Building Society Update - Twin Challenges - Issue 7, Spring 2011

Welcome

Stephen Williams

We are entering better times. Strong capital levels and robust governance structures are now in place at most building societies.

However, economic uncertainties remain, downside risks are prevalent, and new capital requirements and forthcoming regulation could damage the sector.

In this publication we have provided our thoughts on a number of key areas of interest and concern for the industry such as raising governance standards, the UK Bribery Act, the potential implications of the International Accounting Standards Board's proposals and the FSA's new Remuneration Code.

In addition, we have also performed a survey. This has reviewed the capital position of a significant sample of the largest 40 building societies. From our review, we have concluded that all the societies sampled would meet the core tier 1 requirements set out in Basel III in December 2009, including the additional 'conservation buffer' of 2.5%. Of the societies sampled, 80% would also have core tier 1 ratios in excess of 10.5%.

It is therefore clear that despite the challenges that new regulation like Basel III can present, societies appear to be well placed to respond to requirements for increased levels and quality of capital, funding and liquidity. This is down to societies typically having a generally low reliance on short-term wholesale funding, prudent levels of liquidity holdings, limited appetite for innovative capital instruments and dependence on retained earnings.

I hope you enjoy the read.

Governance in building societies

In this short piece we take a look at the current state of building society governance. Always an important issue, improving governance matters now more than ever. We examine the numerous market challenges facing our sector, from Treasury, rating agencies, investors and the effects of the Walker report, and make recommendations as to how societies should react, as well as approaches to consider, concerning risk and remuneration.

Why is governance important?

For individual societies:

• A strong Board will drive the society forward in these continuing uncertain times. However, to remain competitive, the governance framework must also be both effective and flexible to enable decisions to be made quickly.
• Effective governance provides the society with the ability to move the risk appetite quickly and in a controlled way.
• An effective governance framework maintains confidence from all stakeholders – including possible capital providers and longer term funding counterparties.
• Effective governance ensures the regulators see the society in a positive way.
• NEDs have a particular "Trust" like responsibility to manage the society in the interest of present and future members.

For the sector as a whole, improved governance is required in order to provide comfort to the FSA. This may enable them to relax the boundaries of the Building Society Sourcebook, providing individual societies with greater strategic flexibility.

Where is governance at this time within the building society sector?

There are some fantastic examples of strong governance throughout the sector, but there are also some immediate pressures:

• Reputational issues for the sector continue, and there is a perception that the FSA now sees the sector as part of the problem, and blames poor governance within the sector allowing this to occur.
• Building Society Sourcebook – need for alignment of governance and risk management systems and skills with business models and activities.
• Credit rating agencies – the credit downgrades have caused difficulties especially for those societies who are dependent upon covered bond programmes and other forms of wholesale funding. The agencies are demanding better governance.
• Institutional investors – PIBs and subordinated debt holders are demanding better governance, given the losses they have suffered in a number of transactions recently.
• The building society sector will need to continue to look for alternative ways of raising permanent capital and longer term liquidity. However, any new "equity" investor will demand better governance (and also require the interest of such investors to be met).
• The Walker Report.

How should societies react?

At the Board level what is important?

• Balanced board composition – boards will require a blend of experience – financial industry expertise, business experience and independence. However, it is important that certain Board members also have an allegiance to the locality and to the hinterland of the society. This is an important balance and is often hard to achieve.
• Time commitment needs to be increased for Board members – Walker stated a minimum time commitment of 30 to 36 days for NEDs on a major bank – but what about a building society? Walker also stated that a Chairman should devote two-thirds of their time to the business of the entity for a major bank – again, what about a building society? At the very least the time commitment required has increased, which will limit the capacity of NEDs to retain or assume board responsibilities elsewhere.
• In these times, personalised induction, training and development plans need to be in place for NEDs.
• New approach to meetings – rigorous challenge should be the norm, and NEDs should be ready, able and encouraged to challenge and test proposals on strategy put forward by the executive. In particular, NEDs should satisfy themselves that board discussion and decision-taking on risk matters is based on accurate and appropriately comprehensive information and draws, as far as they believe it to be relevant or necessary, on external analysis and input.
• There will need to be externally-facilitated board performance evaluation.

Risk Committees

Board Risk Committees should also be established where these are not in place. However, for smaller societies perhaps these can be established as part of a dedicated separate agenda within the framework of the Audit Committee with common membership. Increasingly, annual reports will also be required to describe risk strategy, appetite, and tolerance.

There is also a journey that should be embarked upon in the appointment of a Risk Officer. There are few examples at this time of the appointment of Chief Risk Officers, but there is a need to start this journey. This will elevate Risk within the society and create a greater level of independent challenge. The Risk Officers tenure, remuneration and removal should also require Board approval.

