Dec 16, 2009

Collateral damage

The Opes debacle has eroded the foundations of ANZ's reputation, but there were already problems lurking in the bank that John built. Danny John and Stuart Washington report.

It was a night to savour. And not just for the irony of Hanoi hosting one of the most prestigious award ceremonies on the calendar of that capitalist high temple, banking.

Gathered in the glittering ballroom were hundreds of bankers who had flown in to pay tribute to the region's top professionals, recipients of annual achievement awards from the Asian Banker website.

Australia was well represented, with awards going to St George, National Australia Bank and Commonwealth Bank.

But standing tall that March night was John McFarlane, ANZ's recently retired chief executive, the proud winner of a lifetime achievement award.

The Scots-born McFarlane was recognised for the indelible mark he had made on the industry in his adopted country and further afield: ANZ is the only big Australian bank that is determinedly pursuing growth in Asia.

The tribute was unashamedly positive: 10 years of leadership in which revenue had doubled to $10 billion; a tripling of the bank's stockmarket value to $53 billion; promotion of women in management that was almost unparalleled; and building ANZ's presence in Asia at a cost of $800 million.

"McFarlane has also been credited in instilling a strong staff culture in the bank and it is clear from speaking to his former employees that they have as much admiration for him as a leader as they have pride in working for the bank," the award judges said.

There was an equally impressive gong for the bank: the trophy for Achievement in Risk Management for 2007.

Looking back now, the March 17 awards - just six weeks ago - look like an exercise in sarcasm. Three days later ANZ had advanced a $95 million loan to the stockbroker Opes Prime, a week before its collapse. It unleashed a storm that did significant damage to the bank's reputation, a reputation which McFarlane had built assiduously during his decade-long tenure at the top.

The very culture that McFarlane nurtured, and was gushingly recognised for, has been effectively undermined by revelations that four middle-ranking employees in the unit that had overall responsibility for Opes had trading accounts with the broker. Now fundamental questions have replaced awards for the bank that John built.

How could it lend so profligately against such poor credit risks as Opes and Tricom? Where were its risk management policies and procedures? How could this happen? And how good was McFarlane really?

PROBLEMS that emerged during the Opes debacle came from within ANZ's institutional banking division, an area that had been a thorn in McFarlane's side for years.

As the new chief executive, Mike Smith, said bluntly at ANZ's half-year results announcement on Wednesday: "It has quite clearly been mismanaged for a long time."

McFarlane inherited a bank with multiple problems in 1997, including the damage to its reputation caused by slashing branch numbers in Australia, from 1600 in the early 1990s to fewer than 800 by 2000.

But he also had to deal with an institutional banking division that was caught out more badly than its peers during the Asian credit crisis in 1997 and again by bad corporate loan losses on Pasminco and Enron early in the 2000s.

McFarlane was both inherently cautious and a calculated moderniser in his time. He was no big risk taker, and indeed steered away from huge plays.

A banker's banker, he concentrated on what he thought banks should do best - primarily, providing great customer service where it mattered, face-to-face at the counter, handling their money wisely and offering affordable home and personal loans.

The positive result of McFarlane's stewardship for ANZ was a reputation that 12 months ago was seen by rivals as practically bulletproof. It had the lowest cost-to-income ratio, the happiest staff and the highest customer satisfaction measures.

McFarlane's strategy tended to favour the more traditional retail parts of ANZ's business over the corporate side, even though almost half of his career had been spent with the likes of Citibank and Standard Chartered.

His mantra on institutional banking was that of "de-risking" the business.

But this policy changed when "de-risking" resulted in a substantial drag on profit growth. Earnings actually declined halfway through the 2004 financial year from a division that contributed a third of the group's overall profits.

McFarlane sought to fix this four years ago with the recruitment of a new high-flying boss from London, Steve Targett.

That episode is now before the courts as the result of a multimillion-dollar unfair dismissal case by Targett, who parted company with ANZ last June. His case provides two telling insights into the internal workings of the bank.

First, the central thrust of Targett's claim is that he was overlooked as McFarlane's successor after having apparently been enticed to join ANZ in 2004 for that reason.

Targett's case exposes internal dissension that dominated much of the final year of McFarlane's tenure.

Rivalries simmered. The chairman, Charles Goode, launched what amounted to a public spat with McFarlane as Goode attempted to dislodge him. Eyes were taken off the ball.

Second, the case spells out in fine detail McFarlane's loss of confidence that Targett's high-powered hiring strategy had turned around the division's performance.

The writing was on the wall at last April's interim results announcement when McFarlane described the profit contribution from the division as "subdued". It was a none-too-subtle reference to low revenue growth and increased staff costs, which restricted profit growth to just 4 per cent before provisions for bad debts.

The contrast to the stellar increase in the retail banking business and the total profit, up 16 per cent to a record $2.1 billion, could not have been starker. Institutional had let the side down.

There is an acceptance now that ANZ became too cautious during the boom time and lost business to domestic and international competitors.

Targett was gone within six weeks.

He is now suing ANZ for $57.7 million, alleging board and other bank representatives hired him under false pretences, because he had not been favourably considered for the role of chief executive despite assurances when he was hired he "would be best placed to secure the role".

ANZ had steered clear of the private equity and mega-lending mergers and acquisition boom over the previous three years. Ironically, in light of problems surrounding many highly geared investments these days, this lack of visible success was to cost Targett his job and dash his hopes of taking over from McFarlane.

Instead, Targett's mandate was to concentrate on what were considered less risky and more profitable areas of business.

The retreat from offshore lending to the supposedly safer ground of wholesale funding and financing in Australia seems to have inadvertently encouraged the division to swap international risk for more hidden problems back home.

