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Case study

China and the WTO

The World Trade Organization produced the following statement in response to the conclusions of negotiations on China’s accession.
Banking
Upon accession, foreign financial institutions will be permitted to provide services in China without client restrictions for foreign currency business. For local currency business, within two years of accession, foreign financial institutions will be permitted to provide services to Chinese enterprises. Within five years of accession, foreign financial institutions will be permitted to provide services to all Chinese clients.
Insurance
Foreign non-life insurers will be permitted to establish as a branch or as a joint venture with 51 per cent foreign ownership. Within two years of China’s accession, foreign non-life insurers will be permitted to establish as a whollyowned subsidiary. Upon accession, foreign life insurers will be permitted 50 per cent foreign ownership in a joint venture with the partner of their choice. For large-scale commercial risks, reinsurance and international marine, aviation and transport insurance and reinsurance, upon accession, joint ventures with foreign equity of no more than 50 per cent will be permitted; within three years of China’s accession, foreign equity share shall be increased to 51 per cent; within five years of China’s accession, wholly foreign-owned subsidiaries will be permitted.

 
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Case study

Ethical investment policies and the ethically-orientated investor segment – the Co-operative Insurance Society Limited (CIS)

Headquartered in Manchester, England, CIS is the only Co-operative insurer in the UK and is one of the largest providers of personal financial services in the country. A particular point of interest is that the Co-op has developed a strong affinity with that section of the population that displays a strong ethical orientation towards a range of issues. Indeed, the Co-operative Bank has clearly positioned itself as the ethical bank. What is interesting is the way in which the Co-op Bank and CIS have adapted their marketing mixes in ways that are consistent with their approach to segmentation and positioning. Here, we consider how the needs of the ethically-orientated segment have been reflected in CIS’s approach to investment management.
As a member of the Co-operative movement, CIS shares this ethical underpinning which, when applied to investment, has always been construed as requiring the optimization of financial returns for customers. Recognizing the increasing sophistication of the market, in 1989 CIS introduced a range of unit trusts (mutual funds) to which was added, in 1990, a fund that screens companies on environmental, health and safety criteria. These positive criteria are supplemented by negative criteria relating to animal testing, armaments, oppressive regimes, tobacco and nuclear power. Like other CIS products, units in this fund, now known as the CIS Sustainable Leaders Trust, are sold through the Society’s direct sales-force in people’s homes. The availability of this product has extended the interest in social investment within the Society’s customer base, and the Trust has always been amongst the largest funds of its kind, although it represents less than 1 per cent of CIS’s overall assets. The managers of the fund have been able to demonstrate that the adoption of an ethical approach to a fund’s structure is financially as well as ethically sound. Indeed, the following data, supplied by S&P Micropal, show how well the Trust has performed compared with industry acknowledged benchmarks

Ă‚ÂŁ1000 invested on 31 December 2002 was, on 31 December 2005, worth:

● £1664 if ‘invested’ in the FTSE All-Share Index

● £1672 on the basis of the Average UK All Companies Fund

● £1733 if used to purchase units in the Trust (assuming the income was reinvested).

There is a continuing market for screened investments, although the potentially greater financial risk must be made clear to customers. Nevertheless, the trend has been towards using enhanced analysis required to integrate social, ethical and environmental (SEE) considerations with the investment mainstream. In 1999 CIS launched a programme known as ‘Responsible Shareholding’, applying to all equity funds and based on engaging with companies on matters of concern. These matters were identified through a customer consultation exercise, from which an ethical engagement policy was developed which provides the basis for approaching companies. In part, this represents a reaffirmation of the Co-operative movement’s democratic roots, but it also acknowledges the fact that SEE issues are increasingly important in establishing a company’s social responsibility and future sustainability. This does not relate only to a company’s community activities, but also to the way in which it develops its workforce, for instance, and above all how it governs itself in the relationships between management, board, shareholders and other stakeholders. Analysis of corporate governance is an important part of Responsible Shareholding, and CIS undertakes to vote on every motion put to investee company AGMs (whenever possible), supplemented if necessary by attendance to raise questions from the floor. Reporting is seen as an essential component of corporate responsibility, and detailed analysis takes place of disclosure on matters such as executive remuneration and SEES issues, in order to determine how the Society’s votes will be exercised. Along with some other UK investors, CIS has been recognized in the press as one of the foremost UK institutions practising Socially Responsible Investment (SRI). It is becoming increasingly accepted that such activities contribute to investment sustainability – UNEP’s Asset Management Working Group concluded in 2004 that environmental, social and corporate governance issues affect long-term shareholder value, sometimes profoundly. If this is proved, it will demonstrate that an active response by companies to SEE and governance concerns voiced by customers does enhance the financial returns that they receive.

