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I am writing this blog in Japan where we have historically
strong relationships with some of the top Japanese
banks in the derivatives, risk and regulatory areas.
I always enjoy visiting Japan. We have now extended
our Japanese business to Japanese regulatory reporting
(BOJ and FSA) where we have already won two non-Japanese
bank customers. This is a further part of our commitment
to Asia where we now have over 100 employees. We
have also had commercial success in Asia; for example
in Singapore we have recently gained prestigious
new clients for Regulatory reporting from our competition
as well as winning brand new clients, while we are
extending our global collateral management relationships
to bank's operations in Tokyo and Singapore.
Our main regulatory focus at present is however
in the UK where as the market leader in bank regulatory
reporting we have a tremendous opportunity to assist
our 140 or so UK regulatory customers in the transition
from light touch to heavy touch regulation, beginning
with the reform of liquidity reporting including
liquidity stress testing. Our origins in the Risk
Management and financial instrument valuation space
since the early 1990s and the Regulatory Compliance
business also since the early 1990s make us well
placed to handle this transition well. Others are
making lots of marketing noise about what they could
do, but we are already doing it!
The regulatory space is not exactly short of interest
at the moment. Mr. Obama has announced his vision
for US financial regulation in the last week, while
the EU has just agreed a system of having some EU
wide super-regulators for Banking, Insurance, Securities
and Systemic Risk. Time will tell what effect this
will have on local reporting in the UK and other
member states, but I have not met a single person
in the last six months who thinks that there will
be less regulation in the next five years than in
the last five years. Obviously that means a lot
of work for Lombard Risk in this environment, but
we have an advantage of starting that process with
a significant customer base in the regulatory space.
The other main business of the company, collateral
management software, has been growing fast with
a strongly increasing pipeline for COLLINE® from
banks and asset managers in the USA, Europe and
all over the world. Nothing succeeds quite like
success, and our contract wins in the last few months
with major clients have certainly helped our message
spread beyond our own efforts at spreading it.
I am often asked whether I see green shoots of recovery.
My own take is that things are getting slightly
better, particularly for banks and banking centres,
after a traumatic 2008. From the anecdotal evidence
of New York taxi drivers saying things are better
to our own experience that we have a growing pipeline
and are closing deals, it is hard to see that things
are turning down further in the financial sector.
But there is no hiding that London was very hard
hit by the banking crisis, and that its competitive
position has been weakened for several years to
come by the return to more simple banking. It is
of course greatly in the interests of France and
Germany to try to level London down further with
more uniform regulation, and we have seen the first
round of this in the last week. It will however
take a lot to beat the advantages that 15 million
English speakers in the London commuter belt and
the UK's less burdensome labour laws give London.
And once the UK election is out of the way, there
should be greater certainty of policy which will
be helpful. But the tax take from the City and its
workers will be much reduced for years, not only
because of reduced earnings of firms and lower bonuses
and staff numbers but because of the huge tax loss
carry forwards. One of my budgetary predictions
is that the time that tax losses can be carried
forward for will be greatly reduced.
Lastly, like many others I have followed the events
in Teheran with immense interest. It needs unbelievable
courage to stand up against a tyrannical regime
which would rather shoot its own people than lose
power even when it is frightened that it has lost
the support of the people. The Iranian people deserve
much better. To hear the "Supreme Leader" use Friday
prayers to whip up a crowd composed of his own thugs
to chant Death to Britain and Death to America is
an extraordinary flashback - not something I expected
to hear in 2009, and quite a perversion of a religious
event. At least the Iranian people have shown us,
so encouragingly, that they are much better than
their leaders. It bodes well for the future.
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This week I have been very busy making sure that
what can be signed for our year end is in fact signed.
Despite some good progress in closing deals it is
incredibly encouraging that our pipeline remains
very strong.
The G20 summit this week is apparently the biggest
gathering of world leaders since Bretton Woods.
After weeks of anticipation it is hard to see that
the outcome will not be an anticlimax. Let's hope
that at least there is a continued commitment to
free trade as well as most likely some statements
about regulation. However as a UK taxpayer I am
truly grateful to the Bank of England Governor Mervyn
King for saying that further fiscal stimulus is
beyond the UK's means. I personally have no wish
to spend the next fifteen years paying excess tax
to cover a spending binge which the country does
not need although it may be the governing party's
last hope of staying in power after 2010, nor to
see the country needing the help of the IMF.
In common with most other responsible employers
we are issuing guidelines to our staff asking them
to avoid the City of London (not London of course)
on 1st/2nd April when massive demonstrations are
planned around the G20 summit and to avoid "dressing
like bankers". It is quite annoying that this should
have to happen. The City is a vital part of the
UK's economy, and as important to the UK economy
as engineering is to Germany or Japan. How can someone
rational therefore be against the City ? It is such
nonsense. I do think we have not been helped by
some politicians using loose and inflammatory language.
Harriet Harman who is Deputy Leader of the UK Labour
party, said on BBC at the beginning of March about
Sir Fred Goodwin's £700,000 pension (ex CEO of RBS)
that "It might be enforceable in a court of law,
this contract - but it is not enforceable in the
court of public opinion, and that is where the government
steps in." This is scarcely the language of a country
in which the rule of law is paramount. If you don't
want fire then avoid pouring fuel on the flames.
