Posts Tagged ‘Banking’

Leaders not models

Tuesday, June 15th, 2010

Business school graduates preparing to take their place in the working world should rely on critical thinking, integrity and their strength of character to shape their business success. These attributes will always be more important than blind faith in financial models, according to former chair of the Commonwealth Bank and chair of the Future Fund Board of Guardians, <i>David Murray,</i> OA.

Murray was addressing the UTS Business graduation ceremony on 12 May. He took the opportunity to consider what failures in business leadership contributed to the devastating financial crisis, the ramifications of which are still spreading across the globe.

According to Murray, current business education is still influenced by the pre-financial crisis environment. Post-crisis thinking is yet to fully emerge. A business degree awarded today has been earned in a world which had come to revere the power of mathematical modelling, and hold firmly the belief that any risk can be quantified and traded – even when market signals inferred an extreme risk.

True leaders need more than the ability to model outcomes – they need thinking skills, judgement, and a moral code that relies on more than ego or popularity. Business graduates must ask themselves: Have we learned how to think, or have we learned how to model?

Murray used three examples of failures in leadership thinking that, in his mind, contributed to the financial crisis.

#1: Government bonds are not risk-free

Government bonds are not risk-free. Governments can go bankrupt, default and find themselves unable to pay. Even governments underwritten by the power of the robust and wealthy European Union. Just ask the holders of Greek bonds. Yet a key assumption behind the capital asset pricing model (CAPM), the mathematical model that underpins the valuation of assets today based on future cash returns and which determines the rate at which cash flows are discounted is that government bonds are risk-free.

We hold this belief in risk-free government bonds because sovereign governments have the power to raise revenue and/or reduce expenditure if faced by the prospect of default on their bonds. Even if they refuse to act, there has been a belief that another government will bail them out, and because they will need future funding, they will see the error of their ways and fall into line. In human terms, people forget that those who lend their savings to others are entitled to be repaid.

The implications of this misplaced assumption are considerable. If you do your maths based on an incorrect set of figures, the outcomes will be unreliable. If you calculate investment risk, based on an arguably false sense of security that the CAPM model offers, then you will not have an accurate picture of the risk you are taking.

#2: Rating is not an exact science

When a ratings agency rates a bond or mortgage as triple A, the model assumes a probability of default of 4 in 10,000. That figure gets input to the computer program, on the assumption that the rating is an exact science. If a subsequent rating is lower, many large institutional investors in the world are forced to sell the lower-rated assets because their portfolio model requires that they only invest in triple A rated assets. This can set in motion a downward spiral in prices.

#3: Loss + declining ratings + mathematical models + leveraging = dangerous spiral

Banks incur a probability of loss on loans from the day they fund them. Yet, the ‘mark to market’ model which underpins accounting standards, does not allow banks to build reserves in good times for future losses. Thus the huge losses brought to account during the crisis had the affect of exacerbating it. Even worse, the declining market prices reflected a market momentum driven by the ratings, the mathematical models and super leverage – a dangerous spiral.

How could our financial leaders (public and private) allow spirals to develop with such serious cosequences both now and for many years to come?

Outcomes flow from inputs and systems. Without examining the nature of systems, it is impossible to assess likely outcomes. This requires critical thinking because every system is governed by people who need and respond to leadership, symbols and signals – all of which will affect the systems.

Leadership requires the exercise of judgement, and this relies on the values and beliefs of leaders.

Successive Greek generations have come to believe that tax avoidance and government indebtedness are okay. Greek leaders thought it was acceptable to lie to the rest of the world about their fiscal position – and they weren’t telling small lies. The outcome is that people have been killed in riots in Greece, as the size of the adjustment is so large and people try to get to grips with what it will mean in terms of their personal financial security.

In Britain’s case, a hung parliament coming after an enormous budget deficit means that firm fiscal action will probably be deferred, and an early next election may still not produce a clear mandate and decisive action. This is not about credit default swap prices, it is about people, their political systems, beliefs and behaviours.

How then do our graduates of today – the leaders of tomorrow – think about their role in the future?

In Australia, 16% of school leavers earn a university degree and only 4% a postgraduate degree. Because leaders need thinking skills to operate at higher levels of complexity of work, we should assume most will come from the graduate cohort.

Imagine our future if our leaders think everything can be modelled, and that the models are flawless.

No doubt, every graduate is thinking about promotion. At UTS, history tells us that business graduates acquire substantial skills and are more likely, on average, to get good work and get on the experience curve. But this leaves the exercise of judgement which requires exposure to critical thinking and an understanding of people and human systems.

Pre- financial crisis, two large systemically important banks in the United States had the same strong credit rating. They were both SEC- (US Securities and Exchange Commission) and Sarbanes–Oxley-compliant. They both complied with the Fed’s supervisory requirements and were capital adequate. Their PE ratios were similar.

Why is it that one virtually failed and the other did not? Clearly the leadership of one bank made some superior judgements about what they would and would not do. Not only that, the people in this bank trusted their leaders and had confidence in their judgement. This culture of trust and confidence turned out to be more important than all the regulation.

Leaders require an additional dimension – a moral code and strength of character which is not based on neediness, ego or popularity. There is no textbook on this but there is one good way to get on the path to good leadership.

Remember that ultimately, reputation is all you have. It can only be nurtured and be preserved by integrity of behaviour.

Tags: , , , , ,
Posted in MONEY AND MARKETS, PEOPLE | No Comments »

Banking on community: Crowdfunding

Monday, March 15th, 2010

Bank said no? Join the club. Now there’s a new way to fund your idea: ask the crowd. Rachel Botsman reports.

