experiment – i.e. global bank bailout – has over the past eight years evolved into a more or less permanent subsidisation of the private banking and financial systems by central banks. The system has become addicted to free money. And like all addictions, the habit won’t be broken easily. That means central bankers’ plans to raise interest rates in the immediate months ahead will likely “hit a wall” well before the announced rate levels they are projecting. Plans to sell off balance sheets will almost certainly be limited to the US Fed for some time. The ECB and BOE – as well as Bank of Japan and others – will wait and see what the Fed does. The Fed will proceed at a snails pace that will represent little more than mere tokenism, and in the event of further slowing of real GDP growth, or US financial markets correcting in a major way, it will halt selling altogether. In short, there will be little Fed balance sheet reduction before the next recession, and a continued escalation of balance sheets by central banks globally. Central banks will enter the next recession with further bloated balance sheets. The Fed is thus on the verge of another major disastrous monetary policy shift and experiment. It will be unable to raise interest rates as it has announced, by 3 to 4 times a year for the next two years. Nor will it be able to sell off much of its current balance sheet, since anything but token adjustments will accelerate rates even higher. In this writer’s opinion, the federal funds rate cannot be raised above 2%, or the 10 year Treasury yield much above 3%, without precipitating either a serious financial market correction or an abrupt slowing of real economic growth, or both. What the eight years since the 2008-09 financial crash and great recession reveals is that the major central banks, led by the Fed, have painted themselves in a corner. The massive liquidity provided to their banking systems – engineered by

After eight years of treating symptoms and not the disease, the global financial system has become addicted to super-low rates and to continued central bank excess liquidity provisioning.

The European Financial Review August - September 2017

zero rates and QEs – failed even to adequately bail out their banks. Today more than $10 trillion in non-performing bank loans still overhang the major economies, despite the more than $20 trillion added to their central bank balance sheets in just the past eight years. The fundamental changes in the global economy and radical restructuring of financial, capital and labour markets have severely blunted central banks’ main monetary tool of interest rate management. Just as reduction of rates have little positive effect on stimulating real investment and economic growth, rising rates will have a greater negative impact than anticipated on investment and growth. The Fed and other central banks may soon discover this should they raise rates much faster and further or engage in more than token balance sheet reduction. Central bankers at the Fed, the BOE and ECB will of course argue the contrary. They will promise the economy can sustain further significant rate hikes and can commence selling its balance sheet without severe negative consequences. But these are the same people who in 2008 promised rapid and robust recovery from QE and ZIRP programmes that didn’t happen. What happened was an unprecedented acceleration in financial asset markets as equity and bond prices surged for eight years, high end real estate prices rose to prior levels, derivatives boomed, gold and crypto-currencies escalated in value, and income inequality soared to record levels – all fuelled by the massive $10 trillion central bank liquidity injections that drove interest rates to zero or below. And now they tell us they plan to raise those rates without serious negative effects. Anyone want to buy the Brooklyn bridge? I think they’re also trying to sell that as well.

Dr. Jack Rasmus is author of the just published book, “Central Bankers at the End of Their Ropes? Monetary Policy and the Next Depression”, Clarity Press, July 2017, and the previously published “Systemic Fragility in the Global Economy”, also by Clarity Press, January 2016. For more information: http:// ClarityPress.com/RasmusIII.html. He teaches Economics at St. Marys College in Moraga, California, and hosts the radio show, Alternative Visions, on the Progressive Radio Network. He blogs at jackrasmus.com and his twitter handle is @drjackrasmus. References 1. For the author’s 2016 analysis of global financial restructuring, Systemic Fragility in the Global Economy, Clarity Press, January 2016. 2. The theme of how central banks’ interest rate policies are failing is addressed in more detail in the just published book, Central Bankers at the End of Their Ropes: Monetary Policy and the Next Depression, by Jack Rasmus, Clarity Press, July 2017.

Society

The Crisis of Trust in Democracy and Globalisation BY GRAHAM VANBERGEN

Crimes of the rich and powerful elite have led to a global crisis of trust. In this article, the author elaborates on how societies have now lost their confidence and faith to established authorities and governments. But in a globalised world where there’s no trust and only fear, how can we expect the future to be bright?

Thousands of people gathered in central London to demonstrate against the UK government's economic policies. © BBC

rust is in crisis all around the world. The four key institutions of trust in business, government, NGOs, and media have been in decline for years. So much so that the majority of respondents to the Edelman Trust Barometer1 now believe that the overall system is simply no longer functional and does not work for them. The consequence to such an environment of suspicion and cynicism is that people’s concerns over globalisation,2 the pace of innovation, employment prospects, immigration and eroding social values are turned into fear. And fear-factor politics has become endemic. The consequence is evidenced in the rise of political figures such as Donald Trump, the rise of extreme political parties across Europe, the collapse of establishment politics in France, the failure of the Italian referendum, Brexit and then the Theresa May election debacle. All these events are inextricably linked because they were all decisions that were fundamentally driven by a lack of trust. The Barometer revealed nothing less than a malignancy sweeping across democratic nations in

Government is now the least trusted institution in half of all 28 nations in the survey.

particlar. Trust in the media is now at an all-time low. Government is now the least trusted institution in half of all 28 nations in the survey. Even trust in business leaders has collapsed globally, plummeting in every country studied – whilst right at the very bottom of the survey results, government leaders retain the title of least credible. This should really come as no surprise. In the last ten years the scandals rocking democracy have been epic. The global financial crisis that emanated in America, swept around Europe like an uncontrollable fire – austerity its only strategy of resurrecting the lifeless corpse of what was once a vibrant economy. Bailing out the banking behemoths on Wall Street and the City of London, Paris, Rome and Athens, all paid for by the less well off is cited in so much anger. Financial crimes, mass money laundering tax havens, ponzi schemes, privatisation of state assets, cover-ups and the looting entire countries, the list goes on and on. But in truth, these are the crimes of the rich and powerful and people know it. The survey found that 53 percent believe the system is rigged, unfair and has failed them. Worse, only 15 percent believe the system is working at all and another third aren’t sure. Just think about that for a moment. Of 28 democracies, only 15 percent of the population believe that their lot is OK. Tellingly, the survey actually asks the financially well off, the elite, what they think of the very system

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Society

they are exploiting and even they agree the system has failed. In addition, 48 percent of the top quartile in income, 49 percent of the college/universityeducated and a majority of the well informed (51 percent) also agree that the system has actually failed. To recap, less than one in five of the mass population and only half of the elite think democracy and the institutions that supports it is now functional. And yet, the gap between the trust held by the informed public and that of the mass population has widened to 15 points, with the biggest disparities in the US (21 points), UK (19 points) and France (18 points). The mass population in 20 countries distrusts their institutions, compared to only six for the informed public. It’s interesting that the establishment have been seriously challenged in all three of those countries with the biggest disparities. As you read the 66-page report and survey findings, it becomes apparent what the real state of “the system” really is in. Dire and critical are the words that come to mind. Fear of destabilisation is driving sentiment. Corruption tops the list,3 but immigration, globalisation and eroding social values along with the pace of innovation all follow close behind. These fears are well founded and manifest themselves in the most sudden of political change, hence the failed Italian referendum, Trump, Brexit and even new French president Emmanuel Macron. The highly publicised emergence of “fake news” has not helped of course. The dramatic rise of social media and huge use by billionaires and corporations to push their message with micro-ads to manipulate elections and referendums is feeding the fear. Search engines are now providing more news delivery than human editors from the traditional sources of news. People are now trapped in their own “echo chambers” that only makes matters worse and they are now known to reject any notion that they don’t believe in, reinforcing the lack of trust. Proof of this can be seen in one part of the report that confirms that a person like yourself is now just as credible a source of information as is

Figure 1: Credibility of Leadership Crisis Percent who rate each spokeperson as very/extremely credible

CEOs

37% Credible

29% Credible

Source: The 2017 Edelman Trust Barometer

Search engines are now providing more news delivery than human editors from the traditional sources of news. 30

Government Officials

The European Financial Review August - September 2017

a technical (60 percent) or academic (60 percent) expert, and far more credible than a CEO (37 percent) and government official (29 percent). “People now view media as part of the elite”, said Richard Edelman, president and CEO of Edelman. “The result is a proclivity for self-referential media and reliance on peers. The lack of trust in media has also given rise to the fake news phenomenon and politicians speaking directly to the masses. Media outlets must take a more local and social approach.” One should not forget that the mass population make up nearly 90 percent of the global population and half of them live on less than $2.50 a day. Globalisation has not rescued them from poverty,4 and the Eurozone has been described as a “poverty machine” as its economy continues in stagnation mode.5 The mass population mistrust of government is prevalent in Italy, Spain, Germany, France, UK, Sweden and Poland. All of these European countries now present systemic political risk to the establishment. The US and Australia are included and surprisingly, so is Canada. Trust in the British media has fallen 4 places in just one year to seventh from bottom, only just behind, Turkey, Poland and Russia. Trust in NGOs has fallen in 21 of 28 – Britain again falls four places to seventh. In all these findings there was the real sense of injustice. Then there was a lack of hope; a lack of confidence and a desire for change and it was the government who is predominantly the cause of all this anxiety. In 2017, 50 percent of the countries in the barometer have reported a complete loss of faith in

“the system”. The US ranks 13th from last, the UK 10th last, Germany 9th, Italy 2nd and France last. In contrast, Russia, China and the UAE rank the top countries for faith in their systems.

As Edelman eludes, change is coming from the people because change was made for them without their consent. Corruption is now feared by 77 percent of respondents. And 79 percent are fearful about globalisation, 83 percent are concerned about social erosion and 72 percent about immigration. The pace of innovation concerns 68 percent – no doubt this will increase over time with continual reports of the rise of robotics and technology such as artificial intelligence. As for the UK’s decision to leave the European Union; 54 percent said that the system had failed them and that they were fearful for the future. That fear dropped to 27 percent for those that voted to remain in the EU. Traditional news and broadcast media are now showing the steepest declines in audience of all mediums. 53 percent of people do not listen at all to people or organisations that they do not agree with, with 59 percent finding the information they want from search engines. Contrary to what the government’s say, 64 percent believe in leakers

and whistle-blowers, but only 36 percent believe in corporate press releases and company statements. Globalisation is notable as 50 percent agree it is taking them in the wrong direction with 60 percent fearing; loss of jobs to foreign competitors (60%), immigration (58%), jobs moving to cheaper markets (55%) and automation (54%). Here we can see how protectionism is now dominating the political arena. 72 percent in the survey say the government should protect their jobs, 69 percent the government should prioritise their own country needs and 50 percent say we should no longer sign trade agreements. All of the survey findings are leading towards the understanding that there is a fundamental shift going on right now. Influence and authority that came from the traditional elite supported by experts and their institutions has fully inverted as people start to reject established authority. “The implications of the global trust crisis are deep and wide-ranging”, said Edelman. “It began with the Great Recession of 2008, but like the second and third waves of a tsunami, globalisation and technological change have further weakened people’s trust in global institutions. The consequence is virulent populism and nationalism as the mass population has taken control away from the elites.” As Edelman eludes, change is coming from the people because change was made for them without their consent.

Figure 2: Fears Further Erode Belief in the System Percent of respondents with various fears who also believe the system has failed them

77%

79%

83%

72%

68%

Corruption

Globalisation

Eroding Social Values

Immigration

Pace of Innovation

Source: The 2017 Edelman Trust Barometer

Graham Vanbergen’s business career culminated in a Board position in one of Britain’s largest property portfolio’s owned by one of the world’s largest financial institutions of its type. Today, he writes for a number of renowned news and political outlets, is the contributing editor of TruePublica. org.uk and Director of NewsPublica.com References

1. 2017 Edelman Trust Barometer: http://www.edelman.com/trust2017/ 2. The Grim Realities of Globalisation: http://www.europeanfinancialreview.com/?p=9975 3. Corruption I the European Union: http://truepublica.org.uk/eu/corruption-european-union/ 4. Poverty – global facts and stats: http://www.globalissues.org/article/26/poverty-facts-and-stats 5. Eurozone is a turning into a poverty machine: http://www.telegraph.co.uk/business/2016/10 /24/the-eurozone-is-turning-into-a-poverty-machine/

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Digital Transformation

The World-Class Performance Difference: Digital Transformation and Finance in 2017 and Beyond BY GILLES BONELLI

Most achievers aim for the label “world-class”. In this article, the author elaborates on what sets world-class finance organisations from the rest of the world, their approach to the age of digital transformation, and beyond. World-class finance functions outperform the peer group in these two key areas: 1. Efficiency. World-class finance functions are more productive and less costly. 2. Effectiveness. World-class organisations are faster and better at delivering strategic value to internal and external stakeholders. The difference between world-class finance organisations and the peer group is significant. In “Raising the World-class Bar in Finance Through Digital Transformation”, a new report from The Hackett Group, it was revealed that teams belonging to the former category operate at 45% lower overall cost as a percentage of revenue than teams belonging to the latter category.1 The effectiveness gains seen by world-class finance organisations are impressive. They pay invoices within terms 95% more often, diminish error rates by 66%.

The Hackett Group’s report defines “worldclass” finance functions as those organisations that achieve top-quartile performance across several weighted metrics in its finance benchmark. The term “peer group” refers to organisations with finance functions which aren’t “world-class”.

Technology Enablement at Lower Cost World-class organisations also look far beyond the confines of their own function and department.

The European Financial Review August - September 2017

They focus on financial and non-financial KPIs – to the point where 85% rely on a more mature performance scorecard. Their approach includes deeper consideration of where to place activities and a high emphasis on process automation to lower costs and raise efficiency. In addition, their talent development programmes tend to be more sophisticated. World class organisations make fewer errors and are generally of higher value to the wider business. Investment in technology is typically self-funded, and time saved by automating time-consuming tasks tend to be allocated to higher-level tasks that require human intervention – and developing their capabilities further. This emphasis on technology plays a significant role in achieving the efficiency and effectiveness gains seen by world-class finance organisations. By adopting new tools, they limit their operational costs and empower employees to concentrate on tasks that add value to the business – such as analysing data and partnering with the wider enterprise to reduce management time to action. Despite their focus on technology, world-class finance organisations actually spend 61% less on it than their peers. In part, they achieve this by through standardisation and simplification of their systems. It is unsurprising that world-class finance teams know how to spend less and get more out of technology: their superiority in planning, governance, legacy systems and adopting new tools has allowed

them to effectively remodel the finance service delivery model. But how can the peer group emulate their approach to digital technologies? Digital Transformation Digital transformation is the planning, design and execution of change to becoming a digital business. A digital business is a business that creates value through the pervasive use of digital technology in product and service, partnering, collaboration and execution of work. The peer group may have some disadvantages in comparison to world-class organisations in digital transformation: they have less ability to invest in overall competency, capability in process standardisation, collaboration, talent, and structural change. But world-class organisations do not simply throw money at a problem: they invest in creating a digital-ready workforce. Creating this digital-ready workforce requires a considered, strategic business services digital transformation plan. As defined in The Hackett Group’s report, business services digital transformation amounts to “improving customer experiences, operational efficiency and agility by fundamentally changing the way business services are delivered, using digital technologies as the enabler of holistic transformation”. Essentially, it is a means of using technology to create new ways to do things. It is distinct from older change methods, which largely emphasised creating efficiencies in manual processes. These efforts may be ongoing, but digital transformation has many more items in its toolbox: social media, predictive analytics, robotic process automation (RPA), artificial intelligence, and more. These technology & data-centric approaches aren’t just speeding things-up or streamlining them: they represent a fundamental shift in the way these things are done. This is not to say that traditional efforts to automate tasks are absent from the peer group: they have been ongoing for several years. But if the initiatives that are already in place were once transformative, they are no longer resulting in incremental performance improvement. There are other opportunities for performance gains: The Hackett Group’s 2017 Key Issues study revealed that 97% of those finance leaders surveyed believe that digital transformation will have a step-change impact on

their organisation’s performance – and that 91% expect it to have a significant effect on their service delivery model. Companies, who are capitalising on these opportunities and who are adopting a digital transformation approach can cut process costs by 20%, to nearly the levels seen by world-class finance organisations, while simultaneously boosting effectiveness. To access these benefits, peer group organisations should focus on the following six areas.