There are major changes planned in bank and securities
firm regulation coming at the end of 2009 or early
in 2010, and I have been spending time with some
of our major customers discussing what is likely
and sharing our plans. For those not as familiar
with bank regulation, the issue is enhanced liquidity
reporting in the UK and elsewhere as discussed in
FSA consultation paper FSA CP 08/22 which can be
read up more fully on http://www.fsa.gov.uk/pages/Library/Policy/CP/2008/08_22.shtml
, and stress testing which can be read about on
http://www.fsa.gov.uk/pages/Library/Policy/CP/2008/08_24.shtml
. It can be anticipated that many other regulators
are watching this closely and that once in a more
final form similar rules will be introduced in a
number of other countries. This is a very big deal
for bank regulation and as such a clear opportunity
for Lombard Risk as the market leader in UK bank
regulatory reporting and the Global number 2 in
bank regulatory reporting.
I also had a very enjoyable trip recently to Singapore
where our business is doing quite well on the regulatory
side, and enjoyed meeting most of our customers
there and some prospects. We have been gaining,
and look like continuing to gain, good market share
there at the expense of one of our competitors that
has recently had a very major multi-site project
cancelled by a large bank and has lost other customers,
some to us. We now have close to 100 Chinese speaking
staff in our firm around our Asian offices, and
it seems hard to imagine this won't be an advantage
in Singapore and other Asian countries in months
and years to come.
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There has been an interesting development in the
regulatory space over the week-end. European politicians
have got together and declared in effect that the
previous system of regulation has been ineffective
(or at any rate insufficient) and that there needs
to be an additional level of super-regulation at
EU level chaired by the European Central Bank to
monitor system-wide risks and another to combine
(but not replace) the efforts of National Supervisors.
This is based on some of the recommendations of
a recent report by former Bank of France Governor
Jacques de Larosière, also former Head of the IMF.
In addition there have been clear admissions by
some European politicians such as Angela Merkel
that Basel 2 has proved inadequate because of its
pro-cyclicality. These are indeed interesting developments.
Like any model the key issue is whether a “backtesting”
of the de Larosière proposals would actually have
alerted the authorities and banks faster to the
impending catastrophe that hit our banks. After
all the authorities in each country already look
at systemic risk and the regulators already talk
to each other a lot in organizations like the Financial
Stability Forum. It isn’t clear in the case
of most of the banks in the UK that all the information
on bank portfolios was greatly obscured by cross
border issues across Europe. That might be different
for an Austrian bank lending today in Hungary or
Russia, but any issues with that are a late crisis
effect causing issues now rather than the early
warning which everyone would have liked 2 years
ago.
In the UK we have continued furore about the pension
arrangements of the ousted CEOs at HBOS, RBS and
others; while understandable I am left with an uneasy
feeling that this is a wonderful diversion of the
spotlight away from those who should more properly
be in it. It does come back to my theme in my November
blog that while senior bankers are certainly responsible
for individual decisions at their banks, they are
not responsible for systemic risk. Responsibility
for that lies fairly and squarely between Governments,
Central Banks and Regulators. They need to start
accepting that the immense destruction of wealth
from the 95% fall in bank share prices that has
hurt so many pensioners is their responsibility
too, not just that of the bankers themselves. So
many of those pensioners wanted relatively low risk
investments and the systemic breakdown failed them
badly.
One of the questions I am sure will be asked again
and again is why policymakers did not heed numerous
warnings from senior bankers on the pro-cyclicality
arising from a combination of Basel 2 and mark to
market. I am a strong believer in mark to market
– a far better solution than having hidden
reserves. But while Basel 2 was a great improvement
on what came before it, the effect of its capital
calculation provisions combined with a rigorous
mark to market for assets in which there is very
little market was to require banks to maintain more
capital at the bottom of the business cycle and
less at the top of the business cycle. This makes
no sense. That said, Basel 2 has not yet been applied
in the USA or other major countries like China,
so while this is an important factor for UK and
other EU banks, the collapse of the U.S. mortgage
market remains the big issue for U.S. banks. It
is hard to see that regulators were not aware of
European banks’ exposure to that market.
I am very encouraged that recent interviews with
Lord (Adair) Turner of the FSA have been very frank
- a great breath of fresh air.
I am constantly asked what I think the outlook is
for the next couple of years. I do think 2009 will
be a very difficult year for many but I expect the
year to end on a more positive note than the beginning
with a turn in the stockmarket by the end of 2009.
The City of London and the New York Tri-State area
will remain badly hit by everything that has happened,
with financial sector employment not regaining its
previous level for years, and bank bonuses suffering
the same. After the fall in the Pound, the Euro
looks vulnerable to me - people think it's the new
DM but really it's also the Drachma, the Peseta
and the Irish Punt. And the majority of credit exposure
to Eastern Europe lies in the Eurozone.
The key to the recovery will be banks' confidence.
The coming bank reporting season will help get us
through that, but there will be one or two horror
stories on the way and more unexpected cash calls
like HSBC. The obvious policy measure that Governments
all over the world should take now (and I have been
saying this for months now !) is to have countercyclical
capital ratios for banks - i.e. let banks leverage
themselves more in the bad times like now, and less
in the good times. Costs the taxpayer nothing and
ends the paralysis.
