Corporate Strategy Weekly Radar Update

Week ending Friday 22 June 2012 (Theme: Interconnected Risks + EUREPO curve)
Highlights Insights A week serendipitously marked by the AFR series of articles on 'the future of Financial Services', the confirmation that the media industry is reaching a long announced tipping point, the release of the census numbers highlighting changes in Australian society and a sense that we approaching make or break time for Europe: hence the appendix on connected risks (leveraging the WEF 2012 report) Financial Services post-GFC, Regional banks are pursuing differentiated approaches to remain competitive in the retail banking sector, including middle Australia (SUN), community (BEN) and multi-channelled and integrated (BOQ). NAB announced easing of its aggressive residential lending campaign, which has seen it offer the lowest variable rate of the majors for the last 36 months. This campaign has seen its market share lift from 12.8% to 14.7% since Sept 2009. Investment banks facing pressure to right-size following economic (lower M&A activity, conservative markets), regulatory (credit and capital obligations) and tech (direct-market access platforms bypassing investment banks) impacts. ASIC launched an investigation into discount rates and growth assumptions within the Financial Services Industry given volatile markets, falling revenues and lower EPS. The carrying value of goodwill could be impacted if ASIC finds companies have been overstating the worth of their operations. Paul Keating called on banks to tap Australias $1.3b pool of retirement savings to reduce the need to borrow overseas. APRA pushing for the introduction of independent trustees on the boards of Super Funds (as occurs with ADIs and Insurers), despite the Federal Government rejecting this move. Moodys downgraded 15 global banks, including Bank of America, Goldman Sachs, JP Morgan, Morgan Stanley and Citigroup. Specialist insurer Beazley Lloyd's looks to expand in Australia: they operate in Europe US Asia, underwrote $1.7b GWP last year. Other industries Microsoft launched Surface tablets 1st computer under MS brand. Fairfax announced a radical business restructure: loss of 1900 jobs (~20% of staff), closure of 2 printing presses, SMH and The Age to move from broadsheet to tabloid and plans to switch to a digitalonly model if advertising markets deteriorated markedly. News Ltd also announced the reduction of east-coast divisions from 19 to 5 (~ 1000 job losses), as well as the acquisition of Business Spectator and CMH (the Packer family interest in Pay TV.) However, Kerry Stokes (26% shareholder in CMH) may yet frustrate the deal. Australian Economy Global Economy NZ GDP grew at 1.1% in March quarter, more than twice analyst consensus (0.5%) and RBNZ forecast (0.4%). Australian 2011 census numbers show the resources boom is reshaping Australia: 21.5m (+8.3% from 2006): Qld and WA population grew 10% in 5 years. They also show in outback WA that average pay after school year 12 is only 15% higher than after year 11. Even more dramatic: offshore, Year12 earn 94.4% of those who left school after Year11: the boom isn't giving incentive to education G20 summit in Mexico focused on the EU, as analysts increasingly worry of the risks of a new banking crisis. Signs are: a) the return of cross border risk: capital is currently leaving the very countries that need it. b) the recent inversion of the EU-REPO curve Germany approved 750B ESM and EFSF (euro zone bailout funds), but remains unmoved by pressure to allow for further reforms of banking unions, eurowide bank deposit guarantees, Eurobonds or a government debt redemption fund. US Fed extension of its stimulus "Operation Twist" through the end of this year, but disappointed it did not offer additional easing Despite share of housing loans dropping from 14% to 8% since the GFC (due to combination of flight to safety to Big4 and BankWest StGeorge mergers), regionals banks experienced strong new lending growth in year to April, Bendigo & Adelaide and Suncorp rising 5.8% and 5.5% respectively (the best placed major ANZ at 3.2%): coinciding with NAB and other majors becoming less competitive in variable rates, and shifting focus to margins. Morgan Stanley speculates no frills based on advisory, broking and capital markets should be key drivers for the 15 Investment Banks operating in Aus as they supposedly move away from proprietary trading and exotic financial activities. However this view seems at odds with the reality of a growing new Finance 'innovation' High Frequency Trading, 25% of ASX trades, 70% in the US, poorly understood and regulated. ~$43B Goodwill is held by Aus FS companies, incl. ~$5b by SUN, $8.8b by WBC (St George) and $2.3b by CBA (Colonial): analysts believe "the current down trend of FS share prices is reflecting a material downgrade of long-term growth expectations that could trigger tough conversations with auditors about the current value of past acquisitions". Beazley covers niche sectors (marine, contingency and political risk) and broader segments (property, reinsurance and professional indemnity): they plan to expand in local professional indemnity (currently held by CGU business Aon and niche providers). Beazley bought specialist personal accident and life underwriting management agency Momentum Underwriting Management, which had an office in Australia, in Nov 2008. In 2011 Beazley expanded into the Aust. disability cover through the purchase of 2 companies: Australian Income Protection and Blue-Gum Special Risks. Microsofts strategy may not be in direct 'volume sales' competition with iPad, but rather to use Surface tablets to showcase to manufacturers what could be achieved with Windows. They surmise there is a market for corporate tablet users: the challenge is they have lost 1st mover advantage to Apple who have stitched up the app market. Increased concentration in the media industry: Fairfax plans to paywall SMH and The Age follow domestic (AFR, TheOz) and international (WSJ, NYT) trends. Whilst NYT is cited as a successful digital strategy (100K subscribers in 1st month), the Boston Globe (metro paper comparable to SMH-Age) won just 19K subscribers after 3 months. Observers question Fairfax selling online auction house Trade Me, which represented Fairfaxs one growth asset, growing an average of 12.7x in 2010 and 2011. 28% of Fairfax estimated enterprise value of $3.3b before the sell. News & CMH: If Packer sells CMH, it will be the end of a century long in the media. The $2b from the sale are expected to fund a takeover of Echo Entertainment, and bolster the familys interests in the gambling industry. Cross border risk is the risk that a borrower might not be able to repay his euro lender for reasons more related to the sovereign than to the corporate borrower himself. The REPO curve inversion means that EU banks aren't committing beyond 1 month, and surging short term borrowing costs put pressure on banks liquidity (see appx B)