Digital technology Digital customer engagement tools deployed for the benefits of the key stakeholders of the finance function, create additional channels of communications unconstrained by geographical limitations. By using online portals, the organisation can centralise and better maintain information underpinning key communications and account activity – granting more transparency and boosting accessibility for all internal and external users. By tailoring technology to support human interfaces, world-class organisations achieve a better collaboration between business partners. For example, the level of usage of online planning systems is six time higher in for the world-class compared to the peer group.

Robotic Process Automation Robotic process automation allows tasks that would ordinarily require human intervention to be undertaken by robots. At its simplest, RPA enables these tasks to be performed according to predetermined rules set by the finance team. Cash application, for example, used to be a task that required manual human intervention. Robotic process automation means that this process is conducted automatically: the robot searches for remittance advices according to a particular keyword (or keywords), they reformat them according to the team’s requirements, and they then post them to the general cash ledger. This saves time for the finance department – which is then empowered to focus on more important business or operationally-critical activities.

20% Companies, who are capitalising on these opportunities and who are adopting a digital transformation approach can cut process costs by 20%, to nearly the levels seen by world-class finance organisations, while simultaneously boosting effectiveness.

Analytics-driven Insight Big data and advanced analytics serve to bolster the decision-making capability of the finance function. These disciplines make it possible

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Digital Transformation

to create predictive models that automatically gather historical data, external data (segmented according to factors such as industry) and financial information that’s readily available in the public record within a single holistic view. The applications are manifold. For instance, in credit risk management, it becomes possible to assign risk ratings that suggest the likelihood of default to any counterparties. Joined together with exposure and recovery-rate assumptions, finance teams are able to gain an accurate view into their customers’ creditworthiness – enabling them to determine how much finance is available to them, and on which specific terms. Another example is the use of predictive analytics as a key tenet in forecasting – achieving a more accurate forecast by relying on an automated process free from human bias.

Modern Digital Architecture Modern digital architecture is concerned with optimising the flow of information in a business. In the context of finance, the term “modern digital architecture” often refers to how cloud-based applications and to a lesser extent on premise applications should be rationalised and integrated for a more efficient, effective and ultimately more valuable finance function. For a comparable set of functionality, cloud-based technology tends to be more cost-effective and faster to implement and has the advantage to significantly expand the reach of the finance function’s technology. Cloud-based planning & analytics tools can simplify selfservice and make it far easier to collaborate globally. The linchpin of the digital world is data. In this context data integrity can become more robust and wide-ranging, and everyone must be encouraged to take a greater role in all data, in particular that which underpins the budgeting and forecasting process.

Digital Workforce Enablement Digital workforce enablement refers to the use of digital tools and platforms to improve knowledge creation, dissemination, and the overall productivity and value contribution of employees whether they be operating in the same location or not. New communication methods, such as social media, can be used by the organisation to simultaneously expand its appeal to newer generations of employees and minimise inefficiencies in existing processes – nurturing an open, collaborative, and value-creating work environment. Certain tools even make it possible to crowdsource answers from employees when there is a pressing question – limiting overreliance on methods such as phone calls and emails, which are not always attuned to the urgency of the department’s needs.

The European Financial Review August - September 2017

Digital transformation is a significant part of these efforts, but it is not the only part.

Cognitive Computing Cognitive computing is the simulation of human thought processes in a computerised model. Cognitive computing involves self-learning systems that use data mining, pattern recognition and natural language processing to mimic the way the human brain works. Cognitive computing is emerging in finance as tools which would use cognitive computing in business could improve the ability of finance teams to run models, make forecasts, and interpret big data sets. This could improve the finance team’s overall value contribution – and its overall efficiency. The above six considerations are highly recommended components of any modern digital transformation strategy. But the world-class performance advantage for finance organisations is not simply a matter of adoption: it is about using technology judiciously, in a way where the maximum possible effectiveness is mined from the lowest possible pool of resources. Allocating funds to these areas may well boost a peer group organisation’s transition to world-class status – but finance teams should maintain a vigilant eye for all process-based inefficiencies. Digital transformation is a significant part of these efforts, but it is not the only part.

Gilles Bonelli, Practice Leader, Enterprise Performance Management & Business Intelligence Executive and Account-to-Report Process Advisory Program, EMEA & ASIA. In his current roles, Mr. Bonelli advises C-level executives and their teams on proven practices to drive better enterprise and functional performance. He has extensive experience working with company leaders in the telecom, entertainment, media, financial services, government, travel/ transport, utilities, oil and gas, and fastmoving consumer goods sectors. Before joining The Hackett Group, Mr. Bonelli worked as a Business Consultant at PricewaterhouseCoopers, Deloitte and Axon Consulting. He is a Fellow of the Association of Chartered Certified Accountants. Reference 1. http://www.thehackettgroup.com/research/2017/wcpafn17/

Technology

How Technology Impacts Execution for Portfolio Managers BY IRENE ALDRIDGE

With all the changes happening to the markets the past several years, author Irene Aldridge discusses how technology has significantly shaped the execution quality for portfolio managers. The article emphasises the realities of a data-driven industry wherein better information means better success.

nvestment managers are increasingly concerned about the quality of their execution. Indeed, how you execute the orders in today’s markets may make or break investment profitability. Changes to the markets over the past several years place execution quality at the top of the priority list for investment managers. Most of the changes in the markets are directly related to computing power and automation within the financial services sector. Automation is a driving force in the financial markets: today’s computers are scoring mortgage applications, reviewing technicalities in swap legal agreements, process trading orders and even increasingly make investment decisions in a push toward a lower-cost automated portfolio management. Automation drastically reduces costs, improves the customer experience, and lowers the expenses of businesses across the industry ensuring competitive survival. Relative to other areas of business, execution expense now really matters in ways not seen before, and nickels and dimes associated with execution decisions may or break a portfolio manager.

Computers seldom become ill, are hardly emotional, and make superior cool-headed traders who stick to the script and don’t panic.

The European Financial Review August - September 2017

What are the current market forces that portfolio managers should be aware of in the execution space? The most obvious issue facing most portfolio managers today is the trading venue selection. For the US equities alone, along with the 21 exchanges, we now have 36 alternative trading systems (ATS), also known as alternative trading venues or, simply, dark pools. Dark pools trade anonymously and without displaying order information before trades are executed. The lack of displayed information is the key difference between dark pools and registered “lit” exchanges. Exchanges show the entire limit order book, down to how many shares are in each limit order, while dark pools hide all limit-order book information. Institutional investors that trade large blocks and lack appropriate algorithmic expertise may go to dark pools and “hide” their large orders from other traders. Then, however, they risk the traps of unregulated markets and other, potentially malicious market participants also hiding in the dark. Future traders, too, are presenting with competing platforms: ICE and CME are just two large powerful names in the global trading of futures contracts with many upstarts taking care of matching various kind of derivatives around the globe. Finally, in the 5x24 forex markets that truly barely sleep, rules are few and execution choices are close to limitless. High-frequency trading (HFT) is another execution concern for portfolio managers. HFT likewise capitalises on plunging costs of technology. When programmed correctly, HFT software has built-in advantages over manual trading. Computers

seldom become ill, are hardly emotional, and make, in short, superior cool-headed traders who stick to the script and don’t panic. Of course, some recent research purports that some people, especially those attuned to their intuitive or biological responses, can outperform machines. Well, good for those few! By and large, however, human traders tend to be a superstitious, irrational lot prone to, well, human behaviour, and no match for their steely automated trading brethren. Perhaps one of the largest advantages of machines, however, is not that they can contain their nonexistent feelings, but in their information processing power. Humans have a finite ability to process data. We may, possibly, be able to stare at some 16 screens all at once, but our eyes can still only process 24 distinct visual frames per second. Should the information update faster than that, we simply miss it. Computers, on the other hand, can process unlimited volumes of data at the speed of light. Even more importantly, following just a few news sources and several price charts in today’s interconnected continuously arbitraged markets is simply not enough. News leaks out into the markets in chaotic and often unforeseeable ways. Processing the entire realm of information, including quotes for some 6,000+ stocks, hundreds of thousands of options, interest rates, futures, and social media is what separates today’s successful traders from the not-so-successful ones. And machines simply do it better. No extreme human physiology allows us to simultaneously read in-depth news and analyses on even 100 financial instruments. HFT strategies, on the other hand, are generally wellequipped to process reams of information on the fly. Still, all HFTs do not fit in the same mold. Some are market makers, using predominantly limit orders, passively waiting for the market-order-armed liquidity takers to arrive. Others are aggressively pursuing the best price available at a given point in time. Both categories, passive HFT and aggressive HFT, have their parallels in the world of human traders: passive HFTs are automated versions of their human market-maker predecessors, and aggressive HFTs are modelled on former prop traders and day traders. Passive HFT are a set of HFT strategies mostly placing limit orders. As such, passive HFT end up buffering market liquidity, and making markets. Prominent passive HFT firms include Virtu and Knight Capital Group. The market makers, whether human or robotic, follow the same basic principles. Market-making strategies consist of often-simultaneous placement of limit orders on both the buy and the sell side of the limit order book. The simple two-sided quotation works great when markets are quiet or range-bound. However,

when the markets move rapidly in one direction or another, market makers risk severe losses. The market makers’ risks are largely a result of their potential information asymmetry. For example, suppose that the latest trade price of IBM stock is $155.76, and a market maker is quoting $155.74/$155.77. Suppose further that another trader with better information strongly believes that the IBM market is about to fall, say, to $155.00 in the next 20 minutes. To capitalise on his fleeting informational advantage, the second trader places the market order to sell IBM stock. The trading venue matches the market sell order with the market maker’s limit buy order at $155.74, leaving the market maker holding a long position in IBM in a rapidly falling market. Fast-forward 20 minutes, and the market maker is in the hole at $0.74 for every share he bought. The phenomenon is known as adverse selection whereby the uninformed market makers and other traders are “picked off ” by better-informed market participants. Is being better-informed illegal? Of course not. Some superior information costs a pretty penny, and substantially reduces the informed traders’ gains from trading, when netted out at the end of the day. What is a market maker to do? The market maker needs to (1) hedge his exposure, and (2) become better informed. Hedging exposure is always costly. For instance, the market maker may decide to purchase options or other derivatives to hedge his exposure to the underlying. A put option will do the trick, but at an upfront premium. Another route is to obtain better information. One way of gearing up on the information frontier is segmenting traders into better-informed and worse-informed, and essentially front-running better-informed traders using prehedging or anticipatory hedging. The strategy works mostly at a broker-dealer’s market maker, since order flow on exchanges and other venues outside of a broker dealer are largely anonymous. Another, more ethical route comprises investing into premium data that is indicative of the market’s near-term direction, shrinking the information barrier and pre-empting sharp moves. Once again, computerised market makers win the bots-versus-humans debate as information is king, and the ability to process vast amounts of information simultaneously is cash. Robots, often abbreviated to “Bots”, using market orders that trade using intricate strategies of professional traders are collectively known as aggressive HFT, as opposed to passive market makers. Unlike passive HFTs, aggressive HFTs tend to use market orders to capitalise on fleeting information at their fingertips. In the industry, the return advantage from fleeting informational is often referred to as rapidly decaying alpha.

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Today’s portfolio managers’ jobs are more data-driven than ever, placing demands of sophisticated data analysis and other techniques on the candidates. What kinds of inferences do aggressive HFTs deploy? To put it simply, all kinds. The most successful aggressive HFTs, like QuantLab, use a multitude of information sources to create an informational haystack, from which big data-driven inferences are extracted about the prospective market movements.1 Why should portfolio managers care about HFT? Aren’t HFTs’ actions too-short term to interfere with portfolio managers’ investment horizons? And aren’t latest delay-based exchanges like IEX explicitly designed to stem HFT? Latest research shows that aggressive HFT tend to rapidly consume available market orders, eroding liquidity available to portfolio managers. The effect is particularly severe during news announcements and other times when aggressive HFT is imbalanced: when participation of aggressive HFT buyers among all trades significantly dominates participation of aggressive HFT sellers, and vice versa. In the process, aggressive HFTs increase bid-ask spreads and create higher volatility. This affects portfolio managers on two fronts: 1. Financial instruments with higher aggressive HFT participation tend to be more volatile, a condition that can be explicitly incorporated in the portfolio management framework, and, 2. Execution in the wake of imbalanced HFT produces highly substandard results relative to the market due to removed liquidity; the adverse impact, however, dissipates in about 20 minutes when the markets return to their normal state. To enhance performance, portfolio managers should incorporate aggressive HFT tracking in their own toolkits in order to not only improve their portfolio management, but also to improve their execution by knowing when the aggressive HFT imbalances occur and, consequently, when to scale down or halt execution to avoid aggressive HFT. Why not turn to a venue like IEX who claim that by design they’ve eliminated aggressive HFT from their pipes? The claim is a falsehood given the core of the US market structure, known as National Best Bid/Offer (NBBO) system. Under NBBO adopted as part of Regulation NMS in 2005, orders of all market participants, HFT and non-HFT, have to be executed at the National best quotes that are continuously collected, aggregated and disseminated by the US Securities Information Processor (SIP). If an HFT order arrives at a

The European Financial Review August - September 2017

venue that does not possess NBBO, it is likely to be redirected to another trading venue. The redirection in the search for NBBO may repeat several times, and during the process the aggressive HFT order can be far off its original venue, potentially ending up on IEX. In the end, due to NBBO, aggressive HFT equity orders end up distributed evenly across most of the US Exchanges, making venue selection for the purposes of HFT avoidance pointless. However, the question of when to execute, as opposed to where to execute, is very topical, and tracking aggressive HFT provides the answer. The tracking follows aggressive HFT in anonymous markets and is looking to pinpoint specific footprints. The footprints, unintelligible to the human eye, become clearly visible following mathematical transformations. Again, robust computer systems come to the rescue processing in-depth market information and delivering straightforward inferences from complex data. Today’s portfolio managers’ jobs are more data-driven than ever, placing demands of sophisticated data analysis and other techniques on the candidates. Some portfolio managers are instead relying on the outside data vendors, opting to purchase quality data inferences rather than spend several years building the data sets and ultimately losing to the competition. Companies like AbleMarkets.com provide services of tracking and reporting aggressive HFT participation across a wide breadth of financial instruments. Tracking today’s market conditions for portfolio managers is no longer limited to the daily Open, High, Low and Close. Adapted from Aldridge, Krawciw, Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes (Wiley, 2017)

Irene Aldridge is a quantitative Big Data researcher and Managing Director of AbleMarkets, the Big Data for Capital Markets company. Aldridge is co-author of “Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading, Flash Crashes” and author of “HighFrequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems”. Note 1. Many of the HFT strategies are discussed in detail in Irene Aldridge, High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems (Hoboken, NJ: John Wiley & Sons, 2009, 2013, translated into Chinese).