I feel quite schizophrenic in the current economic
environment - I listen to radio in the morning and
read the FT on the train and think the company or
its customers must surely no longer be there. Then
I get to work and find myself negotiating or working
with colleagues on several multi hundred thousand
pound contracts where we have won the business -
after all banks can't avoid regulation and they
need collateral management. And the initiatives
from the regulators on Liquidity can surely only
be good for us. Then I take the train home and the
cold shower starts all over again as I read the
Standard !
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Lombard Risk earlier this week made a formal announcement
to the London Stock Exchange about the relatively
small impact of the credit crunch on its business
so far, but I thought it would be helpful for our
stakeholders to hear more about this in my own words
in an article I have just written which is reproduced
after this paragraph. This makes today’s blog
entry much longer than usual, but so be it. I need
to point out that this is my blog alone, just as
what I say in an investor meeting or a chat with
a staff member or customer would be my words alone.
Although of course I talk frequently on these subjects
with my board, these should therefore be taken as
my thoughts only and not a formal board position.
The speed of the worldwide liquidity crunch has
been stunning and at times almost impossible to
believe. Three weeks ago the world was staring into
the abyss of a catastrophic systemic meltdown. This
seems to have been averted by massive Government
action on a co-ordinated basis between major countries.
But the fact is that within a matter of months we
have gone from a system where central banks acted
as a lender of last resort to one where central
banks are the main provider of liquidity to all
banks because banks will not lend to each other
and there have been massive contractions also in
commercial paper funding. The unwinding of hedge
fund positions and other deleverage effects has
given rise to daily volatility comparable to previous
annual volatility (witness the Pound going from
USD 1.63 to 1.52 and back to 1.59 in 24 hours on
24th October). Stock prices have gone down very
heavily as the effect on the real economy has now
become very apparent.
We now face calls for a new world order and this
will be determined largely by politicians and policy
makers. The real danger is that there will be a
backlash against bankers for causing the whole crisis
when in reality politicians and regulators must
share some of the blame. However good the market
information of Goldman Sachs or the economics department
of Citigroup, individual institutions can never
have the same ability to gather information as the
authorities in a country who gather information
from all banks and market participants.
Governments and regulators are powerful. They have
access to information, they can guide and if necessary
they can arm-twist. They often do in Financial Markets,
an example being the UK FSA a few years ago being
very assertive in ensuring more timely documentation
in derivative markets which has been followed through
to create greatly safer markets for instruments
like credit derivatives. Another example was the
UK Government forcing banks not to charge for the
use of each others' ATMs. So Governments clearly
have the power to give very strong guidance over
certain types of activity, and if necessary they
don't hesitate to use it. But they all failed to
realize that imprudent lending to individuals and
banks' standards of verification of personal income
would become a major systemic issue rather than
just an issue of imprudent banks losing money. Why
was that - because banks became so efficient at
originating this type of risk and then repackaging
it that the losses fell on many more people and
in far larger amounts than on the originators themselves.
Systemic risk is most definitely an issue for Governments
and Central Banks not for individual bankers. But
these Authorities didn't identify in time how big
a bubble banks had managed to create, or if they
did they didn't take steps to deflate it gently.
Additionally if Central Bankers didn't know or shout
loudly enough, it also suited Governments to acquiesce
because economic growth accompanied by low headline
inflation rates is what bolsters politicians' credibility
and gets votes. It suited Governments to take the
credit for years of economic boom which caused a
property bubble and huge increases in paper personal
wealth. Now that the property and related securitization
bubble has burst and much of this paper wealth is
gone, it is of course expedient to lay the blame
for the resulting bursting of the bubble on the
imprudence of the banks that we as taxpayers have
had to bail out. Success has many fathers yet failure
is always an orphan. Yet we surely can't just blame
the banks but need to blame the Governments and
Central Banks for not sounding much earlier warnings
on this systemic threat despite having much more
access to information than individual banks about
what was really going on. So it seems to me that
what clearly happened is as follows:
1. Banks became very good at the "originate and
distribute" model, partly pushed in that direction
by the capital treatment being vastly better than
holding assets on their own books.
2. As assets were repackaged there was less incentive
to ensure high credit underwriting standards. If
your customer is happy with what he buys there is
little incentive to improve the product.
3. The repackaging of securities was done professionally
but institutional investors started to relax their
standards by investing based on rating rather than
fundamental analysis. Should you blame the salesman
for mis-selling or the buyer for buying something
he hasn't analysed properly ?
4. Internal capital models in the Basel 2 banking
regulations necessarily had internal credit ratings
enshrined in their methodology. How could a regulator
challenge a bank's internal ratings for such paper
when it could point to the rating agencies giving
the issues very high ratings.
5. The rating agencies had inadequate models to
stress test the impact on structured products such
as CDOs or if they did have them they failed to
apply appropriate stress tests; if they had applied
stress testing of even one quarter of the market
moves that have taken place they could never have
given such high ratings. They were very highly paid
for doing such ratings, so were inherently somewhat
conflicted in not wishing to kill the goose that
laid the golden egg.
6. The Authorities either failed to compile appropriate
data to aggregate what was happening or, if they
did, failed to interpret it properly to see the
increasing systemic risk that this property bubble
and efficient securitization presented. In the specific
case of the UK this may have fallen between the
cracks with the FSA having all the bank specific
data and the Bank of England only having overall
data.