Remuneration

The Walker Report stated that at least half of executives' compensation should be performancerelated long-term reward. This is an entirely separate debate but it is important that pay is linked to long term member value through whatever arrangements are established.

There is definitely also a need for an increase in the oversight of remuneration policy and packages for all executives who perform a significant influence function for the society, or those who could have a material impact upon the risk profile of the society.

Other matters

This list should not be exhaustive but Board's should also consider:

• The positioning of the Risk and Compliance department.
• The roles of the Boards of individual regulated entities within the Group.
• The adequacy of the conflicts of interest policy in place.
• The effectiveness of the whistleblowing procedures in place.

Conclusion

Many building societies are reacting positively to the increasingly competitive market, and would appear to be well positioned in the present market uncertainty.

In particular, the sector continues to retain a strong local presence through extensive branch networks, with continuing strong links between building society brands and their local communities.

However, improved governance will ensure that the building society model continues to provide sustained and long term value for current and future members.

UK Bribery Act Raising the bar

On 30 March 2011 the Ministry of Justice published the finalised Adequate Procedures guidance on the UK Bribery Act 2010; becoming effective on 1 July 2011. The Act introduces stringent legislation to prevent bribery and more readily enforceable offences that organisations, including UK building societies, will need to factor into their risk management processes going forward.

Penalties and offences

The maximum penalty for bribery under the Bribery Act is increased from seven to ten years imprisonment with an unlimited fine. Perhaps more significantly, the Act is silent as to how fines on companies will be calculated – it may open the door for larger scale fines, in line with those levied in the US. High profile examples of these include the fine paid by Siemens amounting to $1.6bn and by Halliburton amounting to $579m.

Content

The Bribery Act contains:

• Two general offences of making or offering to make a bribe and receiving or soliciting a bribe.
• A new specific offence covering bribery of a foreign public official to influence them in the performance of their duties.
• The Act also creates a new offence under section 7 of the Act for failure of a commercial organisation that fails to prevent persons associated with it from committing bribery on its behalf.

Associated persons could include not only employees, agents or subsidiaries but a wide population of third parties who perform services, for or on behalf of an organisation. This potentially creates a significant risk of liability for a society under the Act.

Scope

• Section 7 of the Act applies to organisations operating in the UK (even if not UK registered), and to UK based organisations conducting business anywhere in the world, including the conduct of associated persons as mentioned.
• The Act is far reaching in terms of the offences and activities that it covers e.g. excessive or overly lavish corporate hospitality.

Appropriate defence

The Act provides for an organisation to defend against the section 7 offence of failure to prevent bribery, if it has adequate procedures in place to prevent associated persons from committing bribery, for or on its behalf.

The following six principles, set out in the finalised guidance, may help you decide whether you need to be better prepared:

Proportionate procedures – a society should have anti-bribery and corruption procedures that are proportionate to the specific risks faced by the business – and appropriate to the nature, scale and complexity of its activities.

Top level commitment – senior management should be able to demonstrate their commitment to preventing bribery, establishing a culture that supports this commitment and communicating the society's anti-bribery policy throughout the organisation.

Risk assessment – the society should perform a regular and comprehensive assessment of the nature and extent of its corruption risks.

Due diligence – the society should understand the background and reputation of the parties with whom it does business.

Communication (including training) – societies' anti-bribery policies should be effectively embedded in day to day business processes.

Monitoring and review – the society should implement appropriate monitoring and review mechanisms to ensure compliance with relevant policies and procedures.

Practical implications

Do you need to carry out due diligence of all your suppliers?

You only need to think about doing some due diligence on persons who will actually perform services for you or on your behalf. It is very unlikely that you will need to consider carrying out due diligence on someone who simply supplies goods to you or persons further down the supply chain.

Is hospitality, promotional and business expenditure permitted?

The Act does not intend to prohibit, hospitality, business expenditure and promotions for the purpose of improving the image of the organisation, or to build or develop relationships, where it is reasonable and proportionate. For example, the guidance states that in order to amount to a bribe under section 6 of the Act, (bribery of a foreign public official), there must be an intention for a financial or other advantage to influence a person in his or her official role, and thereby secure business or a business advantage.

In our experience when corrupt payments have been made by employees, representatives or business partners of an organisation, some key questions asked by enforcement authorities include:

• Did the organisation effectively communicate the policy regarding bribes, and that they should not be offered or paid on its behalf to the employee, representative or business partner? And;
• Did the organisation effectively control and monitor the activities of the employee, representative or business partner to ensure compliance with the policy?