Technology

The Dawn of Assistive Technologies BY FIACHRA O’BROLCHÁIN

Technological developments have resulted in great advances in assistive technologies – technologies designed to help people with impairments, both physical and cognitive. Assistive technologies promise great benefits to individuals and society as a whole, but they are not without ethical problems. If we are to maximise the benefits of these technologies and avoid their downsides, ethical analysis will be required alongside technological expertise.

he market for assistive technologies has been growing over the last number of years, growth that can be expected to continue. The term “assistive technologies” is an umbrella term for technologies designed to help people with impairments, both physical and cognitive. These could range from wheelchairs, to apps that prompt users to do something (take medicine at a certain time or learn or relearn language), communication devices, and even brain-computer interfaces. Whilst

technologies such as wheelchairs are familiar, many assistive technologies are novel, relying on breakthroughs in ICT, sensor technologies, and neuroscience. As such, more and more assistive technologies are being designed to help people with cognitive impairments, such as intellectual disabilities or dementia. The United Nations predicts that by 2050, the population of people over 60 will be 2.1 billion. The population of people over 80 is growing even faster. Populations are, virtually everywhere, again, meaning that a greater percentage of the global population will suffer from conditions such as dementia. People with disabilities form the world’s largest minority. Approximately 10% of the world’s population have a disability. The percentage of people with an intellectual disability is about 1% in high-income countries, and 2% in low- and middleincome countries. As medical systems improve, particularly in more affluent nations, people with disabilities are achieving life-expectancies of 85% to

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95% of the general population. Consequently, the requirement for these sorts of assistive technologies will increase. This has been acknowledged by the United Nations, which, in its 2006 Convention on the Rights of Persons with Disabilities obliges signatories “To undertake or promote research and development of, and to promote the availability and use of new technologies, including information and communications technologies, mobility aids, devices and assistive technologies, suitable for persons with disabilities, giving priority to technologies at an affordable cost.”1 As assistive technologies advance, they hold out immense promise for people with physical and cognitive disabilities, such as ensuring that users are able to live independently for a much longer time. The continuing development of assistive technologies is not without ethical problems however. It seems to me that if we want to truly benefit from the development of these assistive technologies we need to address the ethical issues as early as possible. This will not only benefit users, but will also benefit state bodies or private institutions hoping to use of assistive technologies, as well as those who design and develop technologies, who will know they are less likely to face unexpected problems after their products have gone to market. Ethical analysis of assistive technologies will play a key role in their truly addressing contemporary and future problems. So what are some of the ethical problems that need to be addressed? Amongst the most prominent of these problems is the issue of privacy. Many new types of assistive technology will gather data on their users. Much of this data might be intimate in nature, concerning a person’s health or emotional state. This data might be sold or transferred to other groups for commercial or medical reasons. Usually, the solution to this problem is held to be informed consent. That is if a fully informed user of the assistive technology gives their consent to the data gathered about them being used by whoever is gathering that data, it is considered acceptable. However, given that assistive technologies are being designed for the most vulnerable members of our societies – people with intellectual disabilities or people with dementia – obtaining informed consent is difficult. Much of the information about data gathering and use is difficult to understand and grasp; some of the users might not be capable of consenting, as they may lack the requisite cognitive capacity. Moreover, some

might consent but at a later stage no longer feel comfortable with that decision, or might simply have forgotten that they ever made it. There are further issues – take the idea of smart homes. Smart homes are homes full of assistive technologies that can monitor the health and behaviour of their residents, alerting suitable guardians to problems. Obviously, privacy issues will need to be resolved in order for smart homes to be viable for users. The problem does not stop with the informed consent of users however – the sensors in smart homes will also gather data on anyone visiting the house – relatives, friends, and helpers. The challenge of obtaining their consent or protecting their privacy will also need to be addressed. There will be broader ethical questions that need to be tackled. Take for instance the distribution of assistive technologies. Those who have access to such technologies can obviously expect benefits as a result. Distribution according to market forces will likely result in increased inequalities, as those who can afford assistive technologies for their aging relatives or children with intellectual disabilities are able to improve their loved ones’ lives significantly, whilst the rest have to make do. On the other hand, distributing assistive technologies to all who will need them – particularly in regions with aging populations, i.e. Western Europe and Japan – will be expensive. Whilst this is not a new issue in terms of access to care for the elderly, the potential of assistive technologies to help people with intellectual disabilities does present a new issue. Assistive technologies might, in some cases, significantly improve the capacity for a person with an intellectual disability to live an independent life. In other cases, assistive technologies will help carers hugely, allowing them greater independence and reduced stress. Given the potential of new technologies to improve increase a person’s freedom, there exists a forceful argument that governments who are claiming to guarantee the freedom of citizens ought to be providing such technologies for those same citizens. Determining how to justly distribute assistive technologies will be a major challenge for governments in the coming years. The ability to access assistive technologies, or otherwise, will also play a role in issues of marginalisation and stigmatisation. Many people, particularly those with intellectual disabilities are in no way visually distinct. Ensuring that assistive technologies will not make them stand out is of the utmost importance. There also exists a risk that those

The lure of the techno-fix is very real. Of course technologies can bring many benefits and improve many peoples’ lives, but we must not assume that they will solve all problems and we must be wary of over-reliance on them. 40

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who do not have access to assistive technologies, or who choose not to use them, e.g. some people with autism spectrum disorder (ASD), are not marginalised as a result of not having the technologies. We must be wary of assumptions that technology can “fix” certain conditions. Firstly, the presupposition that certain conditions need to be fixed is controversial, particularly in relation to ASD. Some people will choose not to avail of assistive technologies – perhaps they will not want technological prompts altering their behaviour. There is a possibility that the availability of assistive technologies for people with ASD will result in an expectation that those with ASD should use assistive technologies to adapt to the rest of society. This will not suit all people with ASD. Secondly, depending on how the questions of distribution are resolved, assistive technologies may not be available for many who require them or would make use of them. Again, it will be necessary to avoid marginalising such groups. Indeed, while there is no doubt that assistive technologies will improve the lives of many people, we must be careful of viewing them as a panacea. The lure of the techno-fix is very real. Of course technologies can bring many benefits and improve many peoples’ lives, but we must not assume that they will solve all problems and we must be wary of over-reliance on them. Technologies might bring losses as well. As mentioned, many assistive technologies are being designed for elderly people – from smart homes, to cognitive training apps, to social robots. Undoubtedly, such technologies will bring many benefits to elderly people and people with dementia – from protecting their modesty, to helping them organise themselves, to ensuring that they are safe. Yet, we must consider what impact such technological solutions will have. Will the elderly become more marginalised than they already are in contemporary society? Can the companionship offered to a person with dementia from a social robot ever replace the companionship of a real person? For sure, this might reduce costs of healthcare for an increasingly large aging population – social robots and other forms of automated care will be cheaper than hiring healthcare professionals – but cost is not the only consideration. As well as thinking about the impact such changes will have on those directly impacted, we must consider the way such changes will impact wider society. Will societies

The ability to access assistive technologies, or otherwise, will also play a role in issues of marginalisation and stigmatisation. making extensive use of such technologies begin to ignore the reality of aging? If we reduce the amount of time we spend with people with dementia (for instance), will we stop practicing care? Will we lose something essential to our humanity? None of this is meant to suggest that we should not continue to develop assistive technologies. Assistive technologies will not only change the lives of many people for the better, but are likely to change many societal practices and arrangements. Many people are already benefitting hugely from their development, and this can be expected to continue. The demographic changes that we can expect also suggest their necessity. Yet, they should not be developed in an ethical vacuum. Ethical analysis can help prevent negative unintended consequences emerging, and can help us situate technologies in a broader context – that of the whole society and its values. Featured Image: One of Craig Hospital’s assistive technology, located in St. Englewood CO, USA.

Dr. Fiachra O’Brolcháin is an Applied Ethicist at the Institute of Ethics in the School of Theology, Philosophy and Music at Dublin City University, and an ASSISTID Marie Curie Visiting Research Fellow at the School of History, Anthropology, Philosophy and Politics at Queens University Belfast. His research focusses on the Ethics of Technology. His current project is focussed on the ethics of assistive technologies for people with intellectual disabilities, autism spectrum disorder, and dementia. Reference 1. United Nations. (2006). Convention on the Rights of People with Disabilities. New York: United Nations.

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“Bringing Captive Insurance into Focus” SINGLE PARENT STRUCTURES GROUP/ASSOCIATION CAPTIVES SEGREGATED PORTFOLIO COMPANIES

2nd Floor, Genesis Building, George Town P.O. Box 10027, Grand Cayman KY1-1001, Cayman Islands

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Investment

A Companion Guide to Exploring the Subtleties of Asset Management BY HUGUES LANGLOIS AND JACQUES LUSSIER

The article elaborates on the current state of knowledge of asset management and on the truly important and impactful factors in investment strategy implementation. Drawing key points from their book, Rational Investing – The Subtleties of Asset Management, the authors provide a comprehensive guide on how to efficiently approach investment decisions.

rogress in any discipline can be attributed to the scientific method of accumulating knowledge through proper experimentation, either through small increments or large leaps forward. However, even when significant breakthroughs occur, there can be resistance among experts to reach a consensus if it threatens existing business models or challenges one’s expertise. Such resistance is greater in areas where randomness explains a large portion of outcomes and where existing business models are highly profitable. The asset management industry is certainly one such example. Asset management is not only about financial concepts and mathematics. A comprehensive investment approach requires an understanding of several social sciences; economics, psychology,

Rational Investing – The Subtleties of Asset Management by Hugues Langlois and Jacques Lussier

history, and sociology for example. It is hard to find an unbiased source of information that is neither too simple and overlooks many of the important issues nor too complicated and communicated through in a heavy textbook format. In Rational Investing – The Subtleties of Asset Management, our objective was to create a short (i.e. 200 pages) non-technical book that gives a broad overview of asset management from both an academic and a practitioner perspective. We cover the structure of financial markets, active versus passive management, what we can and cannot forecast, the sources of investment performance, some stylised examples of portfolio building, and cognitive biases in investment management. We hope to offer a guide to professionals involved in financial decisions that do not have a formal education in finance, to recent graduates who want to consolidate their learnings and relate them to industry practices, and even to seasoned finance professionals who want to challenge their knowledge. Below we present some of the issues discussed in Rational Investing – The Subtleties of Asset Management. We do not take a stance in the debate between active and passive management, between fundamental and quantitative investing, or to what extent markets are efficient or driven by investors’ behavioural quirks. Rather, we provide a roadmap for understanding and integrating the issues required to make adequate investment decisions. Our purpose is to present the current state of knowledge in asset management, support investors in their decision to

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be active or not, and convey what truly matters to the implementation of investment strategies. The Structure of Financial Markets and Active Management To be successful active investors, we first need to appreciate the difficulties that lie ahead. When the market allocation is formed and there are no changes in the composition of the market (e.g. IPOs), active investing, which is defined as holding a portfolio different from the market portfolio that contains all assets weighted by their market capitalisation, is a zero-sum game. Whenever we outperform the market by one dollar, another investor or group of investors somewhere has to be on the losing side and lose one dollar. Active investing is also costly: we invest in research, in data, but also our own time to spot good investment opportunities as well as incur trading costs. All of these costs decrease all active investorsâ&#x20AC;&#x2122; performance. This has important consequences whether you want to be an active manager yourself or if you want to invest in an actively managed investment fund. As active managers, we need to be good enough to consistently beat other active investors and to cover our costs. Empirical evidence illustrates that such feat is hard to achieve. Reports by SPIVA (S&P Indices Versus Active) show that asset managers, whatever the style or asset class, have much less than a 30% likelihood of outperforming their benchmark in the long run. We describe in Rational Investing a peculiar state of the asset management industry: active investors are crucial because they conduct research and allocate capital in the economy and some fund managers are truly skilled at beating their benchmark, yet investing in actively managed funds is more often than not a poor choice for many investors. Research shows that a small portion of fund managers are able to consistently create value above their benchmark. However, their value-added

Whenever we outperform the market by one dollar, another investor or group of investors somewhere has to be on the losing side and lose one dollar. 44

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is greatly diminished by the level of fees charged to investors. As the size of the asset management industry increases, competition among managers further hinders their ability to beat the market. Ultimately, the client is often left disappointed. What Should We Try to Forecast? Investing and forecasting generally go hand in hand. Deciding which assets to buy or which fund manager to hire involves making a forecast about future events. A review of the evidence on our forecasting ability in all areas related to social sciences is not encouraging. The trader-philosopher Nassim Taleb describes our forecasting record as dismal and marred with retrospective distortions. Even when an individual has correctly forecasted an event, we must remember that in an environment where thousands of economists, strategists, and managers make predictions, some will invariably be right by chance alone. What matters is whether they can consistently produce useful forecasts. Unfortunately, if we track all the forecasts of those who have been right about a specific event â&#x20AC;&#x201C; such as having forecasted the 2008 financial crisis â&#x20AC;&#x201C; we find that most often their overall track record is unfavourable. Phil Tetlock of the University of Pennsylvania tracked the forecasting accuracy of 284 experts that made 28,000 predictions over 18 years and of 15,000 participants in ACE (Aggregate Contingent Estimation), a tournament of five forecasting teams involving several universities. His work illustrates our deficiencies when it comes to forecasting events. We actually are better at forecasting expected investment return and risk using simple statistical methodologies. But even then, the portion of future events that we can forecast is limited, a lot more so for expected return than for risk. Unfortunately, many managers focus on the former. Embracing Three Sources of Performance All investment performance can be analysed through three performance drivers. A clear understanding of these sources of performance allows to design better benchmarks to analyse fund managers or newly proposed investment products and to design better portfolios. First, exploiting rewarded sources of risk compensate investors with higher average return

Without a doubt education and a clear exposition of investments facts and fictions help us improve our investment decisions. for bearing broad risk factors in their portfolios. Several investment products, marketed under the alternative beta, exotic beta, or more recently smart beta appellation are designed to combine several risk factors. Such products will favour stocks with small market capitalisation, value and quality characteristics, positive momentum, and low risk. A large proportion of the average traditional manager’s and even hedge funds’ excess performance can be explained by exposures to these same factors. Recognising this fact simultaneously creates higher standards for active managers and puts downward pressure on management fees. Identifiable risk factors are not constrained only to the stock market. We can design better portfolios across asset classes that have many of the same structural characteristic as those of well-managed traditional portfolios. We illustrate in Rational Investing how two types of investors – a relatively unconstrained institutional investor who has access to better information and trading capabilities and a relatively more constrained retail investor – can implement risk-return efficient investment portfolios. The second performance driver is identifying mispricings in financial markets. This is the Holy Grail of investment; spotting undervalued investment that will surely shoot up in value. Most fund managers sell themselves through their ability to exploit mispricings from financial markets and measuring this skill, known as their alpha, is a crucial problem in investment management. One of the biggest challenges faced by investors when selecting a manager is being able to isolate the performance attributed to a strategic exposure to rewarded factors and then distinguish which portion of the unexplained return is attributed to a genuine alpha or to good luck. The final performance driver is diversifying unrewarded sources of risk. Investors can reap large reward from betting on single investments, but also suffer large losses. Diversification is often misunderstood and overlooked as a performance driver, but reducing the impact of bad luck is a sure path to improving long-term performance. A key issue throughout the book is that statistical algorithms and systematic strategies, witht proper expert supervision, can replicate a large portion of the best managers’ performance. This creates a downward pressure on management fees and a higher hurdle for traditional active

managers. However, a threat is usually accompanied by an opportunity; active managers can and are adapting their practices to benefit from algorithms and systematic investment strategies. We are not far from a situation in which the practices of the best fundamental managers and those of the best quantitative managers are hard to distinguish. Conclusion Good decision making involves “understanding information, integrating information in an internally consistent manner, identifying the relevance of information in a decision process, and inhibiting impulsive responding”.1 When luck plays a small role, a good process will lead to a good outcome. But when luck plays a large role as in the investment management industry, it is difficult to predict the outcome over a short period. Patience and rigorous analyses are required. Without a doubt education and a clear exposition of investments facts and fictions help us improve our investment decisions. Rational Investing seeks to trigger a productive conversation on asset management for the benefit of all investors and present a comprehensive guide to tackle investment decisions.