Any predictions in such a market can look laughably
out of date in hours let alone days or months. But
here is what I think may happen :
1. There will without any doubt be changes in bank
regulation, both information provided and how proactive
bank regulators are with banks - less "light touch"
than before. Whether these changes will shut the
stable door after the horse has bolted is irrelevant
- there will be tightening of regulation in all
major countries and on a very co-ordinated basis.
2. There will be lots of criticism of the role of
derivatives particularly in the US but at the end
of the day this will be seen to be misplaced as
these play such an important part in allowing risk
to be transferred in a very clear legal framework.
Any changes will be limited to more detailed reporting
requirements and ensuring more controls on inappropriate
mis-selling.
3. The more esoteric structured securitization products
like CDO² will die a death owing to lack of market
demand for them rather than regulation.
4. More will be reported to regulators, but in turn
Central Banks will be asked to revise the statistical
information that they publish to include more in
the way of scenario analysis and stress testing
of the whole system. This will cost more to do,
but the cost will be peanuts compared with the cost
of the catastrophe that has been presided over.
One such risk factor that should be included would
be some analysis around the consequences of a property
price fall. Government with all its information
can do this while individual firms cannot unless
they pool some very sensitive data. Governments
may want to share this data internationally or create
a supranational agency. My guess is they would rather
control it and share it than let an external body
do it, but then it may create less personal risk
for politicians to let an external body do it, so
this decision will be interesting to monitor.
5. There will be critical evaluation and Government
enquiries into why there was no anticipation of
the storm, when data on property financing and CDOs
was available from quite extensive reporting already.
It will be less embarrassing for the incoming Obama
administration in the US to demand such an enquiry
than for the current UK administration which has
been in power for 11 years. We all saw for years
that America was living beyond its means on the
back of rising property wealth, and buying more
and more goods from China who then lent more and
more money back to America and that this was not
a sustainable position. But few individuals were
able to see the scale of the bubble. The authorities
could have, and should have shared it.
6. Far from becoming extinct, credit derivatives
will eventually become widely publicly traded and
quoted on exchanges. Why should it only be the financial
elite who use this valuable market ?
7. There will be some re-evaluation of what the
Authorities should share with the public and when.
The natural inclination is to avoid creating instability
as no-one wants to start a run on a bank, but in
this case minor instability earlier would have been
preferable. This issue is at the heart of the matter.
8. There will be a complete re-evaluation of the
role of Rating Agencies. Should there be legislation
to make clear that they have a duty of care to investors?
Should they perhaps also revise the rating system
to include not just present rating but some estimate
of the sensitivity of rating to changes in market
conditions. AAA-S1 meaning AAA and stable might
be obviously less risky than AAA-V3 meaning AAA
but very volatile.
9. Many hedge funds that rely on leverage will face
a lethal combination of investor withdrawals and
having to reduce their leverage. Many will close
or merge - even good ones run by highly capable
people.
10. Smaller banks and others like credit card companies
will face a tough time and will have to redefine
their business models to survive successfully. Many
will merge and others will disappear.
11. The UK Government will become by far the biggest
hedge fund in the UK with its stakes in several
banks funded by massive issue of bonds. The Government
will have a structurally huge incentive to try to
keep interest rates low.
12. The overall effect on the UK could be massively
negative. The City is by far the UK's most successful
international industry and any significant weakening
of the City by this crisis will be extremely serious
for both the UK's foreign currency revenues and
the UK Government's tax take from City firms, from
high earners in the City who will earn less and
from tens of thousands of people in the City who
will lose their jobs altogether. Expect an even
weaker pound in the next year, and sharp UK tax
rises after the next UK election. Let's hope that
UK policy makers fully recognise the seriousness
to the UK economy of a weakened City because acquiescence
in a new world banking order of back to basics without
financial innovation will hurt the UK greatly (and
the New York tri-state area by the way) and benefit
countries like Germany and Japan with a very strong
industrial base. I suspect our policymakers do recognise
it, but they will need to be very tough in withstanding
pressure from other countries with less to lose.
What does this mean for Lombard Risk?
Positives are:
i) we are in absolutely the right areas of risk
and regulation
ii) In the risk area banks want to spend despite
cutbacks elsewhere. There is tremendous interest
in collateral management at the moment. With COLLINE®
we are the number 2 player in the world in collateral
management software and are rapidly catching up
the number 1. We have a good and growing pipeline
for our collateral management software, and there
is also pressure from regulators to handle counterparty
risk and liquidity better.
iii) In the regulatory area we have a very large
customer base of over 200 banks, and we see lots
of pressure likely from regulators to deliver additional
reporting functionality. Our customers will need
this and we will be expecting them to pay for it.
Negatives are:
i) some of our customers will disappear and others
will merge
ii) there will be more pressure to cancel non-essential
projects - thankfully most of ours are essential
One of my biggest concerns at present is the lack
of liquidity in the AIM market and the nervousness
of investors generally. A company like us that is
a market leader in various spaces and Global Number
2 in others needs access to capital at sensible
valuations in order to be able to expand fast and
pursue an M&A strategy. This is available in
the Private Equity market. Yet the last two weeks
have seen our share price fall by over 30% for no
apparent reason but more to the point on only a
few thousand pounds' worth of selling. This volume
could easily have been mopped up by me or directors
believing in the company but we are now in a close
period due to our interim results and under AIM
rules are unable to deal. One has to ask whether
such rules really in practice serve to protect the
interests of investors given that director dealings
have to be disclosed anyway. But such is the way
of all regulations - they can have unintended consequences.
