Bank's Investment and Marketing - Essay Example

?Questions Part A (50 per cent of the marks) (1000 words) 1a. Using Extract by Linda Whitney and the study materials, briefly outline three regulatory challenges that might arise from the employment of sales staff in the financial services industry. (12 marks) One of the major concerns for independent regulation of the financial services industry relates to the structure of large investment banks, where multiple divisions within the same company structure may have interests with clients that compete or conflict with each other. For example, with Barclays PLC in 2009, 40% of the banks income came from traditional interest bearing loans while 30% came from financial services and 30% came from direct investment gains. (Shipman, 2011, p. 9) Financial sales staff within a large investment bank such as Barclays could potentially enjoy a significant competitive advantage in the marketplace by knowing the advance order patterns of their customer base and using this insider knowledge for “front-running” market trades in stocks, bonds, or commodities. Many large clients seek the services of an investment bank precisely for this reason, as the collective knowledge base of the financial sales experts in the group should allow the client to gain a preferential entry and exit point for market trades. However, financial sales staff can also abuse this inside knowledge, as for example, Goldman Sachs did in creating the Abacus tranche of mortgage bonds for hedge fund trader John Paulson which were designed to fail, but sold to pension funds, private investors, municipalities, and other investment banks as legitimate long-term investments while simultaneously being shorted by Paulson’s hedge fund. (SEC, 2010) This type of concealed information which is withheld from some clients while being made available to privileged investors or other divisions within the bank itself represents a conflict of interest within the investment banks that is very difficult for financial regulators to detect and prevent. A second challenge for regulators can be found in the direct investments made by banks operating in the volatile financial markets of stock, bond, commodity, and derivative trades that can directly threaten the viability and deposits of traditional savings and loan customers. The numerous recent stories about “rogue traders” at UBS, Societe Generale, and Barings Banks, as well as the collapse of Lehman Brothers, show how leveraged investments in stocks, bonds, and derivatives can threaten the viability, stability, and core deposits of clients using these banks for traditional financial services. Therefore, regulators need to be able to monitor the capital reserves of bank and also the relationship of these reserves to leveraged market investments in other sectors that can go negative and lead the entire bank into insolvency. This threat also exists when banks hold their reserve capital in seemingly risk free bonds, such as those issued by national governments and municipalities. While these may appear to be the ultimate safe, long-term investments for holding capital reserves in the banking sector, the example of the potential Greek sovereign default and the poor state of municipal budgets across Europe and America show how even these type of deals must be watched by regulators in order to insure that the banks remain adequately capitalized as required by the Basel Accords and other international regulatory statutes. 1b. Explain and evaluate how policymakers in the UK are addressing the three regulatory challenges you raised in 1a. (8 marks) The regulators in the UK are addressing these concerns with investment banks by re-evaluating and updating the Basel II accords that establish “Tier 1” capital reserve regulations for the industry. One consequence of this is limiting the ability of the banks to over-leverage into investments that could put the “core” financial services such as savings and loan accounts at risk. (Shipman, 2011, p. 22) “Under the Basel III rules, banks will have to raise their ratio of core Tier 1 capital from 4 per cent to 7 per cent of assets, by 2018. Most UK banks started to raise their core Tier 1 capital ratios after the 2008 crisis, so by 2010 most were already above the new 7 per cent minimum. For example, Barclays’ core Tier 1 capital ratio was 10 per cent on 31 December 2009.” (Barclays, 2010, p. 3) Another example can be seen in the nationalization of banks such as Lloyd’s and RBS, which involves not only the issuance of new shares to recapitalize the institutions, but also the potential break-up of these large financial groups into smaller companies that can be managed and regulated more easily. The internal information sharing and insider trading issues are much more difficult for regulators to pursue in the financial services industry, as they are often not privy to information regarding these types of transactions, conversations, or agreements within the investment banks themselves unless an obvious instance of fraud or market manipulation occurs. Bloxham (2011) discusses the new efforts in the UK to regulate the financial services industry as falling into two main themes. (Bloxham, 2011, pp. 1-2) The first is an effort to promote “systemic stability” and the second is an attempt to promote “consumer protection”. (Bloxham, 2011, pp. 1-2) These efforts “include an intention to dismantle the Financial Services Authority (FSA) and shift the prudential part of its regulatory responsibilities to a new Prudential Regulation