Hugues Langlois is an Assistant Professor of Finance at HEC Paris. He holds a Masters in Financial Engineering from HEC Montreal and a BCom in Finance and Economics and a PhD in Finance from McGill University. Hugues Langlois was a Portfolio Manager at Desjardins Global Asset Management from 2007 to 2013 before co-founding IPSOL Capital with Jacques Lussier. Jacques Lussier is Co-Founder, CEO and CIO of IPSOL Capital. Jacques is responsible for IPSOL’s investment strategies across asset classes and, with the IPSOL’s Head of Research, sets the research agenda for the firm. Jacques earned a PhD in International Business from the University of South Carolina. He is the author of the book “Successful Investing Is A Process” published by Wiley and Bloomberg Press in 2012. Jacques co-authored with Hugues Langlois “Rational Investing – The Subtleties of Asset Management”. The book was published by Columbia University Press in March 2017. Reference 1. M.L. Finucane and C. M. Gullion, “Developing a Tool for Measuring the DecisionMaking Competence of Older Adults,” Psychology and Aging 25 (2010): 271-88.

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Investment

Young Professionals and Impact Investment BY MARGUERITA CHENG

Thanks largely to the growing affluence of millennial investors, “socially responsible” (SRI) and “impact” investing represent an significant economic and financially consequential force. In this article, the author elaborates on the rationales behind this reality and the concrete impact that this progressive generation holds.

over the past several years. J.P. Morgan and the Rockefeller Foundation’s Global Impact Investing Network (GIIN) expect the market to swell to $500 billion by the year 2020.3 According to GIIN, the growing impact investment market provides financial support to address some of the world’s most significant issues. Sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services including housing, healthcare, and education are all on the radar of impact minded organisations. To qualify as an impact investment, an investment must meet certain criteria (as outlined by GIIN). These particular qualities help to differentiate impact investing from other forms. 1. Intentionality: Impact investors strive to achieve social or environmental goals which are socially motivated. 2. Investment with Return Expectations: Impact investments are expected to generate a financial return on capital and, at a minimum, a return of capital.

oday young professionals, or millennials, play a crucial role in the success of impact investment. This population, born between 1980 and mid-2000s, are especially concerned with how to make the world a better place. They have a profound influence on a company’s corporate social responsibility (CSR). CSR refers to any organisation’s business approach where they contribute to sustainable development by delivering economic, environmental and social responsibility benefits for all stakeholders. Millennials are more likely to engage with brands when issues of social responsibility are important to the company.1 Millennials compromise 24% of the adult population in the 28-member European Union in 2013. The largest absolute number of millennials in a survey country was in Germany: 14.68 million. The smallest number was in Greece: 2.02 million.2 Impact investments strive to create positive impact beyond financial return such as a social, economic, or environmental benefit. Impact investing has grown into a multibillion-dollar market

Millennials compromise 24% of the adult population in the 28-member European Union in 2013.

The European Financial Review August - September 2017

3. Range of Return Expectations and Asset Classes: Impact investments generate returns that range from below market (sometimes called concessionary) to risk-adjusted market rate. 4. Impact Measurement: An important aspect of impact investing is the commitment of the investor to measure and report the social and environmental performance and progress of underlying investments. Impact measurement helps ensure transparency and accountability, and is essential to informing the practice of impact investing and building the field.4 How Young Professionals Make Impact Investing Successful Schroders Global Investor Study 2016, found that millennials (aged 18-35) are more likely to place greater importance on environmental, social, and governance (ESG) factors than older investors (aged 36+).5 The survey found that the millennials viewed ESG factors as equally important as investment outcomes when assessing investments. Eurobarometer survey commissioned by the European Parliament in 2014 concluded economic concerns remain the most mentioned issues at the national and European levels, though the prevalence of this response continues to decrease. The results of the survey demonstrated an increase in concerns about immigration. Immigration is now the third most mentioned issue at the national level, after unemployment and the economic situation; and the fourth greatest concern at the European level, after the economic situation, unemployment and the state of Member Statesâ&#x20AC;&#x2122; public finances.6 After the recent tragic events, such as the Manchester Attack at the Ariana Grande concert in England and Bastille Day attack in Nice, France, the European population has experienced an outpouring of support for the victims and families. American millennials are also acutely aware of economic issues, such as the 2008 housing market collapse and resulting financial crisis, which has been described as the worst economic disaster since the Great Depression of 1929. It happened even after efforts by the Federal Reserve and Treasury Department to prevent the US banking system from collapsing.

Schroders Global Investor Study 2016, found that millennials (aged 18-35) are more likely to place greater importance on environmental, social, and governance (ESG) factors than older investors (aged 36+). European millennials have also dealt with economic crisis and financial uncertainty such as the European Sovereign Debt Crisis which began in late 2009. While the US has seen its economic signs increasing, the picture is less optimistic in Europe, where the International Monetary Fund forecasts the GDP of Germany to be increasing at only 1.3%, France by 0.9%, and Italy by 0.4% in 2015.7 Millennials are influenced by what is happening in the world and how it affects their inner circle. National Endowment for Financial Education found that parents have the greatest influence on their childrenâ&#x20AC;&#x2122;s financial knowledge â&#x20AC;&#x201C; more than work experience or high school.8 Influence is increased by the frequency of communication between parent and child. According to an article in the UK Journal, Psychologist, more than half of millennials phone, text, or email their parents nearly every day. Another 25 percent report contact several times a week.9 In Europe as in the United States, feelings regarding the future are not a generational issue, rather they are a cultural one. Data has shown both young and elderly Europeans see themselves as victims of fate, while young and old Americans alike see themselves as masters of their fate.10 The global population faces an impending transfer of wealth from parents to their children. Millennials and Generation Xers combined stand to inherit between $30 and $40 trillion dollars from the Baby Boomer generation.11 Millennials have a different set of values from their parents and grandparents. Young adults desire a double benefit which would include both a social and financial return. Influencing the Global Society, Business and Political Leaders Worldwide As of 2015, young professionals make up the largest portion of the workforce in the United

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Millennials want to make their money count and help others in the process. To engage millennials in impact investing, businesses need to identify what this population relates to and cares about. States accounting for more than 34 percent of all workers.12 This has created a powerful group who are changing the way businesses and political leaders think and work. One tool used by millennials is Influencer Marketing which combines with two other forms of marketing: Social-Media Marketing and Content Marketing.13 A huge component of influencer marketing has to do with social media. Because they are digital natives and grew up with the internet and have more social media savvy than other generations, millennials use a variety of social networks for receiving news and finding information, especially Facebook. Through using these social media outlets they learn about different points of views on local and worldwide topics and issues. The young adults of today use social media as a huge platform to voice opinions on investments and share news of companies who share their values. Roughly half or more of millennials in six of the seven European Union nations surveyed by the Pew Research Center in 2014 believe that “success in life is pretty much determined by forces outside our control”. This includes 63% of young Germans and Italians and 62% of young Greeks and Poles. (Brits were the exception, with only 37% of those ages 18 to 33 agreeing with that statement.) By contrast, slightly more than four-in-ten young Americans (43%) share this view.14 “Millennials believe social media can be their megaphone to make an impact on issues they care about. This group is

The European Financial Review August - September 2017

far more likely to use social media to address or engage with companies around social and environmental issues.”15 Millennials also use social media to show their disappointment. In 2014, former First Lady Michelle Obama launched her healthy eating campaign, Let’s Move! Students responded to their lunch food with the hashtag #ThanksMichelleObama and attached pictures of gross looking concoctions. The White House didn’t immediately comment but others weighed in stating that not all lunch meals looked like those from the pictures and that school lunches have been complained about for decades.16 Social media users also post about boycotting a product or company. On April 9, 2017, O’Hare International Airport police removed passenger David Dao from United Express Flight 3411. A video surfaced of an injured Dao being dragged off the flight. The hashtag #BoycottAmericanAirlines appeared followed by memes and jokes about the incident. AB InBev is a beer brewer in Belgium. Around the globe, their foundations support local communities where they operate. In the past 20 years the Anheuser-Busch Foundation in the US has contributed more than USD 573 million to charitable organisations. In Colombia, Fundación Bavaria has two main strategic goals: entrepreneurship and improving the quality of life in vulnerable communities and within Bavaria’s value chain.17 Research confirms that millennials and teens invest in products that give back. H&M stores have a recycling initiative

and will influence their peers through social media channels. It is a win-win situation for the business world and for future leaders of tomorrow.

where shoppers can drop off unwanted garments – no matter what brand and what condition – in all H&M stores across the globe. H&M Foundation has partnered with The Hong Kong Research Institute of Textiles and Apparel to develop technologies to recycle clothes made from textile blends into new clothes.18 One World Play Project is headquartered in Berkeley, CA with regional offices in Asia, South America and Africa. The company sells durable dog toys and soccer balls and also gives thousands of soccer balls and play resources to organisations working with youth in disadvantaged communities worldwide.19 TOMS Shoes is a popular company with a reputation for its various impact investments. Through the sale of shoes, TOMS provides shoes, sight, water, safe birth and bullying prevention services to people in need. The company works with over 100 different giving partners. BoGo Bowl also gives back after someone buys a product. BoGo Bowl sells dog food, and donates a bag to shelter animals for each bag purchased.20 To engage millennials in impact investing, many corporations encourage them to share posts and comment on social media such as posting online petitions or information on what companies are doing. Millennials want to make their money count and help others in the process. To engage millennials in impact investing, businesses need to identify what this population relates to and cares about. Millennials will want to invest more if they feel a connection

Blake Mycoskie, founder of TOMS Shoes, in the Misiones provinces of Argentina, giving away the company's 1 millionth pair of donated shoes, Sept. 2010 © Anonymous / Today

Marguerita M. Cheng is the Chief Executive Officer at Blue Ocean Global Wealth and Blue Ocean Global Technology. Prior to co-founding Blue Ocean Global Wealth, she was a Financial Advisor at Ameriprise Financial and an Analyst and Editor at Towa Securities in Tokyo, Japan. She is a CFP® professional, a Chartered Retirement Planning CounselorSM, a Retirement Income Certified Professional® and a Certified Divorce Financial Analyst. References 1. Ames, Eden (2017) Millennial demand for corporate social responsibility drives change in brand strategies. American Marketing Association. https://www.ama.org/publications/ MarketingNews/Pages/millennial-demand-for-social-responsibility-changes-brand-strategies.aspx 2. Strokes, Bruce (2015) Who are Europe’s millennials? Pew Research Center. http://www. pewresearch.org/fact-tank/2015/02/09/who-are-europes-millennials/ 3. Abhilash Mudaliar, Hannah Schiff, Rachel Bass, Rachel Mudaliar, Abhilash, Schiff, Hannah (2016) Annual Impact Investor Survey. Global Impact Investing Network. https://thegiin.org/knowledge/publication/annualsurvey2016 4. Global Impact Investing Network (2016) What you need to know about impact investing. https://thegiin.org/impact-investing/need-to-know/#s1 5. Schroders (2016) Schroders Global Investor Study 2016. http://www.schroders.com/ en/media-relations/newsroom/all_news_releases/schroders-global-investor-study-2016millennials-put-greater-importance-on-esg-factors/ 6. Standard Eurobarometer 82 (2014) Public opinion in the European Union, First results. http://ec.europa.eu/commfrontoffice/publicopinion/archives/eb/eb82/eb82_first_en.pdf 7. Strokes, Bruce (2015) Who are Europe’s millennials? Pew Research Center. http://www. pewresearch.org/fact-tank/2015/02/09/who-are-europes-millennials/ 8. Golden, Paul (2017) Where Financial Education Has the Greatest Impact. National Endowment for Financial Education. http://nefe.org/Press-Room/News/WhereFinancial-Education-Has-the-Greatest-Impact 9. Fingerman, Karen (2016). The ascension of parent–offspring ties. Psychologist. Vol 29 pp. 114-117 February https://thepsychologist.bps.org.uk/volume-29/february/ascension -parent-offspring-ties 10. Stokes, Bruce (2015) U.S. and European millennials differ on their views of fate, future. Pew Research. http://www.pewresearch.org/fact-tank/2015/02/10/u-s-and-european -millennials-differ-on-their-views-of-fate-future/ 11. Marston, Cam (2014) Great wealth transfer will be $30 trillion – yes, that’s trillion with a T. http://www.cnbc.com/2014/07/22/great-wealth-transfer-will-be-30-trillionyes-thatstrillion-with-a-t.html 12. Fry, Richard (2015) Millennials surpass Gen Xers as the largest generation in U.S. labor force. Pew Research. http://www.pewresearch.org/fact-tank/2015/05/11/millennialssurpass-gen-xers-as-the-largest-generation-in -u-s-labor-force/ 13. Newberry, Christina (2017) Influencer marketing on social media: Everything you need to know. Hootsuit. https://blog.hootsuite.com/influencer-marketing/ 14. Stokes, Bruce (2015) US. and European millennials differ on their views of fate, future. Pew Research. http://www.pewresearch.org/fact-tank/2015/02/10/u-s-and-european -millennials-differ-on-their-views-of-fate-future/ 15. New Cone Communications Research survey (2015) Research confirms millennials as America’s most ardent CSR supporters. http://www.conecomm.com/news-blog/new-conecommunications-research-confirms-millennials-as-americas-most-ardent-csr-supporters 16. Ferdman, Roberto (2014). School kids are blaming Michelle Obama for their ‘gross’ school lunches. Washington Post. November 24. https://www.washingtonpost.com/news/ wonk/wp/2014/11/24/students-are-blaming-michelle-obama-for-their-gross-schoollunches/?utm_term=.14fa9c7f4f06 17. Anheuser-Busch Inbev (2017) Better world. http://www.ab-inbev.com/ 18. H&M (2016) A four year global collaboration to develop industrial solutions and new technologies for textile recycling. https://about.hm.com/en/media/news/general-2016/ new-technologies-for-textile-recycling.html 19. One World Play Project (2016) https://www.oneworldplayproject.com/give-soccer-balls/ 20. TOMS Shoes (2017) Improving lives. http://www.toms.com/improving-lives

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Retirement

What’s Your Retirement Strategy? BY MARY STERK

There are three major areas of focus that contribute to a successful retirement: emotional readiness, health-related issues, and financial factors. Author Mary Sterk shares 5 key retirement questions that will arm you with essential knowledge to build a strategic plan so you can retire with confidence.

questions to ask yourself. The answers will arm you with essential knowledge to help build your strategic plan so you can retire with confidence.

reparing for retirement is exciting, but can also bring feelings of fearfulness as you are moving into new and uncharted territory. You may find yourself thinking, “I want to retire... slow down a bit... enjoy my life, my spouse, and my grandkids.” Then the questions begin to swirl. What if there is a major health issue? Or what if I run out of money? How much do I really need? Is it invested the best way? What if I have to go into a nursing home? There are three major areas of focus that contribute to a successful retirement: emotional readiness, health-related issues, and financial factors. A high level of retirement confidence comes from having your ducks in a row in all three of these areas. Solving one while ignoring the others is not a good plan. Strategically maximise them all, and your retirement years beckon. There are no do-overs in retirement, so it is important to be as educated and ready as possible before you trigger that special event. Although there are many good ways to set yourself up for success, you can’t un-pull the retirement trigger. You only get one shot at this. Here are 5 key retirement

Here are 5 key retirement questions to ask yourself. The answers will arm you with essential knowledge to help build your strategic plan so you can retire with confidence.

How will I spend my time? Retirement has been called the Golden Years, the Eternal Saturday, and the Final Chapter. Personally I don’t think any of those labels apply anymore. The retirement your grandfather desired probably consisted mostly of sitting on the front porch in his rocking chair, watching the world go by. While you are likely looking forward to time spent relaxing, the retirements of today are dramatically different and usually much more active than the retirements of yesteryear. Often, people simply have no idea how they will actually spend their time when they stop working. The questions begin to swirl again. What if I’m bored? What if my spouse gets sick of me hanging around the house? Once I get my list of projects done, what will I do next? Can I afford to do the things I actually want to do? Many retirees now seem to focus more on reinventing themselves and spending time doing what they love. Will you want to travel? Work part time? Pursue a passion? Launch a small business? Understanding how you want to spend your time is critical to planning the financial aspect of a strong retirement. Let me share Helen’s story with you.

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Helen spent her career as a distinguished college professor, teaching art history to young talented minds. Her love of both the old masters and contemporary artists created a learning environment for her students that inspired amazing work. She had spent time during her academic years creating her own art, but it was always sandwiched in when time allowed between her teaching job and raising a family.