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This week sees Lombard Risk moving to its new much
larger office in Shanghai and once again I find
myself writing this blog in a plane over China.
Our new office in Shanghai has space for upto 150
people and will see us through several years of
organic growth or growth by acquisition. We now
house in Shanghai not only a development centre
but also a quite sizeable implementation team to
support projects all over Asia in conjunction wth
our other offices in HK and Singapore.
A huge advantage of China for us is the ability
very easily to deal with Asian character sets. China
itself simplified its own character set about 20
years ago, but it is still an ideal base to support
countries or regions whose character set is Chinese
or based on Chinese. This includes Japan and Korea
(where Chinese characters supplement Hiragana and
Hangul) as well as Taiwan. It is so much easier
to do this work in China than in the UK or even
India, and it makes us an immediately credible company
to support banks' regulatory compliance requirements
in these countries.
We are now looking actively to increase our sales
and marketing effort in China and are looking for
outstanding candidates. With the presence we have
there we believe we have significant revenue opportunities
and that we can be a trusted and reliable partner
for banks in China.
Business elsewhere continues largely unaffected
by the credit crunch. Of course not every deal closes
when expected and not every salesman meets sales
targets, but that happens even in raging bull markets.
Some of our customers are merging which brings opportunity
for more revenue as well as a threat to existing
revenue. But what we are not seeing is large scale
deferral or cancellation of projects. This is not
a commentary on the banking sector as a whole but
is our experience in the risk management and regulatory
compliance space.
On a lighter note I find that Lombard Risk is now
in the GRC space. This is short for Governance,
Risk Management and Compliance. Not an acronym I
had heard of 18 months ago but one I suspect we
will hear much more of like so many expressions
that start life in the US. As my father (who is
a university professor) once pointed out to me,
language continually evolves.
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The end of last week saw Lombard Risk announce
a 25%+ increase in revenues over the previous year
and a return to profitability in the second half
of the last financial year, and it was obviously
very pleasing to be able to announce this. Several
times in the last year I have been told that private
equity valuations for our type of company would
be significantly higher than valuations on AIM,
but I would so like to be able to prove this current
received wisdom wrong – when the end game
of any private equity investment is eventually to
be able to achieve an IPO or trade sale, why on
earth should a fast growing company like us that
has started to become profitable and has already
achieved an IPO trade at less than 1 times historic
revenues when a lot of private equity valuations
are in the range of 2-4 times revenues ? I continue
to have faith that, assuming we continue to deliver
results and growth, the AIM market will eventually
value us in line with private equity valuations
– it just makes no sense for this disparity
to exist. But obviously valuation is for others
to judge and the main way my team can influence
it is to deliver results and spread the message
that we are achieving results !
Once again, I believe strongly that my blog is
a good place to share some of the personal views
which trade partners and institutional investors
expect to receive from me in private meetings, and
which add further insights to the regulatory announcements
we make or need to make from time to time. For obvious
reasons it is harder to communicate 1:1 on this
same level with most private investors, and as a
result they otherwise would only have access to
the regulatory information given to the London Stock
Exchange (LSE), and would be disadvantaged versus
institutional investors.
I have been asked several times what the current
problems in the banking sector mean for our sector
of the market and for Lombard Risk in particular.
Time and time again I have found myself looking
at the level of business we are achieving and then,
after reading European and US newspapers which are
so gloomy at present, wondering whether it is for
real. But it is. I am not positioning myself as
a commentator on the software industry as a whole,
or on IT spending by the financial services sector,
because there are several such expert writers in
the UK and many others internationally, including
some very capable analysts at investment firms,
who do that for a living. But I can only share what
my own experience is.
- Firstly, we are not experiencing any tangible
slowdown in new business demand that I can measure.
This is undoubtedly because we are in some of
the right sectors -- regulatory compliance and
risk management -- which banks either have to
have, or need to have.
No banker that I know is enthusiastic about the
ever growing level of regulation, yet I don’t
know of a single one who thinks that the regulatory
burden is going to decrease in the next 5 years
– and we are the market leader in the UK and,
globally, the number 2 provider in the niche market
of bank regulatory reporting software.
- Secondly, the time is right for improved credit
risk management and, through our COLLINE® software,
we are a global market leader in proactive collateral
management software, which is an integral part
of credit risk management.
No Chief Risk Officer wants to go to his CEO to
inform him that inadequate processes or software
for collateral management have meant that his organization
was among the last to call a counterparty on the
brink of bankruptcy for margin. With what we believe
is the best product in the market both functionally
and technologically (e.g. fully web based end-to-end
collateral management solution including repos and
trade reconciliations) we are seeing a significant
increase in interest in this area. As well as benefiting
from the credit risk market opportunity, we also
have been executing on a huge Y2K type program management
operation requiring delivery of regulatory software
upgrades for Basel and other regulatory changes
to most of our UK customers. This exercise has resulted
in quite a few changes in our processes and operations
– more on this in later updates. We have also
recently delivered the important COREP and FINREP
regulatory reports working for Ireland and Luxembourg,
giving us two new additional markets where we can
compete very credibly. We are also making good headway
in Asia where we will add several more countries
later this year in which we will have an immediately
deliverable solution.