 
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Case study

Internationalizing financial services in the European Union

In 1985 the European Commission published a White Paper, ‘Completing the Internal Market’, which proposed a series of measures to create a single internal market among the countries of the then European Community. This was codified in the Single Europe Act of 1986, the first major amendment to the Treaty of Rome (which had initially established the European Union in 1957). This Act required that the measures outlined in the 1985 White Paper should be implemented by the end of 1992, and included provision for mutual recognition of national product standards and a range of other measures to eliminate barriers to trade within the Union. The Single European Market formally came into being in 1993, underpinned by the ‘four freedoms’ – free movement of goods, services, labour and capital.
In the case of financial services, the single European market aimed to eliminate restrictions on cross-border activity, thus encouraging greater competition, greater efficiency, lower prices and better service for customers. Given the high level of regulation in financial services and considerable differences in industry tradition, the single market relied on the principle of mutual recognition – if a financial services provider was licensed to operate in its home market, then it was effectively free to provide services to consumers throughout the European Union.
Although formal legal restrictions on cross-border activity in financial services have been largely removed as a consequence of the Single European Act, progress towards a genuine single market in retail financial services has been slow. Genuine cross-border trade in financial services failed to grow substantially, and most providers serving non-domestic markets did so by establishing a physical rather than an export presence, with that physical presence typically being via mergers and acquisition rather than greenfield developments. In principal, there is no reason why many retail financial services need to be provided locally; in practice, most are. Take the case of a mortgage; while it is technically possible for a resident of Germany to obtain a mortgage for a house in Germany from a Spanish bank, in practice many customers are nervous of non-domestic providers with no physical presence in the market. Equally, banks may be concerned about lending into a different legal environment where it may prove costly to recover the security (i.e. the house) in the event of default. Differences in tax treatment and consumer protection legislation between countries may also serve as a disincentive to the purchase of savings and investment products across borders. In business markets, progress has been rather faster and the degree of integration is much greater, although considerable effort has been required to address areas such as capital adequacy requirements and accounting standards.
Recognizing some of the particular difficulties with financial services, the European Commission developed a Financial Services Action Plan (FSAP) in 1998 which focused on eliminating barriers to cross-border trade. The Action Plan concentrated on developing a genuine single market for wholesale financial services, creating open and secure retail markets, ensuring the continued stability of EU financial markets and eliminating tax obstacles to financial market integration. Considerable progress was made in relation to the wholesale markets; progress with retail markets was slow and the scale of crossborder activity remained low.
Subsequently, in December 2005, the Commission published a White Paper, ‘Financial Services Policy 2005–2010’, to outline its policies for the rest of the decade. The White Paper focused its attention on ensuring that existing policy changes were implemented and consolidated, improving regulation, enhancing supervisory convergence, increasing competition between service providers and expanding the EU’s influence in global financial services.