Finding your own personal retirement mecca is well within your grasp. When you know the exact point in life when work becomes optional, you have reached the juncture where you can confidently retire – if you want to. When Helen was contemplating retirement, we spent time visiting about what really mattered to her. She discovered that she had a dual desire: to create beauty in the world, and to help the less fortunate living in third-world countries. Helen had saved around $500,000 in retirement accounts, and was able to design a strategy to include funding for both desires in her retirement plan. She allotted a set amount for studio space, gallery and show fees, and painting supplies, so she could create new art to brighten the world. She also included funds designated for charitable giving and travel expenses in her annual budget during the first five years of her retirement, so Helen could contribute to helping those in need. The time Helen took to dream ahead about how she wanted retirement to look and feel made all the difference. She solidified her emotional readiness by carefully considering what mattered most, and allocating resources to it. So here is your chance. What do you really want? I invite you to envision your future without judgement. This is not the time to worry about the “how” – you can flesh that out later. If your dream is to retire and open a bakery in Paris, don’t worry about the details of the work visa, focus on the taste of the chocolate pastry! I don’t know if you’ll be able to align your money with fulfilling every one of your dreams, but I do know that in order to try, you have to understand what those dreams are made of.

The European Financial Review August - September 2017

When can I confidently retire? From a financial standpoint, there is a moment when work becomes optional. This critical point is what I like to call the retirement mecca. Most people see this as an elusive, moving target. Finding your own personal retirement mecca is well within your grasp. When you know the exact point in life when work becomes optional, you have reached the juncture where you can confidently retire – if you want to. Yes, I said “if ” you want to. The beauty of work being optional is that you can choose to work, or you can choose not to. Inherent in the word “optional” is the concept of choice. When you reach the moment work has become optional, you can choose to continue working – but you don’t HAVE to. You can choose to slow down and work part time. Or you can choose to quit the job you’ve had for 20 years and pursue something that lights the fires of your passion... that thing you’ve been dreaming about all of these years. The bottom line is this: when work becomes optional, you no longer are a slave to the job. It’s a delicious level of freedom, and creating a strong strategy that identifies that elusive point can help you confidently make a change when you are ready. Identifying the “when” all comes down to our next question…

How much income each month will I need? There are many formulas out there to benchmark how much monthly income you may need, but there is no one “magic number”. Your amount should be aligned with the lifestyle you want to lead. The best way to determine this number is to look at your current spending patterns, and estimate what expenses will and won’t continue into your retirement years. If you can figure out how to align the income you have with the money you want to spend, you are well on your way to having arrived at your own personal retirement mecca. We have built a tool that can be a fabulous resource for you with this step – download our Retirement Spending Tool1 to help you answer this important question. I know this step can seem boring and tedious. But you can’t pinpoint the moment when work becomes optional until you look ahead and determine your future cash needs. Once you have answered this question, you will have the financial framework built for initial cash outflow during

your retirement. This is a critical piece of information that helps draw a connection between your emotional readiness and the financial components. This strategic planning connects how you want your retirement to look and feel to how much money you need to support that vision.

What are my health related risks during retirement? Some of the biggest issues that retirees face are expensive health insurance, personal medical issues, and high nursing home costs. It is important to evaluate each of these issues to understand how it can impact the success of your long-term retirement strategy. Your level of knowledge is either a strength or a weakness. Weaknesses include a lack of knowledge about the prices and your available options. Turn this into a strength by doing the research to determine your options and cost. Another weakness is not knowing if you have enough retirement assets or income to cover the cost of health insurance or a big health-related expense. Create a strength by filling out the Retirement Spending Tool with the insurance cost information, and setting aside a pool of emergency money to cover any deductible or out-of-pocket expense that could occur. Finally, a weakness would be not determining how a longterm illness or care need can impact your spouse. Turn this into a strength by determining how and when to insure against this risk if it is right for you. Don’t delay retirement because you are afraid you can’t afford to bridge the health issue gap – do your research to find out if you can.

How do I turn what I have saved into income? This is often the hardest part of preparing for retirement. You have spent your entire life saving for retirement, and it is a huge shift

Don’t delay retirement because you are afraid you can’t afford to bridge the health issue gap – do your research to find out if you can.

to actually begin using what you have saved. Certain types of investments are better suited for monthly income, while others are geared more towards long term growth. Ideally, you want income sources that are designed to last your lifetime to be large enough to cover your fixed expenses. If the sources last a lifetime, than you can confidently know your basic needs are covered for a lifetime. See how that works? What if there are not enough income sources? Then it may make sense to take a portion of your retirement portfolio and invest it in a way that creates additional fixed income. This can be done through a variety of investment vehicles such as CDs, certain types of bonds, annuities, etc. Talk to an advisor who specialises in retirement income strategies to learn more about the best options for your portfolio. Sounds easy when you boil it down to just those five questions. But this is where it begins to get complex; each step has nuances and considerations that are unique to you. The ultimate goal in your final strategy is to build upon your strengths, shore up the gaps that can cause problems, and structure things in a way that allows you to protect and grow what you have built. A strong retirement plan can lay the groundwork for a successful retirement lifestyle, but only you can make the final decision. Answering these questions and building a strategy can help you decide if you are truly ready to retire with confidence. Happy retirement planning!

Mary Sterk, CFP ®, is the owner of Sterk Financial Services (www. sterkfinancialservices.com) in Dakota Dunes, SD. Mary is the author of Ready To Pull The Retirement Trigger? Her podcast, Money Guide With Mary Sterk, educates and inspires listeners to create their best financial future. Note 1. http://www.sterkfinancialservices.com/p/toolkit

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Banking

Strategic ALM and Integrated Balance Sheet Management:

The Future of Bank Risk Management BY MOORAD CHOUDHRY

The traditional approach to asset-liability management (ALM) practice in banks operated as a reactive process following product origination by the customer-facing business. In the Basel III era a more proactive approach to ALM is required, in order to manage the balance sheet from an effective viability and sustainability standpoint. The article describes proactive “Strategic ALM” discipline and its implementation process.

anks are by their nature risk taking institutions. This is a requirement of their business, because their corporate clients may wish to tailor their funding to meet the precise needs of their business, so as to achieve some certainty in this area, enabling them to focus on what they do best. Similarly, retail clients may wish to access banking products and services to meet their personal needs, such as purchasing a house or investing for a child’s education. To meet this demand, banks offer the lending terms, maturities, rate options, currency, optionality, and contingencies demanded by their clients, and take on the range of risks that such

Failure to have sufficient funding results in the bank having to rely on central bank liquidity, poor market perception and loss of investors, which could ultimately lead to failure. Thus, ALM becomes the most important aspect of a bank’s risk management framework.

tailoring represents. Because banks have a wide range of clients with varying borrowing and deposit requirements, exposures may to some degree offset each other, but will not match completely in terms of timing, amount and currency. This is more evident as products become more complex and offer more alternatives. Therefore a key area of focus for banks is managing their capital, funding, liquidity and interest-rate risk requirements. These all fall under the umbrella of the asset-liability management (ALM) discipline in a bank. When a bank borrows more than it needs, there can be inefficiencies in terms of capital use. This can also result in added interest rate risk, and a loss when lending on. However, failure to have sufficient funding results in the bank having to rely on central bank liquidity, poor market perception and loss of investors, which could ultimately lead to failure. Thus, ALM becomes the most important aspect of a bank’s risk management framework. In this article we suggest that the discipline of ALM, as practised by banks worldwide for over 40 years, needs to be updated to meet the challenges presented by globalisation and Basel III regulatory requirements. In order to maintain viability and a sustainable balance sheet, banks need to move from the traditional “reactive” ALM approach to a more proactive, integrated balance sheet management framework. This will enable them to solve the

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Banking

multi-dimensional optimisation problem they are faced with at present.

changes to the shape of the yield curve in the short and medium term will impact the bank. • The maturity profile of the banking book: ALM would report and monitor the maturities of all asset and liabilities to measure and control risk • Interest rate risk, essentially the risk of loss of net interest income due to adverse movements in interest rates or interest rate spreads. In essence however, ALM as undertaken in all banks has always been a reactive process, and despite its name has rarely, if ever, managed to integrate origination policy across both sides of the balance sheet. As a discipline, such an approach is no longer fit-for-purpose in the era of Basel III.

The Origins of Asset-Liability Management (ALM) Historically, interest rates were stable and liquidity was readily available to banks in developed nations. Banks focussed primarily on generating assets to increase growth and profitability. However, in the 1970s changes in regulation, inflation, and geopolitics led to greater volatility and thus increased risk from asset and liability mismatches (see Figure 1). This led to the development of Asset-Liability Management (ALM) as a formal discipline, where both sides of the balance sheet are integrated to manage interest rate, market, and liquidity risk. In essence however, this discipline remained reactive in nature, with Treasury and Risk having little or no input to the origination and deposit raising process. Traditionally, ALM was defined by four key concepts: • Liquidity, defined as: º Funding liquidity: the continuous ability to maintain funding for all assets Trading liquidity: the ease with which assets º can be converted into cash • Term structure of interest rates: the shape of the yield curve at any given time depends on interest rate expectations, liquidity preference, and supply and demand from different borrowers and lenders. ALM strategy would consider how

Figure 1: US Treasury yields and US inflation historical levels 16.0 14.0

Inflation 10-Year Treasuries

Rates

12.0 10.0 8.0 6.0 4.0 2.0 0.0

June ’68

Feb. ’82

Oct. ’95

Month Source: St. Louis Fed.

The European Financial Review August - September 2017

July ’09

The Strategic ALM Concept Consider exactly how ALM is undertaken in virtually every bank today, irrespective of size, business model or location. A business line in a bank, following an understood medium-term “strategy” articulated either explicitly or implicitly (but in reality aiming usually simply to meet that year-end’s budget target), goes out and originates customer business, be this originating assets or raising liabilities. It will most likely have little interaction with any other business line, and only the formal review interaction with the Risk department. This is often described as creating a “silo mentality” in the organisation, and is typical of all but the very smallest banks. In some banks an individual business line may have practically zero interaction with Treasury. In this respect it will be similar to all other business lines. Each of these business lines will proceed to undertake business, ostensibly as part of a grand strategy intertwined with other business lines, but in reality to a certain extent in isolation. The actions of all the customer-facing desks in the banks will then give rise to a balance sheet that must be “risk managed”. And the ALM part of this risk management process is then undertaken by Treasury, in conjunction with Finance and Risk. There is little, or no, interaction between business lines and little, or no, influence of the Treasury function or the risk “triumvirate” of Treasury, Finance and Risk in the balance sheet origination process. In other words, ALM is a reactive, after-the-fact process. The balance sheet shape and structure is arrived at, if not by accident certainly not by active design and certainly not as the result of a process

that integrates assets and liabilities origination. The people charged with stewarding the balance sheet through the economic cycle and market crashes have very little to do with creating the balance sheet in the first place. Does this represent best-practice risk management discipline, with separation of duties, four lines of defence, and so on? In a word, no. There is no problem with one department originating assets and another one managing the risk on them. The issue with the traditional approach to ALM is that the balance sheet that is arrived at often lacks a coherent shape, or logic, and this makes the risk management of it more problematic. One would not wish to have a balance sheet that was composed overwhelmingly of illiquid long dated assets funded by wholesale overnight deposits, or a liabilities strategy that concentrated on raising wholesale or corporate funding that was treated punitively by Basel III liquidity requirements. Another example observed by the author involved the funding of trade finance assets (overwhelmingly very short term) by 10-year MTNs.1 In the era of Basel III, it is evident that balance sheet risk management must become more proactive. The shape and structure of the balance sheet must be arrived at because of an integrated approach to origination. What does this mean? Quite simply, the discipline of ALM must recognise that asset origination and liability raising has to be connected. For the ALM process to be fit-for-purpose for the 21st century, banks must transition and adapt from a traditional reactive ALM process to a proactive strategic ALM process. Addressing the three-dimensional (3D) balance sheet optimisation problem. The market environment is creating a 3D optimisation challenge for banks, or at least those banks that are serious about competing and serious about being wellrespected by customers and peers. This challenge requires banks to run optimised balance sheets in order to maximise effectiveness and stakeholder value; however when we speak of “balance sheet optimisation” we do not mean what it used to mean in the pre-crash era, basically working to maximise return on capital (RoC). Today optimising the balance sheet has to mean structuring the balance sheet to meet the competing but equivalent needs of Regulators, Customers and Shareholders. This is the 3D optimisation challenge that we speak of.

1. These illustrations are made to emphasise a point, but they are a few of the very many examples observed by the author at different banks over the years.

Figure 2: Mitigating the Impacts of Basel III

Increase Resources to Achieve Compliance • Increase holdings of Liquid Assets • Increase Capital

Decrease Risk

• Adopt more sophisticated calculation methodologies (Standardised to Advanced) • Hedging (e.g. CDS) • Exit business lines

Manage Balance Sheets more efficiently

Re-Design Customer Offering

• Restructure transactions with customers • Re-design products • Review product pricing • Exit business lines

• Restructure and/or Collapse legal entities • Improve data collection processes

A bank’s risk management practice is an integral part of meeting this optimisation challenge. From the Board level downwards, policy must be geared towards achieving this goal, and strategic ALM is a vital part of the optimising process. However before we consider this let us refresh the regulatory aspects first. We will not cover the myriad requirements of Basel III capital, liquidity and leverage requirements here, which are discussed in depth in other publications. The essence of implementing the demands of Basel III as stipulated by regulators is that many bank’s business models will have to change, to ensure compliance. Figure 2 illustrates this in stylised fashion. The inescapable conclusion since the bank crash of 2008 is that banks must manage their balance sheet more efficiently. This gives rise to the 3D optimisation problem. We articulate it thus: Regulator requirements: banks must adhere to the capital, liquidity and leverage ratio requirements of their regulator. With only a handful of exceptions, this means meeting the demands of the Basel III guidelines. The larger the bank, and/or the more complex its business model, the more complicated and onerous this requirement becomes. Related stipulations such as the Fundamental Review of the Trading Book (FRTB) add to the regulatory demands imposed on banks. Every bank must meet its supervisory requirements; Customer franchise requirements: this is not necessarily anything new. In a competitive world, any bank would always wish to meet the demands of its customers. In a more

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Banking

Implementing a strategic ALM process will make it more likely that the bank’s asset type(s) is relevant and appropriate to its funding type and source, and vice versa. constrained environment this requirement becomes more urgent of course, and this gives rise to the challenge. For instance, a “full service” bank will wish to provide all the products that its customers may demand, and sometimes these products will not be the most optimum from the viewpoint of (1) above. To illustrate one case: the deposits of large corporate customers and non-bank financial customers are considered “non-sticky” under Basel III rules and so carry a greater liquidity cost for banks. From that perspective such deposits are not optimum from a regulatory efficiency view, but the bank must accept them if it wishes to satisfy this part of its customer base; Shareholder requirements: this aspect is of course also not new. The shareholder has always demanded a satisfactory rate of return, and so all else being equal a bank will always want to maximise its net interest income (NII) and enhance or at least preserve its net interest margin (NIM) through changing economic conditions and interest rate environments. But of course the balance sheet mix that meets this objective will not necessarily be the one that is most efficient for (1) and/or (2) above. One example: from a NII perspective a bank will maximise its funding base in non-interest bearing liabilities (NIBLs) such as current accounts (“checking” accounts) or instant access deposit accounts, whereas the demands of Basel III liquidity will often call for an amount of contractual long-term funding, which is more expensive and thus inimical to NII. We see therefore that the demands of each stakeholder are, in a number of instances, contradictory. To maximise efficiency a bank will need to work towards a balance sheet shape and structure that is optimised towards each stakeholder, and it is not a linear problem. Hence, the 3D optimisation challenge arises. This illustrates unarguably the need for a new approach to balance sheet origination and the role of

The European Financial Review August - September 2017

the ALM function. This we term “strategic ALM”. Principles of strategic ALM practice. Strategic ALM is a single, integrated approach that ties in asset origination with liabilities raising. It works to break down “silos” in the organisation, so that asset type is relevant and appropriate to funding type and source, and vice versa. We define it as follows: A business strategy approach at the bank-wide level driven by balance sheet ALM considerations. Strategic ALM addresses the three-dimensional optimisation problem of meeting with maximum efficiency the needs of: • the regulatory requirements • the NII requirements • the customer franchise requirements and must be a high-level, strategic discipline driven from the top down. It is by nature proactive and not reactive. Implementing a strategic ALM process will make it more likely that the bank’s asset type(s) is relevant and appropriate to its funding type and source, and that its funding type and source is appropriate to its asset type. By definition then it would also mean that a bank produces an explicit, articulated liabilities strategy that looks to optimise the funding mix and align it to asset origination. Thus, strategic ALM is a high-level, strategic discipline driven from the top down. Proactive balance sheet management (BSM) is just that, and not the “reactive” balance sheet management philosophy of traditional banking practice. Proactive BSM means the asset-side product line is managed by a business head who is closely aligned (in strategic terms) with the liabilities-side product line head. To be effective the process needs to look in granular detail at the product types and how they are funded/deployed; only then can the bank start to think in terms of optimising the balance sheet. Implementing strategic ALM practice is not a trivial exercise, and can only be undertaken from the top down, with Board approved instruction (or at least approval). Hence we consider an essential prerequisite, which is the Board articulated risk appetite statement, followed by a look at the importance of ALCO. Implementing Strategic ALM The approach to implementing an effective strategic ALM practice has several strands. We describe each in turn.