We would suggest that these questions are useful considerations when senior management are assessing the adequacy of anti-corruption procedures and controls.

Questions senior management should be asking now

In light of our experience working on enforcement actions, and designing and developing anti-bribery and corruption, and our knowledge of the existing guidance, we have set out questions we believe senior management should be asking regarding their anticorruption policies, procedures and controls. To the extent that the answer to any of the questions is "No", we would suggest that senior management need to review the relevant policies, procedures and controls and take appropriate remedial action.

• Does the society regularly perform a corruption risk analysis on its operations in order to identify potential high risk areas and ensure the continued effectiveness of the society's anti-corruption procedures? Factors to be considered would include:
• • business conducted in countries with a high propensity for corruption, which is probably only relevant to a few societies if indeed any;
  • business conducted through financial advisers, joint ventures or other third parties; – business conducted with government customers;
  • business conducted with organisations in industry sectors with a high propensity for corruption;
  • operations where business entertaining is a significant element of the sales process; and
  • previous incidents of bribery within the society or the industries/countries in which the society operates.

• Does responsibility for anti-corruption procedures rest with a designated member of senior management with appropriate access to the board?
• Does the society have a clear anti-corruption policy and code of ethics that are visibly and consistently supported by senior management creating the appropriate "tone from the top"?
• Does the society provide regular training on its anticorruption procedures to its employees, representatives and business partners, and are the recipients of this training documented?
• Are employees, representatives and business partners required to certify on a regular basis that they have read and understood the society's anti-corruption policy and complied with its provisions?
• Are anti-corruption procedures and controls included in day to day business processes? Examples would include:
• • due diligence on prospective financial advisers, joint venture and other business partners. This might include making enquiries with local chambers of commerce, business associations, requesting financial statements, CVs and other references;
  • appropriate review and authorisation controls over the nature and purpose of payments;
  • right of audit over the activities of any financial advisers, joint ventures and business partners; and
  • specific procedures and controls covering the areas of gifts, hospitality, entertainment, customer travel, political contributions, lobbying activities, charitable donations, sponsorships and facilitation payments.

• Does the society have a system of internal controls designed to maintain accurate books and records and prevent their use to facilitate or hide corrupt payments?
• Is compliance with the anti-corruption procedures performed by employees, representatives and business partners regularly monitored by the society, for example through Internal Audit visits and/or data interrogation techniques?
• Does the society have a mechanism in place for providing specific and immediate guidance to directors, officers, employees, representatives and business partners on complying with the society's anti-corruption procedures when dealing with potentially problematic situations? One example would be a compliance help line.
• Does the society have a mechanism in place to allow employees, representatives and business partners to report suspicions of corrupt activity in a confidential manner, for example through a telephone hotline?
• Does the society have a response plan in place to deal quickly and effectively with incidents of potential corruption?
• Does the society have appropriate disciplinary procedures that address violations of relevant anticorruption laws and the society's anti-corruption procedures applicable to employees, representatives and business partners?
• Does the society promote its anti-corruption procedures to its employees, representatives and business partners through its performance management processes?
• Does the society factor corruption risk into its transactional due diligence programs? Corruption issues can be a key issue in the "buy" decision and are better dealt with pre rather than post acquisition.

Summary – Key messages

• The UK Bribery Act has become law introducing strict liability for corporate offences relating to the failure to prevent bribery occurring within an organisation. The only defence is that adequate procedures have been established to prevent bribery.
• A well controlled business is likely to have a substantial amount of the requisite control processes in place to be able to demonstrate adequate procedures – but they need to undertake an exercise now, and on an ongoing basis, to assess to confirm that this is the case.

The Act and more information can be found on the Ministry of Justice website.

The changing world of IFRS

The IASB is currently revisiting some of the principal elements of IAS 39 in response to feedback received on the impact of the standard, in the context of present economic conditions. The revisions are being reflected in IFRS 9.

The new standard will result in several significant changes to the accounting for financial instruments. Whilst the amendments to hedge accounting rules are likely to be helpful, the move to an expected loss impairment model in particular could bring several challenges, including a negative impact on capital and a possible dampening of future profitability.

So who is impacted?

The changes will impact both those currently reporting under IFRS and those undertaking the transition from UK GAAP to IFRS between now and 2014.

Impairment methodologies – a return to "good old UK GAAP"?

Not quite but for those societies that reluctantly released general provisions on adoption of IFRS, there may be some feeling of frustration.

The Exposure Draft (ED) issued in December 2009 proposed an 'expected loss' model, which would result in a smoother recognition of losses over the life of the loan compared to the incurred loss model. At present, interest is front-loaded (which includes a premium to cover the lender's expected losses) with 'lumpy' impairment losses recognised later during the instrument's life.