 
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Case Study

Centralized mortgage lending – a salutary story

The latter part of the 1980s in the UK witnessed the rapid birth, and almost equally rapid nadir, of what were termed centralized mortgage lenders. Names such as The Mortgage Corporation, National Homeloans and Mortgage Express came from a standing start to take of the order of 25 per cent of new mortgage business by 1990. Their success was based upon a combination of opportune timing and the unresponsive nature of traditional sources of mortgages, most notably the building societies.
In terms of good timing, the centralized lenders were able to take advantage of a period of time during which the cost of funds on the wholesale money market was cheaper than retail-sourced funds. Building society mortgages were largely funded by retail-sourced funds – indeed, there were strict limits on the percentage of their mortgage funds that could be sourced on the wholesale money market. Being centralized lenders, they had no branch infrastructure costs to carry and were able to administer new mortgage applications efficiently from one central administration centre. This gave them additional cost advantages which, together with lower funding costs, gave them a clear pricing advantage over their traditional rivals.
Three other factors worked together with their pricing advantage to give the centralized lenders a tremendously strong competitive edge. First, they were able to process new mortgage applications very fast (often within 24 hours, compared with the 4–6 weeks that was typical for building societies at the time). Speed is of the essence for the typical homebuyer as, once a desirable new home has been found, there can often be a race to cement a deal with the seller of the property. Secondly, the centralized lenders appreciated the importance of intermediaries, such as estate agents, mortgage brokers and insurance company sales agents, in placing new mortgage business. In the late 1980s, in the order of 60 per cent of new mortgages were placed with lenders via intermediaries. This resulted in a very low cost of new business acquisition compared with the branch costs of the traditional lenders. Recognizing the role of intermediaries, the centralized lenders focused their own new customer acquisition activities upon them. Thus, high volumes of new business were generated at low cost, and in a short period of time the newcomers were challenging the supremacy of a well-established incumbent industry. Thirdly, the centralized lenders brought product as well as service innovation to the mortgage business. They were able to use their treasury skills to provide new forms of interest rate management, such as fixed rate and ‘cap-and-collar’ loans.
They began to use securitization as a means of putting their loan books off balance sheet and thereby enhancing the return-on-capital to their shareholders. They introduced so-called deferred rate mortgages, most notably the 3:2:1 scheme, whereby the interest rate payable in the first year of the mortgage was a full 3 per cent less than the standard variable rate (SVR), reducing to a 2 per cent discount in the second year and 1 per cent in the third year. The ‘6 per cent’ deferred interest arrived at in this way was to be added to the outstanding loan at the end of Year 3, and the new, higher amount would be repaid at the prevailing SVR from Year 4 onwards.
The meteoric rise of the centralized lenders was also assisted by three factors external to their control. First, the house-purchase market in the UK experienced a sustained boom from 1985 onwards. Secondly, interest rates were falling steadily towards the end of that decade. Thirdly, in 1999 the Thatcher government gave advance warning that it was going to remove a tax-break known as ‘multiple MIRAS’. This had the effect of lighting the blue touch paper on a firework – the housing marketing rocketed property values to stratospheric levels.
Just as propitious timing had brought about the dramatic growth of centralized lending, so too did a set of negative economic factors result in its almost equally dramatic demise. During the course of 1990 interest rates began to rise – indeed, in little over a year the base rate doubled from 7.5 per cent to 15 per cent. Unsurprisingly, the housing market went from boom to bust within just a few short months. The centralized lenders’ price-edge evaporated, causing already declining sales to fall even faster. The rapid rise in interest rates caused hardship for borrowers, and mortgage payment defaults began to grow. At the same time, falling property prices rapidly eroded the margins of security of the lenders. To make matters even worse, many borrowers on deferred-rate mortgage schemes were among the defaulters. This meant that the interest outstanding grew rapidly and added to the losses that would be incurred as security margins disappeared. It should be borne in mind that the centralized lenders’ ‘asset’ base of mortgages was accumulated when property prices were at or near their historical peak, and that loan-to-value ratios were typically 90 per cent. In other words, the lenders had a margin of security of just 10 per cent, while between 1990 and 1992 the average property value fell by the order of 30 per cent. The outcome was that the new lenders withdrew from the market by ceasing to accept new business in order to limit further potential losses for their shareholders. All operational focus was upon damage limitation by acting quickly to gain access to whatever security remained in the valuations of properties in default. Repossessions rose sharply, and so did the financial losses of the centralized lenders.
Inevitably, it was the more ‘successful’ companies which had built the largest books of business that suffered most, and the majority of the high-profile lenders went out of business. Some of the smaller ones managed to survive, and have carried on at the margins of the mainstream business.

 
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