Authority (PRA) that will be a subsidiary of the Bank of England. A new Financial Policy Committee (FPC), also part of the Bank of England, will be created to have oversight of the whole financial system.” (HM Treasury, 2010) Consumer protection services aim to protect the customers of investment banks from the type of exploitation and misrepresentation seen in the Abacus investment bond example. As a result of the 2008 financial meltdown, the FSA is currently being reformed and restructured in England so that the responsibility for consumer protection “will shift to a new Financial Conduct Authority (FCA)”. (Bloxham, 2011, p. 2) This agency will presumably monitor and enforce existing and reformed information disclosure laws regarding financial products and services so that investment banks are less able to offer compromised or misleading advice to clients that encourages them to take on more risk, while understating or misleading the investors on the nature of the security itself. Under UK law, all financial services advisors must report annually on their activities, receive regular visits to their work premises by FSA regulators, and also maintain standards of professional conduct in their business dealings in order to remain a licensed financial services advisor in the country. (Bloxham, 2011, p. 19) CAT (Cost-Access-Terms) standards are another means by which the government regulators have attempted to combat misleading information in the financial services industry and the lack of general public knowledge for the analysis and evaluation of stock, bond, commodity, and derivative investments. (Bloxham, 2011, p. 17) The aim of the CAT standards is to provide a general level of standardization and consumer trust in financial documentation that investment products may be sold and marketed by investment banks and other financial firms to the public in a more open manner. CAT standards provide “consumers with a product that is a reasonable deal. Not necessarily the best on the market but one which, because it meets the standards set by government, should be good enough for most of the target audience”. (Johnson, 2000, p. 13) These standards are not designed to eliminate market risk entirely, as the elements of risk are inherently intertwined with market returns and ROI, but rather to certify that the financial products are standardized and free of misleading legal requirements or terms that would prejudice them against the investor’s interest in a hidden or obscured manner. 2. Three friends have each just enjoyed their fortieth birthdays, and decide to put aside monthly savings for their planned retirement at age 65. They are all self-employed, basic rate taxpayers. Martin and Kevin will each put in ?124 per month, and Sandra ?232 per month. 2a. Calculate how much tax relief on contributions each would receive if their savings were directed to (i) an individual savings account (ISA), and (ii) a personal pension scheme. Report their gross contributions to these schemes and explain your results. (6 marks) Contributions to an Individual Savings Account (ISA) are taken from “after-tax” income with the advantage of tax-deferral of gains during the holding period which extends into retirement. Therefore, a ?124 per month contribution to an ISA over 25 years will lead to a gross contribution of only ?37,200 to the pension fund each for Martin and Kevin, while Sandra’s ?232 per month will result in a gross contribution of ?69,600 to her pension fund. As ISA funds can be used for both savings and investment schemes, the rate of return from interest and stock market gains should compound over time to produce a greater sum than the gross contribution upon withdrawal at retirement. The Personal Pension Scheme or PPS involves a refund of tax costs to the employer who makes the contribution from the government that can be used to effectively add a 20% additional amount to the fund. For example, when Martin and Kevin contribute ?124 per month to the PPS, the tax savings will result in an additional ?24.8 per month in contributions. Over the 25 year term, this leads to a total gross contribution of ?44,640 to the PPS. In Sandra’s case, the 20% tax refund will lead to an actual gross contribution of ?46.4 extra every month, for a total of ?83,520 over 25 years. The main difference in practice apart from the tax benefit in funding the PPS is that the ISA can be withdrawn without penalty at any time while the PPS is limited to use within the age of 50 to 75. 2b. Assume on average a 4 per cent annual rate of inflation, a 6 per cent average annual nominal rate of return, 1 per cent charges, and investment returns credited monthly. For the two schemes listed in 2a, use the Investment Tool (Savings & Inflation module) to calculate the real value net of charges of each friend’s retirement fund. Explain the reasoning behind the numbers you enter in the Investment Tool, and why the two schemes provide different results. How might the size of their retirement funds be improved if the three friends each worked for an employer? (8 marks) In the first example of Martin and Kevin, a ?124 pension payment contribution monthly to an ISA at 6% return over 25 years will lead to a nominal net value of ?86,360 for the fund at retirement. Unfortunately, because of the 4% inflation rate per year, the real net value of the fund is only ?32,395, as this represents the equivalent purchasing power in 2036 adjusted for inflation. If this investment is placed into the PPS with a 20% tax refund each month from the government policy, the