Appendix A: inter-connected mega risks and what they mean for our organisation: a parallel overview of the WEF and Marco Polo frameworks A high level simplified geographic summary of the current key global issues confirms the risks identified by the World Economic Forum The WEF categorised those risks into: Russias pressure to regain Economic: incl. Major systemic financial geo-political weight EU Crisis failure, Chronic fiscal imbalances, Chronic labour market imbalances, Prolonged Volatility of unresolved infrastructure neglect, Hard landing of an the Financial Next wave of NK issue emerging economy Political instability system Tech disruption Oil resources Environmental: incl. Rising greenhouse, gas emissions, Failure of climate change Asias growth needed by the West adaptation, Land and waterway, use Competition threat to the West mismanagement, Irremediable pollution Geopolitical: incl. Global governance failure, Weather events Underdeveloped Africa Growth of Latin Failure of diplomatic conflict resolution (el Nio-la Nia) Rising Chinese investments America (now Societal: incl. Water supply crises, Food that it has shortage crises, Unsustainable population Australias transitioned to growth patchwork economy democracy) Technological: incl. Critical systems failure, Source: Strategy Team analysis Massive incident of data fraud or theft, Failure of intellectual property regime A interesting part of the WEF methodology is the identification of 5 Centres of Gravity (one per category) as the risks of greatest systemic importance: Chronic fiscal imbalances (economic) Greenhouse gas emissions (environmental) Global governance failure (geopolitical) Unsustainable population growth (societal) Critical systems failure (technological) Critical Connectors are risks connected to multiple Centres of Gravity, and join the 5 centres of gravity into one coherent system (they are all economic) Severe income disparity Major systemic financial failure Unforeseen negative consequences of Source: WEF Insight Report, Global Risks 2012, Seventh Edition regulation Weak Signals are more forward looking (see Marco Polo section below) Extreme volatility in energy and agriculture prices The WEF also articulates 3 cases: Seeds of Dystopia Dystopia describes what happens when attempts to build 'a better world' go wrong. This case Tensions when improvements in considers how current fiscal and demographic trends could reverse the gains brought by globalisation economic living standards are not and weaken states: formerly wealthy countries that descend into lawlessness and unrest as they accompanied by increases in political become unable to meet their social and fiscal obligations: as attested by the occupy movements. and civil rights (Arab Spring) Tensions due to the global Rural to Urban migration ('boats' coming to Australia) The rural population is expected to decline around 2023, while urban population will continue to increase. Expectations about the positive potential of the world economy are frustrated by the interplay between fiscal imbalances and demographic trends. The resulting disappointment is amplified by a growing sense that wealth and power are becoming more concentrated (the "1%"). In developed countries, household and national debts Though rapid urbanisation offers One of the most compound the challenge of providing for ageing important macro economies of scale if infrastructure shift since the populations. On average, households in emerging keeps pace, it also makes the gap in industrial economies owe 30% of their annual income, while living standards more immediately revolution households in developed economies owe almost visible. This visibility is also amplified 150%, or 1.5 years, of their income. by the spread of new media (internet) Shrinking tax revenues have deteriorated governments' fiscal positions and reduced their ability to ease social hardship with welfare and countercyclical spending.
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 How Safe are our Safeguards? The cloud of volcanic ash over Europe; the Fukushima meltdown which prompted Germany to shut 8 of its 17 nuclear reactors immediately, with the remaining 9 to be taken offline by 2022; the ongoing EU crisis illustrate the critical role of safeguards and regulation in interconnected domains such global finance, transportation networks, emerging science and new technologies, resources Approaches that have previously been used to respond to risks are becoming increasingly inadequate given the complexity of systems. Conventionally, nation states have adopted a predict-and-control approach, which relies on tools such as regulations, incentives and chains of command The dilemma of regulation. Two recent cases illustrate divergent aspect of regulations: Banking: losses can be passed onto others and banks have been defined as too big to fail: excessive risk-taking is still occurring. On the other hand when stakeholders recognize the importance of having others adhere to safeguards to protect their own interests, incentives are designed to entice everyone in the system to cooperate: during the Icelandic volcanic ash cloud it took only a few days for an iterative process of information exchange between regulators and airlines conducting test flights for the regulations to be amended, illustrating the new school of thought of anticipatory governance. In this model, operators accept the impossibility of anticipating the potential trajectory of innovations based only on past experience and accept the need for dynamic safeguards that can evolve with the system they are safeguarding. The Dark side of connectivity Critical Infrastructure (incl. electricity, water, gas, transport, and information) that underpins our daily lives increasingly depends on hyperconnected online systems. The power shifts from the physical to the virtual world has long been announced and some see it as a clich, however this week's announcements in the Media industry (Fairfax, News Ltd) are a timely reminder that they have very material consequences. "The internet of things" 35% of the global population is online, up from 8% just 10 years ago But perhaps more significantly it is the way we connect that is changing: In 2011, about 470m smartphones had been sold worldwide: double is projected by 2015. This is building the internet of things the high-speed communications network composed of electronic devices rather than people. Currently there are 5b devices or things connected and remotely accessible through the internet, from cars, kitchen ovens and office copiers, to electrical grids, hospital beds, agricultural irrigation systems and water station pumps. This number of devices connected on the internet is expected to reach 31 billion in 2020. This increase of Assets is triggering a surge in liabilities (and need for protection)
Cost and incidence of cybercrime in the US