The IASB received a significant amount of feedback on the ED, much of which was positive; however a number of practical difficulties were identified in implementing a full 'expected loss' model. As a result, a supplement to the Exposure Draft was released in January 2011, in which the following model is proposed:

• Recognition of lifetime expected credit losses using a time-proportionate approach for financial assets in a 'good book' and full recognition of lifetime expected losses for financial assets transferred to a 'bad book'.
• There will be a minimum 'floor' level of provision against the 'good book', which is likely to be the losses expected in the upcoming year.
• The time period for estimated losses relating to the 'bad book' would be the reasonably foreseeable future, being a period of at least 12 months.
• The definitions of 'good book' and 'bad book' will require the exercise of some judgement. The latest guidance suggests that loans enter the 'bad book' at the point where the business' approach to collections changes.

In addition to changes in the accounting requirements, IFRS 9 will include enhanced disclosure requirements, which are expected to include the following:

• Analysis of 'good book' and 'bad book' and where applicable a reconciliation to nominal amounts in the 'bad book', including disclosure of the gross provision amounts, and details of write offs from the 'good book'.

• Disclosure in a tabular format of factors impacting credit losses for the 'good book' with five years of information. This would include lifetime expected losses, balance of outstanding nominal amounts, and any additional provision required to reach the 'floor'.
• A comparison of expected losses with actual outcomes.

On a practical front the change is likely to result in a need to revisit the design of impairment models, which could be a significant exercise for some societies. The new disclosure requirements could require the capture of additional information that is not currently reported within some societies. The increased disclosure requirements will increase the level of publicised information relating to the quality of mortgage books, which will have clear commercial implications.

Classification of financial assets – goodbye to AFS

The change in the classification rules for financial assets will have a material impact on some societies, resulting in increased income statement volatility.

The principal change that has been proposed is the removal of the AFS category. This currently enables certain debt and equity instruments to be held at fair value, with gains and losses being reflected in equity to the extent that they are not permanent impairments. Following the removal of this category, any assets within it will need to be reclassified as either Amortised Cost or FVTPL.

The use of the Amortised Cost category will be restricted to those instruments that are not traded, have basic loan features, and are held by the entity with the business objective of collecting its contractual cash flows rather than though disposal. In addition, the contractual cash flows of the financial asset must relate solely to payments of principal and interest on principal outstanding.

Where debt previously classified as AFS cannot be reclassified as Amortised Cost, it will need to be included in the FVTPL category with all fair value gains and losses being reflected in the income statement.

The treatment of equity instruments that are held as AFS will depend on whether or not they are held for long-term strategic reasons. Where this is the case it is likely they can be classified as Fair Value Through Other Comprehensive Income, with all gains and losses being reflected in equity, including impairments, and with no recycling through the income statement. Equity instruments that do not meet this criterion will need to be accounted for as FVTPL assets.

Hedge accounting – some positive news

The proposed model is principle based, and is designed to more closely align hedge accounting with risk management activities undertaken by businesses when hedging their financial and non-financial risk exposures. It should be noted that the proposals do not yet include portfolio hedging, which will be the subject of a further ED in 2011.

The ED moves towards a new hedge accounting model which combines a management view that aims to use information produced internally for risk management purposes, and an accounting view that seeks to address risk management in the timing of recognition of gains and losses.

The proposals of the ED include:

• A move away from quantitative effectiveness measures, such as the 80 – 125% effectiveness criteria, towards a model in which there simply needs to be more than an accidental level of offset, although the latter is yet to be defined.
• Extending the use of hedge accounting to net positions to improve the link to risk management.
• The removal of retrospective effectiveness testing, albeit that prospective testing is still required and ineffectiveness will still need to be measured.
• Fair value hedge accounting being reflected in reserves.
• New disclosure requirements that focus on the risks being hedged, how those risks are being managed, and the effect on the financial statements of hedging those risks. Certain existing disclosure requirements will change, for example fair value hedge adjustments will be disclosed separately rather than being offset against the hedged item.

Don't wait too long

The new approach to impairment accounting will almost certainly reduce capital and could dampen future profitability. Meanwhile changes to financial asset accounting are likely to increase income statement volatility. However, the changes to hedge accounting may be more helpful in reducing volatility.

Fundamentally this is not just an accounting issue – there will be real commercial impacts and our key message is that these need to be factored into business and capital planning. There will be practicality issues relating to modelling and data capture and these will need to be identified and addressed in advance. There is still a reasonable amount of time to implement the new standard, but don't underestimate the challenge.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.