real contribution is ?148.8 per month, which leads to a $103,633 nominal net value at the end of the 25 years. Still, the inflation adjusted real net value in terms of purchasing power in 2036 would be only ?38,874. In the case of Sandra her ?232 contribution per month to an ISA leads to a nominal net value of ?161,578 at the end of the 25 year period, however the equivalent purchasing power of real net value after adjustment for inflation would be ?60,610. When considering the 20% tax savings that is refunded into her account with a PPS, the contribution total is calculated at ?278.4 per month, resulting in a total nominal net value of ?193,894 in a PPS at the end of the term, which is equivalent to ?72,732 in current purchasing power adjusted for inflation. The main way that these three could improve their retirement savings is if they work for an employer who will match their contributions every month. This would result in a ?248 monthly contribution to the ISA for Martin and Kevin, or ?297.6 monthly for a PPS. Similarly, if Sandra’s employer matched her contributions, she would be saving ?462 per month under this scheme in an ISA and ?556.8 per month in a PPS. These additional funding measures have a great effect with compounded interest over 25 years, resulting in a ISA value of ?172,721 and a ?207,266 value under a PPS. Similarly, Sandra would earn ?321,764 after 25 years with matching employer contributions to an ISA, and ?387,788 in a PPS. 2c. Suggest two ways in which Government pension policy can address the potential problem of myopic behaviour on the part of the three friends? (8 marks) If the three workers listed above chose to forgo pension savings on a monthly basis and spend all of their money without thought for retirement, the government could conceivably force compliance with a retirement savings plan by requiring monthly payments every month from the workers into their choice of funds. The alternative is for the government to collect a similar amount from the workers directly and provide the pension services in retirement to the people directly, as in the Social Security program. This would be equivalent to a State Retirement Pension enjoyed under the National Insurance plan popularly. 2d. Consider two advantages and two disadvantages of the three friends investing their savings together in a buy-to-let property. (8 marks) If the three friends invest in a real estate property for rental, one of the advantages is that they will have a regular income from the property that should be sufficient to pay the mortgage payments on the property over 25 years. Thus, the three may be able to combine to pool their resources for a nominal 10% to 20% down-payment on the property, and use the rental income to pay the property taxes and mortgage over time. This would potentially lead to property appreciation costs over 25 years that could be accessed upon retirement when the property title is clear by reselling the building and dividing the return equally for a retirement fund. One problem with this is the risk of property depreciation, damage, and maintenance costs that can erode profits and returns. Another problem is that the yearly property taxes cannot be deferred on the venture as in a PPS or ISA, and the rental income will be taxed as well. Market timing is a serious issue as is location, for real estate prices have crashed significantly since 2007, leaving many home mortgage holders “underwater” or owing more to the bank for the property than the current market price of the home. This effect is typical in dynamic real estate markets such as tourist locations and condo rentals, so the group is exposed to a series of industry specific risks with real estate that also have to be managed along with maintenance, insurance, and taxes to successfully operate the income property as a rental over time. Part B (50 per cent of the marks) (1800 words) Susan is putting together a pension plan for her retirement in ten years time, a period during which inflation is expected to be significantly higher than today’s rate. 3. Using the information provided in Extract 2 and Table 1, suggest a suitable mix of investment funds for Susan. Consider the limitations of this advice and the extent to which society should also take responsibility for Susan’s retirement provision. (50 marks) Susan should first build an investment plan that clearly documents her retirement goals of total savings and income from investments so that she can begin developing a diversified portfolio for retirement. After identifying the level of income and savings that she requires for her retirement goals, Susan can then develop several investment strategies that are potentially adequate in achieving these goals over time, using the principles of risk management to differentiate the advantages and disadvantages of each strategy. In summary, Susan should schedule meetings with a number of financial professionals and discuss the investment options available for achieving her retirement goals to compare advice and strategies in different stocks, bonds, and commodity investments. Once this information has been gathered, she should study each recommendation given by the financial advisors and make a final decision on an investment plan she is comfortable with dedicating her income to over the next 20 years. In the current global economy, many of the traditional advantages of a diversified portfolio including stocks, bonds, and commodity investments has decreased, because many of the global markets are correlated and moving