The Opes Prime disaster is a devastating blow for the institutional banking operation, and Tricom and Opes take ANZ straight back to the bad old days of its Pasminco and Enron exposures.

It also blots the copybook of ANZ's former chief risk officer, Peter Hodgson, who took over as the head of institutional banking when Targett left.

SOMEWHERE within ANZ there is almost certainly a document that outlines the reputational disaster that was Opes Prime, before the collapse became known to all.

And, under ANZ's own risk-management policies, this document would have gone to the very highest levels of the bank for those senior executives to approve further lending in March.

Within the bank there is a credit and trading risk committee, which is responsible for making key credit-related decisions. It also becomes involved on issues affecting ANZ's reputation. It is chaired by David Stephen as chief risk officer, in Hodgson's old role. Stephen joined ANZ in 2003 as general manager of its wholesale risk business, before being promoted to head all of the institutional division's risk operations two years later.

Other members of the committee include Smith and the senior managing director, Bob Edgar, as well as the chief wholesale credit officer, the chief retail credit officer and at least two divisional managing directors.

The bank's annual report states: "[The committee] ensures that the necessary group executive judgment and experience is applied to critical credit decisions relating to the group's larger and higher-risk customers."

By the middle of March, Opes was both large and high-risk. Large, because by then ANZ had loans to Opes of about $650 million.

And risky, because by the time ANZ decided to advance a separate $95 million lifeline on March 20 Opes was already deep in trouble. And ANZ knew it.

In an affidavit attempting to assert ANZ's ownership over Opes Prime shares, Antony Cahill, ANZ's head of financial institution products, said ANZ had been aware that Opes was in deficit - effectively owing ANZ margin calls - since late February.

In these circumstances it is easy to see how the decision to advance an extra $95 million could not be left at Cahill's level. Or, indeed, at the level of Ben Steinberg, the head of corporate portfolio management and the only ANZ executive whose name appears on the March 20 loan document.

The role of senior management in the final Opes loan is acknowledged by Smith. He said on Wednesday of the level of knowledge about Opes within ANZ: "It was me down."

Just how effective the credit committee was in coming to terms with the dangers represented by Tricom, Opes and the Melbourne-based securities firm Chimaera Capital will be a matter for an internal inquiry.

But where was the credit committee - or any kind of risk management - when the original loans were being written? These were loans that were ultimately secured by little-known day-trader favourites such as Bannerman Resources and Conquest Mining.

And the exposure has been very real: a $650 million lending headache, and a $95 million last-minute - and swiftly disappearing - cash life-line to Opes.

The bank looks to be able to sell the small stocks and recoup almost all of the loans. But it comes at a devastating cost to its reputation of giving more than 1200 investors a significant haircut.

And the highly controversial seizure of a $1 billion share portfolio is set to make a bonanza for the lawyers in myriad court cases centred on the stocks' disputed ownership.

Smith says that a stock lending business making a relatively small $10 million annually was below the radar, despite the large headline figures of its total lending. "This particular business was well down the line," he said on Wednesday. "Had it been in the sights I think we would have picked it up sooner."

The first loan on Tricom's books from ANZ was a $10 million facility made in 2001, at a time when Laurie Emini and Julian Smith were working with Tricom on establishing their now-infamous business model. The pair went on to found Opes.

And ANZ's exposure to the businesses grew and grew, with little or no oversight from ANZ's vaunted risk-management policies.

NOW the clean-up is on. While usually supremely optimistic and combative, the new chief executive is very much on the defensive at present. Smith has said publicly that any ANZ employee found to have broken the bank's rules in the Opes Prime affair can expect little mercy from him as he goes about limiting the damage from its fallout.

The results of the inquiry he is overseeing to work out how ANZ got into the mess and, more importantly, how it gets out of it at the least possible cost, will be carefully couched so as not to give further ammunition to the bank's growing list of critics.

Smith told the Herald the inquiry was a "necessary evil". "I need to have this [issue] resolved," he said.

He is acutely aware that his plans to build a Asian banking powerhouse over the next five years could be derailed by the share value-destroying effect of the legal timebomb now ticking after the Opes implosion.

Smith attempted to define his term early on by publicising his ambition to double the bank's profits to $8 billion by 2012 and, in doing so, become a major player in Asia.

But reaching his Asian growth goals will almost certainly hinge on how he addresses the reputation issue.

"The reputation of this institution is paramount to me," he says. "I will do everything I can to ensure that we uphold that reputation and indeed enhance it."

There are some additional challenges for an Asian expansion strategy after a share price slide of about 30 per cent in the past 12 months.

Wednesday's results made it clear that the institutional banking business is back with a bang, and McFarlane's policy of de-risking the business is now history.

The bank has used the liquidity crisis afflicting foreign banks to move aggressively, grab business and increase lending.

In fact, the institutional banking division performed so strongly it topped McFarlane's former heartland of retail banking, with institutional contributing $1.27 billion compared to retail's $1.2 billion.

But another consequence of the institutional push is that ANZ is once again courting large corporate exposures at a time when credit risk is increasing. Provisions for bad corporate debts have increased to $975 million, up from the last year's first half-figure of $240 million.

Riding this particular tiger is the former risk officer, Hodgson, who has earned his stripes in operational businesses previously, including BZW and Bank of America.

McFarlane quarantined institutional banking problems, but evidently never solved them. The problems would go on to besmirch his previously golden record.

Now it is for Smith, coming from a multinational HSBC background, to weigh whether the opportunities of strong institutional growth during the liquidity crisis outweigh risks shown by ANZ already having a much-larger bad debt profile than its rivals.

It will be up to him whether ANZ's chequered history of managing large bad loan exposures will also come to mar his own time with the bank.

And whether, next time around, ANZ gets a risk management award that doesn't blow up in Smith's face.

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