We also are a provider of software for Anti-Money
Laundering (AML) software, and more and more bank
regulators are demanding that banks and investment
firms have solutions for this. It was pleasing to
see that we came 4th in a recent IBS Publishing
global survey of new business gained for AML software
in 2007.
The UK banking picture remains that we are seeing
a continued deterioration in the market with property
prices falling, greater negative equity, and higher
delinquencies especially on buy to let mortgages.
Quite apart from the Northern Rock debacle, the
share prices of several UK banks and former building
societies have fallen very sharply. More may be
to come and I am told on very good authority that
the property situation in Ireland and Spain is much
worse than the UK. Falls in bank share prices and
the repricing of the Bradford and Bingley rights
issue have inevitably put great pressure on other
firms in the sector which are assumed by the market
to have similar problems and funding requirements.
That restricts their funding which in turn restricts
the availability of credit for buy to let which
in turn can only lead to softer property prices
and more negative equity. If unemployment were to
rise appreciably at the same time as this and higher
fuel and food prices, it would be very damaging
for the personal spending outlook. So this game
is not yet played out, but I do believe this outlook
is now priced into most although probably not all
UK bank share prices. I would personally be surprised
to see any more UK bank failures – although
not at all surprised to see the better capitalised
banks acquiring the weaker banks in the mortgage
market.
The big picture seems to me to be that we are seeing
a major shift of wealth from West to East as the
ownership of banks and other firms changes through
continued recycling of the huge Far Eastern trade
surpluses and of the Middle Eastern and Russian
oil surpluses through Sovereign Wealth Funds and
rich individuals into financial assets. It is a
double gain for such entities that they can now
pick up these shares at historically distressed
prices.
Lombard Risk should be well placed in this fast
changing picture. Firstly our focus areas of regulatory
compliance and financial risk management are areas
that banks either have to have or need to have.
Secondly we are a global business; the current pessimism
of the City of London and many other western financial
centres is matched by the relative optimism of Asian
financial centres as evidenced by the shortage of
high quality office space in Singapore and Shanghai.
Then specific to us we should be able to attack
our cost/revenue ratio further as we build our regional
presence in Asia and further improve our solution
delivery capability. This combination of factors
look set to help revenues and hold down our costs,
which makes me cautiously optimistic.
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Part of my motivation for writing this blog is
that I believe passionately in allowing smaller
investors similar access to my own and the company's
thinking that institutions expect to get. I have
written about this before, but it really is hard
to see that small investors don't lose out on AIM.
They get less information, fewer chances to talk
to senior management and much less access to placings
which are often done at below the market price.
Aside from outstanding exceptions like t1ps.com
and Shares Magazine, there is so little coverage
of AIM stocks that small investors really do need
to do a lot of their own research. I would stress
that the views here are my own and not necessarily
those of all of my board, but again that is what
an institution would get in a one on one meeting!
Among the main strategic issues our company needs
to have a view on at the moment are the following,
in the context that Lombard Risk does business with
about 200 banks and quite a number of asset managers
or hedge funds:
| a) |
How serious is the sub-prime crisis and the
consequent effect on bank liquidity?
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| b) |
If it is serious how significant will that
be for bank and asset management firms’
technology spending?
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| c) |
How is our own company’s current range
of products placed within that? I have just
put on record in my Chairman’s Statement
that “the Group has had a record quarter
for billings and has so far seen virtually
no signs at all of a slowdown in spending
by banks in those areas affecting the Group’s
core businesses”.
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I am struck by the disparity between the gloom
and caution I hear from quite a few senior banker
friends, and the fact that many of the traders who
are mostly in their 20s or early 30s seem to believe
this is no more than a short term correction. Perhaps
it is simply because the latter have never seen
a full scale recession and that they are as dismissive
of the lessons of the past as any generation has
been before them. Or they could be right and for
every experienced risk manager in London or New
York forecasting a downturn, there are Middle Eastern
and Chinese investors waiting to snap up bargains
and recycle some of the vast oil or manufacturing
trade surpluses their countries are enjoying; a
genuine new economy story in fact that few in work
today have experienced before.
Where does this leave banks? The biggest effect
of the U.S. sub-prime crisis followed by the incidents
at Northern Rock, IKB, Landesbank Sachsen and so
on seems to have been to dry up the interbank market
(the lending by one bank to another). This is not
because large banks have no liquidity, but rather
that at a time when there are rumours about the
solvency of individual banks no bank wants to be
left having lent to that bank – there is little
income from lending to other banks and certainly
no prizes for getting it wrong. This in turn means
that those banks that rely on net interbank funding
are being much more cautious about doing business
in case they can’t fund it. Presumably bank
regulators are also making clear that this would
be wise! Add to this the fact that the business
a bank would previously not have taken onto its
books but would have securitized or syndicated can
no longer easily be laid off, and this further dries
up borrowers’ access to funding and also pushes
up the price of the lending margin a bank is going
to charge. And to make it worse some of the loans
that already had been securitized have had to go
back onto banks’ books. So in summary I think
that what this means for banks is the following:
| a) |
Banks already have had to cut back on their
corporate lending and this won’t end
soon.
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| b) |
The lending margin on the new corporate lending
that banks have done has and probably still
is going up in a period of rationing of credit,
and therefore profitability from lending may
still be holding up well.