together. Nevertheless, within each sector of stocks, there are differences of gain and loss that can be targeted for increasing alpha in investments. Susan should begin an investment strategy that focuses on long-term holdings of dividend paying stocks that are selected from international “blue-chip” companies that have a record of consistently increasing their dividend payments. This “Dividend Aristocrat” strategy is easy to monitor in a self-managed pension fund, because she can track the companies in her portfolio for sector specific risk and also sell or exit an equity position if any of the companies stop increasing their dividend payments over time. Diversification within dividend paying stocks is potentially less important than strategically timing the entry point into the equity position. For example, Susan can either buy dividend-paying stocks on a regular basis every month via cost averaging, regardless of price, or save her capital to enter positions when the market is at a low. If the dividend-paying stocks are purchased at the low range of their annual price cycle, a higher yield on the equities over time can result, as well as significant price appreciation over a cost-averaged “buy and hold” strategy. Portfolio diversification should be considered between dividend-paying stocks, fixed-rate income bonds, and precious metals primarily for diversification. Bond allocation should ideally come later in the retirement period, for example to maximize income from yield in retirement, but provides a more attractive method of diversification from stocks when global equity indexes move roughly together. Similarly, precious metals can be an excellent long-term hedge against inflation, but market volatility requires proper timing to avoid purchasing at cyclical highs in price. A 65% equity allocation to “dividend champion” stocks, 20% corporate bond allocation, and 15% precious metals (gold and silver) would be a working ratio that provides Susan with more diversification in her portfolio than a spread of equities selected between sectors of industry in the stock market. As ETF trading is largely responsible for the increasing correlation of markets and sectors globally, Susan could also consider precious metal exposure through ETF vehicles, though physical gold and silver bullion would be a preferred means of hedging the stock and bond portfolio for emergencies and inflation. The “dividend champion” approach to stock investing can be a good hedge for inflation, as these equities can be expected to appreciate at a level that is nearly equivalent to or exceeds the annual inflation rate, but the actual focus of this portfolio is on generating yield from dividend income. Supplementing this with investment-grade corporate bonds is recommended as a factor of diversification, but the yield of these instruments is related to the long-term interest rate as set by the central banks. Therefore, as these rates are at near historical lows, Susan should be careful about purchasing corporate bonds with a long-term fixed rate of interest, as the yield will decrease over time as interest rates rise. Precious metals, specifically gold and silver bullion, can be an excellent hedge against inflation caused by Central Banks who print money to cover large governmental deficits or to bail out financial institutions. Still, precious metals must be securely stored and also have high volatility in price swings. Therefore, a balance of 65% “dividend champion” equities, 20% investment-grade corporate bonds, and 15% precious metals should be not only a secure portfolio outperforming the indices with the cost of inflation, but also providing her with the income from yield that she needs to fund her lifestyle and costs during retirement. Susan is relying on her own work, income, and personal capital to securely fund her own needs in retirement. This is a responsible view, yet as a small investor in the global marketplace, she may see her investments fluctuate wildly in value when the markets experience global volatility or through company-specific risk. If she panics during market turmoil and sells her equity positions at a loss, her hard work, personal savings, and retirement goals will be potentially destroyed by losses. Therefore, by looking at dividend yield and income from equities, she can hold “dividend champion” stocks throughout market changes, reinvesting dividend income before retirement in equity and precious metals positions when the stock prices are at the lower range of their annual or historical cycles. In a Bull Market, this could also be practiced as “dip” buying, whereas in a Bear Market, she can purchase more of the “dividend aristocrat” stocks at cyclical lows to increase yield. Nevertheless, there are serious questions involved with this approach, for it is not clear that encouraging every citizen to look to the stock market for retirement income is a good strategy. Retail investors, pensioners, and non-financially savvy individuals can be manipulated by market makers, hedge funds, and quant traders who have a stronger knowledge of macro-economic trends, financial innuendo, and short-selling than the average citizen. In this sense, society should provide a “safety net” in the form of personal pensions that are not derived from stock market returns, and Central Banks should guarantee pensioners a rate of interest on savings that is sufficient to compound interest and capital over time without leading to the inherent risk of the markets. 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