Recommended Risk Appetite Statement. The Risk Appetite Statement is an articulated, explicit statement of Board appetite for and tolerance balance sheet risk, incorporating qualitative and quantitative metrics and limits. It becomes the most important document for Board approval. This may appear to be a contentious statement but it is self-evident when one remembers that the balance sheet is everything. The over-riding objective of every bank executive is to ensure the long-term sustainability and viability of the bank, and unless the balance sheet shape and structure enables this viability, achieving this objective is at risk. Figure 3 shows a template summary risk appetite statement drafted by the author when he was Treasurer at a medium-sized commercial bank. This statement received Board approval. It is applicable to virtually all banking entities irrespective of their business model, although large multinational banking institutions will need to develop the list of risk metrics much further. It provides a formal guide on the desired Board risk appetite framework, including a description of each of the risk appetite pillars and the key measures that will be used to confirm on a monthly basis that the bank is within risk appetite. As we see from Figure 3, for each of the measures identified an overall bank-wide “macro-tolerance” is set, which is then broken down into tolerances for individual business

lines (e.g. Retail, Corporate). The range of quantitative limits is user-defined; for example, in the section on liquidity limits: • a vanilla institution with no cross-border business may content itself with setting limits for the primary liquidity metrics such as loan-deposit ratio and liquidity ratios, as well the regulatory metrics such as LCR and NSFR; • a bank transacting across currencies will wish to also incorporate FX exposure tolerance; • a bank employing a significant amount of secured funding will wish to add asset encumbrance limits. The Board risk appetite statement is the single most important policy document in any bank and should be treated accordingly. It requires regular review and approval, generally on an annual basis, or whenever changes have been made to the business model and/or customer franchise. It also should be updated in anticipation or in the event of market stress. Armed with the Board risk appetite statement, which must be a genuine “working” document and not a list of platitudes, with specific quantitative limits, the implementation of a strategic ALM process becomes feasible. As well as the Board risk statement, the other ingredient that is required to make strategic ALM a reality is an asset-liability committee (ALCO) with real teeth. One cannot emphasise enough the paramount importance of a bank’s ALCO.

Figure 3: Example Board Risk Appetite Statement Strategic Objective ABC Bank aims to become the Commercial Bank that is respected and trusted by all its stakeholders providing “concierge banking services for ultimate customer service quality", through: committed people; recognising that our long term sustainability is dependent on having sufficient capital and liquidity to meet liabilities as they fall due through the cycle; the protection of our reputation; and the integrity of our relationship with our customers and wider stakeholders. Target Credit Rating Credit rating in line with ABC Bank’s closest peers and country bank average (A/A-) Capital Adequacy

Risk Appetite Pillars Stable Earnings Growth Liquidity & Funding

Stakeholder Confidence

Maintain sufficient capital, quantity and quality, substantially over Regulatory minimums, to cover existing projected risks in extreme but plausible scenarios

Be an agile, sustainable UK Retail and Corporate bank that has stable and efficient access to funding and liquidity, and hence is able to withstand appropriate liquidity related stress, with relevant liquid asset holdings.

Be an agile, sustainable UKK Retail and Corporate commercial bank that is respected and trusted by all its stakeholders and hence maintains stakeholder confidence at all times.

1. CT1 ratio 2. Leverage ratio 3. Available capital 4. Capital buffer minimum over regulatory requirement (ICG)

1. Earnings volatility 2. Return on Capital 3. Return on RWA 4. Cost to income ratio

1. Loan to deposit ratio 2. HQLA buffer minimum 3. Concentration risk 4. NSFR minimum 5. Wholesale funding limits 6. Internal funds pricing regime

Be an agile, sustainable UK Retail and Corporate commercial bank that maintains its capital adequacy in terms of amount and quality, and hence is able to withstand appropriate capital related stress. 1.Employees 2. Regulators 3. Investors 4. Customers 5. Ratings agencies

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Banking

Given this, what is the most effective way to ensure above-satisfactory and effective governance from Board perspective? Elements of Strategic ALM: paramountcy of ALCO. Consider the executive committees, below Board level, that are responsible for the strategic direction as well as the ongoing viability and sustainability of the bank. Which of them has responsibility for oversight of balance sheet risk? Perhaps it is one or more of the following: • Executive committee (or “management committee”): this is the primary committee responsible for running the bank, chaired by the CEO; • Risk management committee: chaired by the CRO, responsible for “managing” all the risk exposures the bank may face, from market and credit risk to technology risk, conduct risk, regulatory risk, employee fraud risk, etc.; • Credit risk committee: chaired by the head of credit or the credit risk officer, this committee is responsible for managing credit policy including credit risk appetite, limit setting and credit approvals. As credit risk is the single biggest driver of regulatory capital requirement in banks (in some vanilla institutions representing 75%-80% of total requirement) it can be seen that the credit risk committee is also a balance sheet risk committee; • ALCO: the asset-liability committee, a template Terms of Reference for which were described in the author's text The Principles of Banking. While all of these committees have an element of responsibility for the bank’s balance sheet, it is the ALCO that is responsible for this and nothing

else. It alone has the bandwidth to discharge this responsibility effectively and to help ensure that the balance sheet shape and structure is long-term viable. The executive committee that is most closely concerned with balance sheet risk on a strategic and integrated basis (both sides of the balance sheet and all aspects of risk) is ALCO. Given this, what is the most effective way to ensure above-satisfactory and effective governance from Board perspective? We suggest that it is to ensure the paramountcy of ALCO, as illustrated in the organisation chart given at Figure 4. The key highlight of the structure shown at Figure 4 is that ALCO ranks pari passu with the ExCo and that it also has an oversight role over the Credit Committee. The former ensures that balance sheet strength and robustness is always given equal priority with shareholder return, and the latter ensures that ALCO really does exercise control over the assets and liabilities on the balance sheet, as suggested in its name. For instance, it would be ALCO, and not ExCo or the Risk Committee, that

would design, drive and monitor the bank’s early warning indicator (EWI) metrics, as it would be the committee with the required expertise and understanding of the balance sheet. With this structure in place, implementing strategic ALM practice can become a reality. Elements of Strategic ALM: integrated balance sheet origination. At its heart the objective of the strategic ALM process is to remove the “silo mentality” in place at banks in order to ensure a more strategically coherent origination process. This will help the bank to arrive at a balance sheet shape and structure more by design than by well-intentioned accident. In the first instance, a bank’s liquidity and funding policy should not be concerned solely with its liabilities. The type of assets being funded is as important a consideration as the type of liabilities in place to fund those assets. For a bank’s funding structure to be assessed on an aggregate balance sheet approach, it must measure the quality and adequacy of the funding structure

Figure 4: Recommended Bank Executive Committee Organisation Structure

Board

Deposit Pricing Commitee / Product Pricing Commitee

Executive Commitee

ALCO Balance Sheet Management Commitee

Credit Risk Committee

The European Financial Review August - September 2017

(liabilities) alongside the capital and asset side of the balance sheet. This gives a more holistic picture of the robustness and resilience of the funding model, in normal conditions and under stress. The robustness of funding is as much a function of the liquidity, maturity and product type of the asset base as it is of the type and composition of the liabilities. Typical considerations would include: • Share of liquid assets versus illiquid assets • How much illiquid assets are funded by unstable and/or short-term liabilities • Breakdown of liabilities: ° Retail deposits: stable and less stable ° Wholesale funding: secured, senior unsecured ° Capital: subordinated / hybrid; equity As part of an active liabilities strategy, on the liability side ALCO should consider: • Debt buy-backs, especially of expensive instruments issued under more stressful conditions at higher coupon; • Developing a wide investor base • Private placement programme • Fit-for-purpose allocation of liquidity costs to business lines (FTP) • Design and use of adequate stress testing policy and scenarios • Adequate risk management of intraday liquidity risk • Strong public disclosure to promote market discipline On the asset side, strategic action could include: • Increasing liquid assets as share of the balance sheet (although liquidity and ROE concerns must be balanced) • De-linking the bank – sovereign risk exposure connection ° The LCR HQLA does not have to be exclusively sovereign debt, but claiming a “shortage” of eligible assets is disingenuous: the HQLA can be exclusively cash • Avoiding lower loan origination standards as the cycle moves into bull market phase • Addressing asset quality problems. ° Ring-fence NPLs and impaired loans? (A sort of “non-core” part of the balance sheet that indicates you are addressing the problem and looking at disposal) • Review the bank’s operating model. Retail-wholesale mix? Franchise viability? Comparative advantage? • Limit asset encumbrance: this contradicts pressure for secured funding In essence, as far as possible a bank’s balance sheet should aim to maximise those assets and liabilities that hit the yellowshaded “sweet spot” shown in the Venn diagram at Figure 5, where the requirements of all three stakeholders are served. Of course, a “full service” commercial bank will still need to offer loan and deposit products that meet customer needs but may be less optimum from a regulator or shareholder

Figure 5: Product Mix Optimisation

requirement perspective. This is the nature of banking and must be accepted. Nevertheless for efficiency and optimisation reasons, the process of strategic ALM is still needed so as to ensure maximisation of the origination of assets and liabilities that cover off all three stakeholder needs, and minimisation of the origination of product types that meet the needs of just one or two stakeholders. We emphasise strongly one of the bullet points above, namely: Strong public disclosure to promote market discipline. A bank that discusses the structure and strength of its balance sheet is assisting the industry as a whole, as regulators point to it (off the record, it is unlikely that a bank supervisor would make this point formally) as a benchmark and as its peers look to it when comparisons are made by analysts. We present at Figure 6 (see next page) a summary highlevel asset-liability policy guide, to be followed as part of the strategic ALM process. Conclusions Bank assets and liabilities are inextricably linked. Banks cannot manage risk and return without considering both sides of the balance sheet at the same time and continuously throughout the business origination process. All areas of the bank must come together to understand

ALM is an all-encompassing discipline and one that should be understood by all senior bankers, particularly the executive committee. www.europeanfinancialreview.com

Banking

Figure 6: Summary of Asset-Liability Policy Guide

ALCO Oversight of Balance Sheet Assets

Liabilities

Strong asset quality, based on resilience of (i) borrowers and (ii) collateral value

Diversity of funding by (i) investors (ii) instruments (iii) geography (iv) currency where appropriate

Adequate share of genuinely liquid assets (liquid in times of stress)

Stability of retail and wholesale investor base, based on (i) their investment constraints and preference (ii) their resilience (iii) their behaviour

Reduced/limited leverage

Maintaining mismatches by (i) maturity and (ii) currency between assets and liabilities to what is manageable through the cycle. Understand the potential risk exposure in times of stress

Minimise asset encumbrance

Adequate level of capital buffer

"Simple" assets and appropriate disclosure/ documentation

Minimise use of complex funding instruments

interest rate and liquidity risks in setting and pursuing high level strategy. Traditionally ALM meant managing liquidity risk and interest-rate risk. But this isn’t full ALM if what one wishes to manage is all the assets and all the liabilities from one integrated, coherent aggregate viewpoint. The balance sheet is everything – the most important risk exposure in the bank. Managing ALM risk on the balance sheet therefore is managing everything that generates balance sheet risk. Proactive ALM or what we call “Strategic ALM” is self-evidently best-practice in the Basel III environment, where one can’t expect to originate assets and raise liabilities in isolation from each other and still “optimise” the balance sheet. We have addressed a number of factors with respect to implementing strategic ALM, from a high-level standpoint. The correct approach to ALM discipline demands a keen appreciation and understanding of other related factors, including: • product type and behaviour; • behavioural tenor characteristics of assets and liabilities (something required to some depth now anyway with implementation of Basel III); • relevant reference interest rate benchmarks; • the Libor-OIS spread, the Libor term premium and determinants of the swap spread;

The European Financial Review August - September 2017

as well as other related aspects such as peer benchmarking and understanding net interest margin (NIM) behaviour. ALM is an all-encompassing discipline and one that should be understood by all senior bankers, particularly the executive committee. In the Basel III era, in order to meet the 3D optimisation challenge faced by banks one must seek to achieve maximum balance sheet efficiency, and that calls for the risk “triumvirate” of Treasurer, CFO and CRO, operating through ALCO, to have a bigger influence in origination and customer pricing. This is now the future of risk management practice in banks. Without this approach, it will be difficult to optimise the asset-liability mix that addresses the “3D” problem of regulatory compliance, NIM enhancement and customer franchise satisfaction.

Professor Moorad Choudhry lectures on the MSc Finance Programme at University of Kent Business School. He was previously Treasurer, Corporate Banking Division at The Royal Bank of Scotland, and is author of The Principles of Banking.