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| c) |
The write-downs banks have had to take on
sub-prime and CDOs are now largely in the
market although there are still difficult
valuation issues when there simply is no price
for the size of position a bank has, and it
may well be that the mark to model approach
used by many banks still does not represent
the worst case – why else would a delegation
of the big accounting firms have spoken with
the FSA about this subject recently?
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| d) |
The real issues for banks are:
| i. |
The one off write-offs on CDOs and
sub-prime have had at least a temporary
adverse effect on bank capital ratios
and on the amount that banks can lend
- unless like Citigroup, Barclays or
UBS they raise new money.
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| ii. |
Liquidity constraints for banks that
have less non-bank deposits than they
do non-bank lending. Of course fear
can change this balance and rapidly
erode a deposit base, the extreme recent
example being Northern Rock. Any such
fear strengthens strong banks and weakens
weaker banks.
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| iii. |
Any possible increase in bad debts
owing to more borrowers having difficulty
in re-financing will be a threat to
bank profitability balanced by the higher
lending margins banks are charging.
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My guess is that of these ii. is the issue now
and iii. is going to be the real issue, and
it is to address both that the central banks
are injecting so much liquidity into the system.
The European Central Bank’s injection
of EUR350 billion this week really is a very
large amount of money. |
Given the above issues for banks, it seems to me
almost inevitable that banks will be looking, in
as discreet a way as possible, to reduce their costs.
Why discreet? Because in the current market, when
every bank is questioning the credit worthiness
of all its customers, no financial institution wants
rumours going around that it itself is suffering
from lack of liquidity. That will inevitably mean
deferring non-priority expenditure or growth justified
expenditure whether on recruitment, premises or
technology. This will surely hurt rental levels
and occupancy rates in the City, event organizers,
those seeking large bank sponsorship, and anyone
selling something a bank can do without for a little
longer.
I look at this macro picture and it argues for
a firm like Lombard Risk that supplies banks and
asset managers/hedge funds to be lowering its revenue
forecasts for calendar 2008 and cutting its own
costs appreciably ahead of a likely downturn. But
then I look at our own order book and find that
we have had a record last three months for billings
and that our key issue is managing implementation
of multiple regulatory projects rather than any
lack of new business. I attend our weekly management
meeting, and find that our sales pipeline for 2008
is healthy and that new deals are there to be done.
This argues for not cutting back.
Every CEO or business leader receives lots of advice,
both internal and external, and has lots of data
to look at. Inevitably not all of that data or advice
points in the same direction, but it is still a
CEO’s job to navigate through fog which will
miraculously lift with the benefit of hindsight.
The present situation for us where the macro picture
is worrying while our own micro picture is encouraging
is an unusual conflict in that data. But here is
our thinking at present:
| i) |
The regulatory software side of our business
is likely to be relatively immune to the overall
issues in the banking sector and the economy
provided we do not see the disappearance of
many banks through mergers or the closure
of London branches of foreign banks. Banks
have little choice but to comply with regulations,
although sometimes they do successfully lobby
for delay in the implementation of regulatory
change.
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| ii) |
With credit risk such a big issue at the
moment, expenditure in the credit risk and
collateral management area is likely to remain
strong, and our Colline product should actually
benefit from this. A bank doesn’t want
to risk being the last bank able to make margin
calls from a risky derivatives counterparty
because it has sub-standard systems.
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| iii) |
We have been and intend to continue growing
the proportion of our headcount in Shanghai.
In some areas like the current regulatory
surge we have had to add to UK headcount in
the short term, but in anything other than
the short term the Shanghai factor should
allow us to reduce costs without reducing
our delivery capability.
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I am glad that unlike many technology firms our
business model for 2008 doesn’t revolve around
selling product or hardware upgrades for which banks
see only marginal benefit, since that kind of expenditure
will surely be at risk in 2008.
In summary I think that the business model we have
at Lombard Risk should allow us to perform well
in relation to other software companies selling
to banks, and that we should almost be judged as
a standalone company rather than as an IT company.
Our current share price of just under 5p values
us at below 1 x historic revenues, and well below
1 x analyst forecast revenues. Quite a number of
software companies trade in the range of 2-3 x historic
revenues. More than that I should probably not say!
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I've been having quite a bit of interaction with
fund managers recently thanks to our excellent Investor
Relations professional Peter Gaze. Many small company
CEOs lament the fact that their broker takes too
little interest in their story, so perhaps the best
way of ensuring one sees investors is to arrange
it oneself. Companies don't expect a broker to arrange
all their meetings with clients, so why on earth
should that be the case with investors? As a company
gets bigger, investors will be more inclined to
find the company, but smaller firms have to do more
of the work themselves.
What this always throws up is the huge disparity
between what institutional investors learn about
a business and what smaller private investors get
to know. The securities laws are designed to protect
smaller investors, but they also take away much
of the ability a company has to treat its shareholders
equally.
Here are a few examples :
| 1. |
If one offers shares for a significant amount
to more than 100 investors, a full prospectus
is necessary. This is a major expense and
causes huge delay following implementation
in the UK of the EU prospectus directive;
not only are the lawyers fees much higher
but the FSA needs 2-4 weeks to read the prospectus.
So even though CEOs like me would much prefer
to make shares available to all our shareholders
and to new private investors, it is much quicker
and more efficient to have shareholder approvals
to disapply preemption rights and approach
a few institutions.
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| 2. |
One might like to approach a few friends
who one knows can afford a few thousand pounds
and see whether they would like to invest.