What it means for our organisation: the "Marco Polo futures" Whilst business and political Areas of Change relevant Examples of 'weak signals' of those risks. (See Marco Polo Team for more operators find it relatively easy to Insurance details on the framework) to intellectually appreciate Big Open Data Car manufacturers capturing and using data to understand driving behaviour these mega-shifts, Virtual Contents items becoming rights rather than tangible items (e.g. music no longer organisations and stored on a CD but rather stored in a cloud) governments do struggle to Increased Socialisation Relay Rides (US) car sharing P2P, bought by General Motors (Feb 2012) link them to their immediate My meaning Swiss Re e-reputation insurance package and Axa is proposing a similar product agendas. Finance 2.0 Canada MintChip project to design a government backed digital currency (Apr It is in this context that Marco 2012) Polo has identified 'Areas of Global Scale The Climate Corporation launched a new model of insurance for farmers to Change' on the Insurance adapt to climate change (founded by 2 ex Google employees) industry, to be monitored..
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 Anecdotal illustration of the type of mapping required for Business and Operational Risks and their Domino Effects: the Japan Earthquake and Tsunami

Appendix B: the alarming EU-REPO curve inversion The REPO market for repurchase agreements plays a crucial role in allowing financial companies to secure short-term funding. At its peak, it provided up to a third of the total funding for some banks including Bear Stearns and Lehman Brothers. Normal REPO curve: logically, 1 year borrowing cost more than short term borrowing because of the greater risk (ignore the 1Day point which is irrelevant to the argument made)

The Inverted REPO curve is a clear signal of stress in the EUREPO market: this means that banks do not trust each other on long tern lending: they are unwilling to commit the collateral (required for the repo) beyond a 1-month contract. Indeed, it appears that 1-day repos are strongly preferred. In other words, banks want to be able to get collateral back and prefer short maturities. This shift also means that the banks themselves dont believe that any ECB boosts will last longer than a month.

Injection of Cash after LTRO1

... Not enough: back in the red

2nd injection of Cash after LTRO2

We are back in the red for a 2nd time, which is having operators very worried...

A historic perspective of the gap between 1 Year and 1 Week REPO rates gives a further insight: Euopean banks already had 2 cash injections 486b which positive effects lasted 1 month, and a second of 529b that only lasted 2 months and a half. We are now back to the critical situation of december 2011 when the European Central Bank had to intervene with LTRO1.

Source: margincall.fr http://www.margincall.fr/2012/06/vers-une-nouvelle-crisebancaire.html