Tax

What Europe’s Big Soccer Tax Evasion Cases Should Teach All Taxpayers BY ROBERT WOOD

Cristiano Ronaldo stands accused of tax evasion, and Lionel Messi was convicted. Yet their tax evasion cases hold lessons for most taxpayers with smaller incomes and less complex lives.

axes have become a curious spectator sport. We all must pay them, and everyone has an interest in keeping their taxes as low as they can. Everyone knows that how you structure your affairs will impact your taxes. And celebrities are often in the hot seat, even facing potential criminal liability if the authorities say they have gone too far. Real Madrid’s Cristiano Ronaldo, the world’s highest paid athlete, stands accused of tax evasion. Like fellow soccer star Lionel Messi – who was already convicted of tax fraud – Ronaldo’s tax case is mostly about image rights and allegedly using shell companies to divert income away from tax authorities. These might sound like unique, multi-million dollar issues having nothing to teach regular-old taxpayers. However, these cases contain surprisingly universal lessons. Hiding things nearly always looks bad. For Messi and his father, Spanish prosecutors focussed on secrecy. The names of the beneficial owners of companies were hidden. The Messis

Hiding things nearly always looks bad. For Messi and his father, Spanish prosecutors focussed on secrecy.

had companies registered in the UK, Switzerland, Uruguay and Belize. They were designed to avoid taxes on 4.16 million euros of Messi’s income from image rights. It did not help that Messi’s name also surfaced in the Panama Papers. Prosecutors allege that Ronaldo refused to provide Spanish tax authorities with complete accountings of earnings associated with his image rights. Prosecutors claim that Ronaldo used an off-shore company, Tollin, to hide his income from tax authorities. They allege that Ronaldo filed tax returns that understated his income, defrauding Spain out of 14.7 million euros between 2011 and 2014. Ronaldo’s agency, Gestifute, released a statement that off-shore structures are common for soccer players, and that Ronaldo’s intent was always to comply with Spanish tax laws. For Americans, the IRS requires worldwide reporting and disclosure, and the consequences of noncompliance can be severe. FATCA, the Foreign Account Tax Compliance Act, requires foreign banks to reveal American accounts holding over $50,000. With a treasure trove of data, the IRS now has the ability to check. Advisers and accountability matter too. Messi’s father Jorge may have had a much larger role than his son in setting up the chain of shell companies at the root of the criminal charges. The athlete’s prison

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Tax

term was upheld at 21 months, but, his father’s term was reduced to 15 months for his cooperation. “Be accountable, and be transparent”, are surprisingly universal lessons, and certainly apply to America’s tax system. Signing a tax return requires some accountability. One of Messi’s primary defenses in the trial was that he did not understand. He said he signed many documents without reading them. Such a defense may not work in the US either. According to the IRS, willfulness is a voluntary, intentional violation of a known legal duty. It is shown by your knowledge of reporting requirements, and your conscious choice not to comply. Even willful blindness, a conscious effort to avoid learning about reporting requirements, is enough. Prosecutors suggested that fit Messi. As the steps that led Messi to be convicted and Ronaldo to be accused are picked over by commentators, accountability and transparency are key. If there are good reasons to hide your ownership from the public, make sure the ownership is not hidden from the government. Moreover, be careful about deals that appear to be almost entirely tax motivated. For Ronaldo, prosecutors point to a large payment for image rights days before a Spanish tax law named for David Beckham Law was repealed in December 2014. The deal involved money for Ronaldo’s image rights from 2015 to 2020. Given

the facts, it may be hard for Ronaldo to say that he did not understand, or is ignorant of tax laws. In virtually any tax system, everyone with income above a certain level must file a return. And in many cases – certainly with the IRS – you must sign tax returns under penalties of perjury. Maddeningly, the line between creative tax planning and tax evasion can be less clear than you might think. Moreover, one can be prosecuted for failure to file, or for filing falsely. Famously, actor Wesley Snipes was convicted of three misdemeanor counts of failing to file tax returns. Filing falsely is a felony. As Snipes’ misdemeanor convictions show, failing to file carries smaller penalties than filing fraudulently. Snipes was one of the more high-profile criminal tax defendants in recent memory, facing prosecution on multiple serious felony tax evasion counts. In the end, it was a partial victory for Snipes, since he defeated the more serious felony counts. But he got prison time, reporting to jail on December 9, 2010. He was released in April 2013. Many tax defendants who do sign and file tax returns try the, “I didn’t read it” defense. American courts have consistently ruled that taxpayers have a duty to read their returns to ensure that all income items are included. Since as early as 1928, US courts have held that even if all data is furnished to the return preparer, the taxpayer still has a duty to read the return and make sure all income items are included. See Mackay v. Commissioner, 11 B.T.A. 569 (1928). In the US, most criminal tax cases come out of plain old civil audits. That fact alone is frightening. If an IRS auditor discovers something suspicious in a civil audit, the auditor can notify the IRS’s Criminal Investigation Division. Notably, the IRS is not obligated to tell you that this criminal referral is occurring. In fact, normally, the civil auditors will suspend the audit without explanation. You might be pleased, thinking that the audit is over, or at least mercifully stalled so that it might not ever resume.

The IRS is vast and imposing, but there is a discrete part of it that is criminal and not civil. If you are visited by an IRS Criminal Investigation Division Special Agent, you should consult with an attorney. You are not legally required to talk to them. 64

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Meanwhile, the IRS can be quietly building a criminal case against you. One big mistake is omitting income. Whether you receive IRS Forms 1099, W-2, K-1, or no reports at all, report all your income. If omissions of income are significant and do not appear to be unintentional, watch out. Excess or aggressive deductions are less likely to be viewed as seriously, but some of this is a question of degree. False statements to the IRS are also a huge mistake. Conduct during the audit itself can be pivotal, and is one reason to hire professionals to handle it. Some of the allegations against Ronaldo relate to conduct during the audit. The IRS is vast and imposing, but there is a discrete part of it that is criminal and not civil. If you are visited by an IRS Criminal Investigation Division Special Agent, you should consult with an attorney. You are not legally required to talk to them. In fact, the Fifth Amendment to the US Constitution guarantees your right against selfincrimination. That means you can’t be compelled to be a witness against yourself in a criminal case. You might assume that by answering a few simple questions you will not hurt yourself or your position – especially if you are just a witness. Regardless of how adept you are at communication, speaking up may actually help the IRS build a criminal case against you. The IRS may (quite honestly) tell you that you are not the target of the investigation but merely a witness.

Maddeningly, the line between creative tax planning and tax evasion can be less clear than you might think.

Even so, you are entitled to retain counsel. In the early stages of IRS criminal investigations, a person may be told he or she is a witness. You might think there is no harm in talking, that your cooperation will make it more likely that the IRS will appreciate you and leave you alone. Be careful. As the investigation continues, a witness can become a target. Even if you are convinced you are merely a witness and will remain so, the US Supreme Court has ruled that you have the right to assert your constitutional privilege against self-incrimination. See Bellis v. United States, 417 US 85 (1974). The danger of getting flustered and misspeaking can be real. Particularly given the fluid nature of who is a witness and who is a target, statements you think sound innocent may not be. Suppose you are simply asked if you do business with Joe or know Sally? If you answer falsely, you may face felony charges. See 18 U.S.C. Sec. 1001. Making a false statement can also be considered evidence of an attempt to conceal other criminal conduct. These risks can make it wiser to politely decline to answer questions, and have your attorney do so. Big soccer stars and others in the limelight may be bigger targets. They may have much more income on their tax returns. But there are sobering lessons for all of us in these cases.

Robert W. Wood is a Tax Lawyer representing clients worldwide from offices at Wood LLP, in San Francisco (www.WoodLLP.com). He is the author of numerous tax books, and writes frequently about taxes for Forbes, Tax Notes, and other publications. This discussion is not intended as legal advice.

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Conquering Europe Through a Joint Innovation Strategy: How Huawei Blends Cultural Revolution and Customer-Centric Principles BY MANUEL HENSMANS

New business strategies have been emerging in the face of globalisation. In this article, Manuel Hensmans tackles how Huawei is successfully conquering Europe through joint innovation centres, cultural revolution principles and a customer-centric attitude.

he Chinese telecommunications company Huawei is one of the first emerging market multinationals to obtain a leadership position in a strategic technology industry in the

West. To do so Huawei has refined a strategy in Europe that it first developed successfully in China: a joint innovation strategy with leading customers and governments. Less than a decade after the company was founded in 1987, Huawei announced that it wanted to become one of the world’s leading players in telecommunications. From the beginning, it recruited talented engineering graduates from top Chinese universities with competitive salaries and employee bonuses, and made it a point to invest

10% or more of its sales in R&D projects as a way of competing with Western companies. Huawei’s strategy in China started by targetting rural townships far from the centres of power and multinational attention. Local operators, hotels and factories needed customised networking gear and central office switches that could operate under local conditions such as poor transmissions quality. As Huawei could not obtain capital from banks at that point, its earliest R&D efforts focussed on customised, costeffective solutions. By making the necessary investments to address their customers’ requirements, Huawei was able to overcome barriers to entry that typically stood in the way of private companies. Local bureaucrats operating far from the centres of capital and power began to see Huawei as an important vehicle for public-private cooperation. Through its work with local operators in China, Huawei learned how to join up with partners (including governments) with a very specific business model: provide customised telecommunications solutions through

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Innovation

customer collaborations that enable a sharing of innovation risks and revenue streams. Eventually, it was able to leverage its business model capability to gain a foothold with China’s largest telecom customers in the major cities. Huawei then applied the same strategy it used to build its market position in China in Europe, formalising it’s approach through joint innovation centres. Culturally, Huawei’s joint innovation strategy blends Chinese cultural revolution principles (constant struggle to improve, everyone shares in benefits and burdens,2 working from the periphery to the centre) with Western customercentric principles. STAGE 1: Offer Customised Technologies that Meet the Practical Needs and Resource Constraints of Target Customers Anticipating significant customer and government barriers to entry in Western European markets, Huawei started sending employees there from 2001. Their first breakthrough occurred in 2004 when Telfort B.V., a mobile telecommunications provider based in Amsterdam, started working with them. Through this collaboration, Huawei was able to produce a distributed base station that costed less and required less energy to operate than traditional ones. In order to win this deal, Huawei had to present a low-risk alternative to what the established vendors provided. It achieved this by offering free testing and technical support. The hardware itself was often priced significantly below that of competitors. And instead of limiting service to typical Monday to Friday business hours, Huawei promised service availability 24/7, with equipment transportation, installation and maintenance at no extra charge. Huawei’s innovation model had been closely tied to its heavy investment in R&D, and to the low cost of Chinese engineering talent, which meant that Huawei was able to assign more engineers to projects than its competitors. Huawei also made huge investment in technology testing, thereby communicating the emphasis it placed on quality while still offering custom solutions that are configured to meet the needs of individual customers.

Joint innovation centres provide a collaborative environment for managing the customer-supplier relationship and remove some of the long-term uncertainties. 68

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STAGE 2: Build Customer Loyalty by Enhancing Practical Innovation with Longer-Term Join Innovation Partnerships

Huawei had to work hard to counter the perception that its products were not of the quality of its competitors. They began to downplay that it was the least expensive provider, while offering highly competitive prices, and emphasised its ability to mobilise its large number of technical people to design and implement smart solutions quickly. Huawei’s innovation strategy began to pay off in significant ways after it signed a deal in 2005 with Vodafone, one of the largest telecommunication companies in the world. What distinguished Huawei’s winning bid from those of others was partly the price, but mostly its speed of execution. Huawei helped Vodafone build and install 10,000 base stations within one year, two to three times faster than its European competitors could. Huawei enhanced its capacity to solve customer problems no European telecom provider with practical innovations that enabled customers to more efficiently transition from one technology generation to another. For instance, Vodafone and Huawei engineers identified a looming strategic problem in 2006: Vodafone needed to retire 110,000 2G sites over the next three years and replace them with equipment to support the next generation of mobile technology. Realising how disruptive the transition might be for Vodafone and its customers, Huawei’s engineers proposed to develop software rather than hardware solutions. This would upgrade Vodafone’s sites to 3G mobile network standards in a more practical, less disruptive and less expensive way. Huawei was able to formalise its relationships with leading European operators like Vodafone and Telenor by establishing what it calls joint innovation centres, which provide a collaborative environment for managing the customer-supplier relationship and remove some of the long-term uncertainties. Joint innovation centres provide a platform for Huawei and its customers to work through complex issues together. Rather than undertaking several projects at once, joint innovation centres focus on one problem at a time. Representatives of the telecom operator and Huawei come together to explore problems and potential solutions. And input from senior management on both sides is an important part of the process. Such high-level involvement helps build trust, which is reinforced by clear rules for protecting intellectual property and sharing risk. In this way, Huawei by 2016 managed to collaborate with all leading European telecom operators – including Vodafone, Deutsche Telekom, British Telecom, Orange, Telefonica, Telecom Italia, Swisscom, KPN, Proximus, Telenor, TDC and TeliaSonera. Their approach was so successful that

competitors established joint innovation partnerships of their own to develop practical and long-term innovations. STAGE 3: Enlist Governments and Other Stakeholders Through Model Citizenship The success of Huawei’s approach to innovation has also depended on being accepted by governments and larger industry players. Huawei has gone to considerable lengths to present itself as the kind of partner European governments could work with. During the global financial crisis and subsequent recession, for example, the company maintained high levels of investment in R&D in Europe and became a champion for major innovation projects. In order to consolidate its market position in Europe, it set up a special public affairs and communications office in Brussels whose job is to frame the company’s investments in terms of how they advance the efforts of European governments and industry players to meet the global innovation challenges of the 21st century. Huawei’s expansion in Europe follows a pattern that closely resembles the one the company used to build its position in China: Start at the perimeter and work toward the centre. In Europe, Huawei initially targetted business opportunities in the United Kingdom and Hungary. Both governments seemed open to hedging their bets away from European Union companies and toward China and Chinabased companies. To overcome resistance from core member countries such as France, Huawei has demonstrated its model citizenship by taking some unusual positions at a time of European budgetary crisis. In 2015, Huawei France’s management disassociated itself from tax loopholes that were being pursued by French, European and North American technology firms by instructing its accountants to find a way to pay a significant amount of taxes on revenues – whilst it was due none given the net losses it makes in the country. It also decided to spend nearly €1.7bn in French R&D and spearhead the European Commission’s Digital Europe ambitions with 5,500 new European technology jobs by 2020. Impediments to Growth Huawei has moved from relative obscurity to

Huawei’s expansion in Europe follows a pattern that closely resembles the one the company used to build its position in China: Start at the perimeter and work toward the centre. being a significant force in the telecommunications industry and has shown an ability to work closely with customers to solve difficult problems and address their unmet needs. However, despite the company’s market acceptance in Europe, it has been seriously stymied in its efforts to break into the telecommunications equipment market in the United States. Although Huawei has had cooperative research relationships with major US companies, it has faced questions about its policies about intellectual property and about the potential for espionage in China. Although Huawei executives denied these allegations, security concerns continue to limit Huawei’s ability to sell network equipment to US companies. The extent to which these concerns will influence Huawei’s position with other governments thus remains to be seen. So far, Huawei has attempted to tie its brand closely to innovation and economic development within the markets in which it does business. But how well it will be able to continue with this strategy going forward remains to be seen.