But to approach them without falling foul
of the Financial Promotions legislation one
has to obtain prior to those conversations
a certificate saying that the person is a
high net worth individual. Even if a CEO like
me knows the person is well off he could be
at legal risk if he doesn’t get such
a certificate.
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| 3. |
New issues are usually done at a discount
to the current share price. Moreover for some
companies there are EIS or VCT tax breaks
for investors in new shares which do not apply
to buying shares in the secondary market.
So by being excluded from placings the private
investor loses not only on price but also
on tax breaks unless he puts his money in
an EIS or VCT fund and invests that way or
unless he has a managed account with a Private
Client stockbroker. Many investors I know
would rather invest their own money directly
into a company and avoid the 4% management
fee and 30% carry fees of an EIS fund, but
this is made more difficult by the rules designed,
rightly, to protect Aunty Ethel! And our firm
is still EIS eligible until July 2007 when,
because we have 120 employees, we will fail
the test of less than 50 employees introduced
in Gordon Brown’s last budget.
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| 4. |
When a transaction is
going on, many institutions that would potentially
be buyers are unlikely to buy in the market
or are precluded from dealing. For a company
on the up, an institution has no reason to buy
in the market if it knows it can buy more cheaply
in a placing, and once it becomes an insider
it is precluded from dealing. So all the poor
private investor knows is that trading volume
has gone down and that the share price is not
doing much. I wonder how many shares are sold
at such times by private investors when informed
institutions are not wrong-footed in a similar
way. |
I don’t know the solution to these issues,
because everyone is acting in good faith and complying
with the law, but the end result is that the private
investor is systematically disadvantaged by the
rules if he or she invests directly, and by management
fees if he or she invests through a fund. My own
favoured solution will be to find legal ways of
reaching out to private investors to put them on
a more level playing field with institutions but
without costing the company huge extra expense and
time. Anyone with good ideas on how to do this is
welcome to e-mail me on

Time to get back to work. Our firm should be a
major beneficiary this coming year from Basel 2
upgrades by all its regulatory reporting customers
in the UK. And our information is that some of our
competitors are behind with their Basel 2 products,
so that gives us a good opportunity to gain market
share!
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It is 5 a.m. in London but
here, on my way back to London from Shanghai over
the Gobi Desert north of Beijing, it is 1 p.m. and
the landscape looks absolutely freezing.
I have become quite a regular
visitor to China owing to our office in Shanghai
where we now employ 32 people, but every time I
come here I still feel privileged to be able to
make frequent visits to this interesting country
that is such a rising force in the world.
This week I spent time in Beijing
as well as Shanghai. It is a place of enormous change,
almost unrecognisable from the Beijing of 10 years
ago. And although Shanghai, where Lombard Risk is
based in China, is where most foreign banks set
up, Beijing is still the place where most Chinese
banks have their headquarters.
As I arrived in Beijing I read
that the largest Chinese bank ICBC now has a market
cap second only to Citigroup, having overtaken Bank
of America last week. But so once did the main Japanese
banks! Will the Chinese banks become stronger and
stronger or will they make the same mistakes as
their Japanese counterparts did fifteen years ago?
We need to help them with our risk management products
to stop that happening.
The visit to Beijing reveals
other interesting information. Some of the major
commercial banks have 10,000 branches in China;
there are 28,000 banks in China (sadly most of them
much too small to be targets for Lombard Risk).
I can see that Beijing has changed beyond recognition,
but to validate this a colleague shows me a newspaper
article which says that of the top 200 bars in Beijing
five years ago only seven exist today. Either their
buildings have been bulldozed to make way for the
future, or they have gone out of business. I bargain
a furry hat for my daughter down from RMB 200 to
RMB 35 (£2).
We meet some impressive people
in Beijing at banks and regulators. The top people
there are world class but it is that much more of
an achievement that they can get things done in
such a huge country.
Back to our Shanghai office
in Pudong where we are building up an excellent
team. Within the last year we have managed to develop
Chinese bank regulatory reporting to a high standard;
this would have been a hugely speculative project
in the UK but now it is a low risk project for us,
and we are the obvious vendor for foreign banks
to select – and in due course Chinese banks.
Making our systems multi-lingual suddenly has huge
buy in from the team which it would never have had
in London. Our Oberon product has been moved forward
very satisfactorily since my last visit, and I discuss
issues around binary options on Fed Fund futures
with our Chinese development manager.
I host lunch for 9 people from
our office in an excellent Chinese restaurant overlooking
the Bund. The bill comes to RMB 1,100 (£70).
Just as I am thinking how efficient
China is, I get involved in a conversation about
increasing the capital of our Chinese company. Back
to red tape – we have to submit a business
plan to the Chinese authorities explaining why we
need a capital increase and explaining how software
is a growing business. All so we can invest more
money in China and employ more Chinese nationals
! Surely with foreign exchange reserves of $1 trillion
they will relax these kind of controls before too
long.
It’s late on Friday afternoon
and I see that the Lombard Risk share price is back
up to 10p again. We announced earlier in the week
that we were on track for 50% like for like revenue
growth. That is based on the growth of our regulatory
software business, our collateral management business
and our ability to scale up our operations in China
at much lower cost than if we had to do it in the
UK. It has been a tiring week, but I leave feeling
we made a very good decision setting up in China.
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