Manuel Hensmans is an Associate Professor of Strategic Management & Innovation at the Solvay Brussels School of Economics and Management, ULB. Before joining Solvay, he was a Research Fellow at Rotterdam School of Management, Manchester School of Management, London Business School, Strathclyde Business School and Lancaster School of Management. His most recent book is called Strategic Transformation, Palgrave 2013, which was translated in Chinese in 2015. Notes 1. Abbreviated version of Hensmans, M. (2017). Competing Through Joint Innovation. MIT Sloan Management Review, 58(2), 26-34. 2. Huawei is an employee-owned firm (more than 98% of Huawei is owned by employees)

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Leadership

Open Source

Leadership BY RAJEEV PESHAWARIA

Just in the last ten years, technology has radically changed the way we live and work. Yet, leadership and management practices in most companies have remained the same for over 50 years. This article proposes essential new thinking needed to survive and thrive in the 21st century.

business have become “open source”. To succeed and thrive in this new era, our thought and action must also become open source. Only those who adopt a mindset of changing faster than change itself will survive. More so than ever before, it is time for both established and aspiring business leaders to question conventional wisdom and adopt “open source thinking” around these five fundamental questions/challenges:

he world’s largest taxi company owns no cars, and employs no drivers directly. The world’s largest hotel service owns no properties and employs no housekeeping or room service staff. Communication has been Whatsapped, memories Instagrammed, jobs Bangalored and life itself Facebooked. Almost everything we knew as normal in both business and social life has changed dramatically in just the last 15 years. We now live and work in the age of 24/7 connectivity where knowledge is free and abundant, ordinary people more empowered than ever before, everything fully transparent, and leaders completely exposed and naked. Global population doubled from three billion to six billion between 1960 and 1999, and is expected to reach nine billion by 2050. On one hand, the population explosion is creating significant pressure in terms of food, water, communal harmony, and other basic necessities; on the other it is creating an abundance of talent and innovation. Thanks to 24/7 connectivity, we can now source talent and innovation far easier and quicker than ever before in human history. Welcome to the 21st century where everyone and everything is 24/7 connected, and where scarcity and abundance co-exist. In this century, life and

Powerful Personal Leadership in the 21st century 1. How must leadership be redefined/reincarnated in the open source era? 2. What style of leadership is best for creating breakthrough success in today’s environment? Open Source Leadership written by Rajeev Peshawaria

Leading the Organisation to Outperforming Competition 3. How to inspire, manage, measure and reward performance at a time when a significant section of the workforce is opting for free agency rather than traditional full-time employment? 4. How to measure employee engagement and effectively address the gaps? 5. How can organisations innovate quickly and more often, and create a pipeline of future visionary leaders at the same time? A detailed description of the open source era we currently find ourselves in, and a chapter on each of the above five challenges supported by a 28-country research study, forms my next book

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Leadership

The main ingredient of leadership is to have enough intrinsic strength to keep going until the better future is created. I call this long-lasting intrinsic strength leadership energy, which can only be obtained through deep clarity and conviction of values and purpose. Open Source Leadership (McGraw-Hill, Oct. 2017). In the paragraphs below I provide a brief synopsis of what we learned about the five challenges from our global study. Powerful Personal Leadership Leadership Redefined: Despite billions spent each year on leadership development, great leadership remains scarce around the world. Why? In my opinion, it is because of how we define and understand leadership in the first place. Most people agree that leadership is the art of influencing others using an appropriate mix of inter-personal skills and authority. Therefore, the focus of leadership development has historically been on skill and personality development; and someone in a position of authority is automatically deemed a leader. That’s exactly where the multi-billion-dollar problem lies. Leadership is neither about skills and personality, nor about position, title, or authority. First and foremost, leadership is about having a burning desire to create a better future. While this has always been true, it is more so now because the unprecedented times we find ourselves in. Unless we redefine leadership away from influencing others using position power, to the pursuit of a better future, we will neither be able to exploit the opportunities, nor solve the challenges posed by the open source era. However, there is one big problem with viewing leadership as a burning desire to create a better future: any attempt to do so encounters stiff resistance. Most people want to be liked and accepted by society, so they avoid doing anything that makes them unpopular. But leadership requires one to be prepared for loneliness and unpopularity in order to create a better future. Often, this loneliness and unpopularity (caused by resistance) continues for very long periods of time. In the case of Nelson Mandela it carried on for 27 years in prison. The main ingredient of leadership is to have enough intrinsic strength to keep going until the better future is created. I call this long-lasting

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intrinsic strength leadership energy, which can only be obtained through deep clarity and conviction of values and purpose. Instead of seeking universal popularity and acceptance, great leaders declare their values and purpose to the world at large, and hope that even though there will be great resistance to change, enough people will eventually support it to gain momentum. In other words, they crowdsource their followers by openly declaring their intentions. It sounds easy but in reality, it is very hard to become crystal clear about one’s values and purpose, and even harder to live a life of values and purpose. Given we humans always seek comfort and social acceptance instead of hardship and unpopularity, most of us don’t even try. Consequently, the leadership development industry also takes the easy way out by focussing on teaching on-the-surface skills. It is time to redefine leadership as the art of harnessing human energy towards the creation of a better future, and to refocus leadership development investments towards helping individuals uncover their leadership energy. Leadership Style: Another grossly misunderstood aspect of personal leadership has to do with leadership styles. On one hand, most leadership literature idealises the virtues of democratic, all-inclusive leadership. On the other hand, you see examples like Steve Jobs and Lee Kuan Yew who created history by doing the exact opposite. So which one is true? We asked approximately 16,000 people in 28 countries to tell us if they thought autocratic, top-down leadership was the need of the hour today. We gave them a list of attributes, approximately half of which were democratic, and half were autocratic, and asked them to tell us what today’s leaders need to do most. In all 28 countries, autocratic attributes topped the chart as shown in Figure 1(see next page). But wait, how can anyone be autocratic in the age of social media and the empowerment of ordinary people? Even though the data says one needs to be autocratic, but will people let a leader get away with autocratic, top-down behaviour? My research shows

it is very possible, but to do so, leaders must practice the five keys of positive autocracy: 1. Earn the right to be autocratic – by consistently living the right values and pursuing the right purpose 2. Be autocratic about values and purpose while remaining humble and respectful with people 3. Provide “freedom within a framework” 4. Listen, learn, and reflect continuously 5. Forgive more often In other words, leaders must realise that in the open source era, their lives are open books. They must live their lives in a way that matches their stated values and purpose all the time, with no exceptions.

Figure 1 In order to drive unprecedented success in today’s fast paced environment, business leaders most need to (Top 3 Statements) Have long lasting energy to see their plans through without giving up amidst challenges faced

39%

Dare to be different and willing to challenge general opinion

37%

Be bold risk-takers that pursue unpopular or unconventional ideas to break new ground

35%

Envision audacious ideas that don’t yet exist

33%

Listen to the views of others but make their own decisions of what is right

////////////////// 30%

Remain firm in their course of action despite feedback and resistance

28%

Use a democratic and collaborative style of leadership in achieving their vision

27%

Take incremental steps to cautiously implement their vision

21%

Listen to find middle ground in the face of opposing viewpoints to preserve harmony

19%

Rely on consensus and support from others to make a difference Enlist everyone’s approval and acceptance to an idea before moving ahead

16%

14%

////////////////// Top Down/Bold(T)

Shared (D+T)

Democratic (D)

Leading the Organisation In this section, I will challenge conventional wisdom around three key areas of management: Goal Setting, Employee Engagement, and Innovation. Goal Setting: It is standard practice in most organisations to encourage all employees to write stretch (above and beyond) goals each year. However, thanks to Vilfredo Pareto we’ve known since 1906 that only 20% of the people will actually achieve them. The 80:20 principle is alive and kicking in almost every walk of life, yet we ignore it in management by expecting all employees to achieve stretch goals. In any group, performance usually falls on a bell-shaped distribution where 20% of workers are excellent performers, 60% are average, and 20% are low performers. This does not suggest that the middle 60 and bottom 20 percent are shirkers or incompetent. In today’s age of uberconnectivity enabled gig economy, ordinary people have a lot of choices about when and how they want to work. For some, succeeding at work through hard work and determination is the main purpose in life. These usually end up in the top 20%. For others, work is important, but so are family and other pursuits. They want to do good work, but are not as ambitious as the top 20%. They form the middle 60% and provide excellent support to the top 20%. Finally, for the bottom 20%, work is just a means to pay the bills because their real passion lies elsewhere, in the performing arts for instance. In the open source era of choices and freedom, why not allow people to choose where they want to be on this bell curve? Why not set minimum instead of stretch goals, and make it clear what the consequences will be? If someone wants to go above and beyond (and 20% will), let them come forward and do so. If someone wants to just do the minimum, so be it as long as they do it efficiently and are happy with minimum rewards as well. Employee Engagement: Each year, millions are spent by large companies on measuring employee engagement. Data is collected through a survey questionnaire sent out to all employees, and each item’s average score is tabulated. Management typically looks at the top and bottom scoring items and develops elaborate plans to prop up the numbers in the following year. This process is repeated each year, but the organisation does not always improve its overall effectiveness and

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Leadership

To survive, organisations need quicker and more frequent innovation. One way to do so is to use crowdsourcing, both internally and externally. efficiency. Why? Because again, the Pareto principle is forgotten. By averaging the scores of all employees, the voice of the top 20% (who produce 80% of the results) drowns under the voice of the remaining 80%. Often, the top 20% are too busy to fill out the survey in the first place. Consequently, by addressing engagement needs based on average scores, the organisation ends up inadvertently encouraging mediocrity instead of excellence. The fix is simple. Collect data in a segmented way so the needs of each of the three segments (20-6020) can be determined separately. We live in the age of big data – this should not be too difficult to do. Innovation: The traditional view of innovation is one of secrecy. Typically, the R&D department spends time and money in isolated incubators to produce new products and solutions. In today’s age of breakneck speed, this might be woefully inadequate. To survive, organisations need quicker and more frequent innovation. One way to do so is to use crowdsourcing, both internally and externally. A couple of years ago, GE aviation did just that.1 They ran a global contest for designs to reduce the weight of engine brackets by 30%, and offered a prize of US$20,000 for the best design. To their surprise the winning design came from a small town in Indonesia, which reduced the weight by a whopping 84%. Now how’s that for exceeding your innovation KPI by 180% at the cost of just $20K? And who would have thought that the world’s biggest aviation

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giant would achieve such a breakthrough for so little, and more importantly from small town Indonesia? Open source leadership enables the democratisation of innovation by crowdsourcing it, thereby significantly increasing the chances of success. In summary, whether we like it or not, the open source era is upon us. The 21st century is very different from the 20th, and only those that can change their own thinking, and the working culture of their organisations, will survive and thrive. Being a lone voice is hard, but sinking our heads into the sand and doing nothing about the changing world around us is not an option either. Many people today worry about technology and robots replacing human jobs and eventually controlling us. One way to mitigate that risk is to use our uniquely human gifts like being passionate about something, sensing, judging, imagining, and leading to create a better future. Developing a mindset along the lines described above might be a great start.

Rajeev Peshawaria is the author of Too Many Bosses, Too Few Leaders and Open Source Leadership. Rajeev is the CEO of The Iclif Leadership and Governance Centre. Prior positions include Global Chief Learning Officer of both Coca-Cola and Morgan Stanley, and senior roles at American Express and Goldman Sachs. Reference 1. How GE Plans to Act Like a Startup and Crowdsource Breakthrough Ideas, Liz Stinson, Wired.com

Insurance

Not So Sure About Insurance BY MORTEN STRANGE

In this article, the author elaborates on key considerations one must make in looking at the Insurance industry. From betting against yourself to the actual odds of benefitting from insurance, the article is both a warning and a reminder that one can simply “live a little better”.

e don’t know what will happen in the future. This banal statement must be at the essence of our financial planning. We cannot control luck, good events as well as bad events, will happen to us in a random manner. So what do you do in that case? I asked my wife this rhetorical question the other day. Her answer was: “You buy insurance.” We live in Singapore, but I am sure most people around the world would say the same thing. But here is the thing: since we don’t know the future, in finance we only have the numbers to guide us forward, the math, the statistical analysis and the probability calculations. Regarding insurance, all the numbers work against us. Insurance works such that a group of people each put some money in a hat, those who need it later are allowed to take some out, maybe more than their share; others may get nothing at all. It is a zero-sum game. Insurance is in fact a reverse form of gambling, you take a position, place a bet if you will, against yourself. Only it is not quite zero-sum. The manager of the hat, the insurance company, takes a cut to facilitate the game. This is similar to a casino, there the House keeps a bit of the turnover; in the gambling business this is

called the “hold rate”. In Singapore we have a huge casino, the Marina Bay Sands, owned by Las Vegas Sands Corp. The hold rate for a typical year varies between 2.8 and 3.5%,1 i.e. for each $100 the average gambler spends, the casino gets to keep around $3; $97 is paid back to the customer. If the gambler keeps on gambling, the probability of him losing all his money is 100%; that is due to the so-called “Gambler’s Ruin” statistical concept which teaches that your probability of going broke in a 50-50 (=zero-sum) game is N2/(N1 + N2), where N2 is your opponent’s money and N1 is yours. As you can see from this simple ratio, this probability will always be more than 0.50 or 50% if N2 is bigger than N1, and for N2 = ∞ (as when betting against a casino) the probability is 100%.2 If you didn’t know this, you shouldn’t gamble, and you should also not buy insurance. The reverse of the “hold rate” in the insurance industry is called the “loss ratio”, it is claims paid out divided by premiums collected, and it is much smaller than in the casino business; according to a report by the Monetary Authority of Singapore, it was 50.2% in 2015 (not 97!).3 This varies of course from country to country; there is an interesting report out by the OECD: Global Insurance

Insurance is in fact a reverse form of gambling, you take a position, place a bet if you will, against yourself.

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Insurance

Adopt a lifestyle where you bet ON yourself by taking care of your health, drive slowly, build up financial muscle; take responsibility for your own life, don’t outsource the risks; you will be better off in the end. Market Trends 2015, look at page 14 of the document for a chart of the loss ratio in various countries.4 In other words, a huge amount from the “hat” does not make it back to the gamblers (sorry, the policy holders). Instead it is paid out as administrative expenses, salaries to employees and profits to shareholders. The insurance industry is a great place to work, but not such a great place to be a customer. So, if you are an average customer, you can expect around half your money back if you buy insurance. But are you average? In many cases, your life is not an even 50-50 gamble; you can improve your odds. If you drive like a maniac and speed and tailgate and jerk in and out of lanes, yes, you might benefit from comprehensive car insurance. If you overeat, smoke 40 sticks a day and never exercise, sure, a health insurance might benefit you. However, if you live just a little bit better than the average person, your odds of staying out of trouble will improve. On top of that, the insurance industry is struggling with fraudulent claims in motor-, accidentinsurance etc; those are all paid for by the honest participants. I am aware of this: The insurance company will invest the premiums they collect, for instance from the many complex life insurance schemes available, and make the capital grow, right? True, that is the general idea. But here is a case story from the real life: Like a good daughter, my wife (who as I mentioned, like most people, believe in insurance) bought a life insurance for her mother some 18 years ago. She paid S$2,400 per year into an endowment policy payable in case of critical illness or death. (One GBP is about 1.76 SGD, but the currency doesn’t really matter in this case). Unfortunately my mother-in-law did contract a critical illness, cancer, and she died last year, by which time my wife had paid some S$43,200 into the fund; she was paid S$43,400 back. A compounded annual return on investment of… it is not even worth calculating! But at least she got her money back; as I document in my book, Be Financially Free, many endowment policy holders are not so lucky. So, you ask: If I don’t have insurance, what do I do if an accident happens, if I have a fire at home or if I die prematurely, what will happen to my kids? Right, you should be prepared for accidents and for unforeseen events. If you don’t have insurance, you must instead have the discipline to save for a rainy day. Don’t give your hard-earned money to an

The European Financial Review August - September 2017

insurance agent. Keep it for yourself and invest it well. You will do yourself and your descendants a huge favour. I know, maybe you cannot go out tomorrow and cancel all your life insurance plans; usually endowment policies penalise the policy holder for early redemption. But at least keep those you have to maturity and don’t buy new ones. Save the money you would usually have paid in premiums and invest this amount in save and liquid US treasury bonds (with the 10-year at currently around 2.2% p.a. return). Had my wife done that she would have had S$53,400 in the bank by the time her mother got sick. The more financially savvy could buy an ETF tracking the S&P 500 index (as Warren Buffett recommends) and expect a return of around 7% p.a. (based on return with dividends re-invested over the past 20 years).5 Invested this way, my wife’s nest-egg would have doubled to S$87,000 by the time she needed it. Don’t bet against yourself with insurance. Adopt a lifestyle where you bet ON yourself by taking care of your health, drive slowly, build up financial muscle; take responsibility for your own life, don’t outsource the risks; you will be better off in the end.

Morten Strange is a Danish-born, Singaporebased financial analyst and writer and the author of Be Financially Free: How to become salary independent in today’s economy (Marshall Cavendish, 2016). You can find a list of his books on https://en.wikipedia.org/wiki/Morten_Strange. Morten Strange is a former petroleum engineer, naturalist and book publisher with a special interest in how global environmental constraints affect our ability to grow the aggregate economy. References 1. http://www.straitstimes.com/business/companies-markets/mbs-earnings-take-a-hit-in-q2 2. https://en.wikipedia.org/wiki/Gambler's_ruin 3. http://www.mas.gov.sg/~/media/resource/data_room/insurance_stat/2015/Insurance%20 Statistics%202015_PDF.pdf 4. http://www.oecd.org/daf/fin/insurance/Global-Insurance-Market-Trends-2015.pdf 5. https://dqydj.com/sp-500-return-calculator/

SWEETPOP.SE

SUSTAINABLE THINKING IS WORKING TOGETHER Almost everybody agrees that the key to a brighter future for the environment is cooperation. If we can set new standards for how we solve problems together we can really make a change. That is exactly what we have been doing for decades in the Swedish process industry. Working together to solve common problems. It is proven to be an effective strategy and we call it the ssg way. But you could also call it sustainable thinking.

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