For more than three and half years, John Halko ran Comfort, a hole-in-the-wall five-table restaurant in Hastings-on-Hudson, New York. He specialised in simple organic home cooking. Being pretty much the only restaurant of its kind, it became a popular dining spot with the locals. In spring 2008, Halko decided it was time to expand to a second location. As it happened, a perfect space opened up, an empty studio just up the street from Comfort’s original site. But he was halfway through renovations when the credit crisis hit. Halko’s initial source of funding – a home equity line – ran out, so he applied for a loan. Despite having an above-average credit history, and a successful restaurant he received a ‘no’, a ’no’ and a ‘no’ from different banks.

Halko realised that his best asset was his crowd of loyal customers, some of whom would eat at Comfort a couple of times a week. Understandably, he felt uncomfortable asking them directly for a flat-out loan but was sure they would invest in the new restaurant, if he made the process simple and worth their while. He came up with the idea of ‘Comfort Dollars’, VIP cards that customers could purchase and get a 20 percent rate of return, in food, on their investment. If you bought a card with US$500 Comfort Dollars, you would be entitled to US$600 worth of food when the new restaurant opened. Through small amounts of money, from lots of different customers, Halko quickly raised the additional US$25,000 he needed to complete the renovations.

Franny Armstrong is a British documentary maker with a relentless passion for films based on David vs Goliath real-world stories that remind us of the impact individuals can make. Armstrong has spent much of the past five years creating The Age of Stupid, a film set in 2055 that takes a part-fiction, part-documentary approach to portray the impacts of climate change. When Armstrong first started the project in 2004, she wanted it to be completely independent of special interest groups and free from the pressures of traditional big movie studios who may have wanted her to tone it down or to hurry up. So she decided to do an open call to the public, whereby anyone could invest in the film. Those who gave £20 were given credit on The Age of Stupid website; those who gave £5000 and up will get 0.05 percent of any profits. More than £450,000 was raised from over 620 individuals by the time the film was released at the end of 2009.

Comfort Dollars and The Age of Stupid show how people around the world are mobilising the power of community collaboration to get things done outside of big banks and the financing middlemen. As with John Halko’s restaurant, this collaboration may be relatively small and rely on an existing community to tap into for funding. Franny Armstrong sits at the other end of the spectrum along with other creative entrepreneurs who are using the internet to bring together groups of diverse and dispersed individuals with a shared passion or interest, to invest small amounts of cash to fund a common project. They are replicating a community funded model on a much larger and unconfined scale.

The idea behind Comfort Dollars and The Age of Stupid is known as crowdfunding, derived from another neologism: crowdsourcing. This concept was coined by writer Jeff Howe as the ‘act of taking a job traditionally performed by a designated agent (usually an employee) and outsourcing it to an undefined, generally large group of people in the form of an open call.’ Crowdsourcing, now a well-documented phenomenon, is applied to solve problems (eg Innocentive, an open innovation community that provides solutions to tough problems), create products (eg Threadless, a community-centred online t-shirt store) or to develop collective repositories of content (eg Wikipedia). Crowdfunding is the same idea; just applied to financing.

Not a new idea

The basic principle of raising money and pooling the contributions of lots of individuals is nothing new. Politicians, (notably President Obama, who, during his election 2008 campaign, raised US$650 million from small donations) and charities have being doing it for years, although not necessarily under this moniker. But the potential of crowdfunding goes beyond a healthy stream of campaign finance or a credit shot-in-the-arm. Crowdfunding can create a community from the outset that will support, invest in and champion something they love, whether it be a film, an idea or a small business, and continue to promote and share in its success along the way. It’s hardly surprising that it’s fast becoming a funding solution of choice for some entrepreneurs, musicians, filmmakers, designers, social innovators, small business owners and even explorers.

Diverse forms of crowdfunding are emerging around the world, particularly in sectors such as fashion, music and sports, where people may feel a sense of emotional attachment to a product or idea. For example, Catwalkgenius enables fashion fanatics to invest in emerging designers in return for perks and a share of the profits; sites such as Akamusic, ArtistShare and SellaBand let people invest anything from US$1 to US$15,000 in a new musician or band; IndieGoGo and Biracy raise money for up-and-coming filmmakers; and the infamous MyfootballClub, started by William Brooks, recruited more than 50,000 sports fanatics to invest US$35 each so they could collectively buy and manage Ebbsfleet United FC in the UK.

Not all crowdfunding sites necessarily focus on one interest or type of product. A new breed of collaborative funding marketplaces is emerging (predominantly in the US) based on a microfinance-meets-venture-capital model, such as Mobincentive, ProFounder, FirstGiving, PledgeBank and Kickstarter, that enable everyone from artists to inventors, athletes to explorers to tap into capital from their communities to fund a wide variety of projects. One hundred and forty-eight backers collectively pledged US$8142 to fund Emily Richmond’s ‘Let’s Sail Around the World’ Project, to research and promote initiatives in sustainability; 62 backers pledged US$5518 to produce 500 editions of The Wonder City, a graphic novel by Courtney Zell and Justin Rivers that re-imagines New York’s history.

Outside of being a collaborative way to fund ideas and fuel creativity, crowdfunding is an inherently powerful and democratic platform to enable the public to influence niche projects. For example, Spot.us, an organisation that enables community funded reporting, was the subject of a recent piece published in The New York Times, ‘Afloat in the Ocean, Expanding Islands of Trash’ about the Great Pacific Garbage Patch, a swirling mass of trash soup. Lindsay Howshaw, a freelance environmental journalist, would not have been able write the piece were it not for the 100 plus donations, amounting to $10,000, that paid for her work on the story.

Similarly, there are the likes of first-time inventors such a Gretha Oost, a Dutch designer living in Melbourne, who needed a lump sum of upfront investment to bring her invention to fruition. Oost has invented a slick reusable water bottle that filters tap water on-the-go. Recognising that it would be difficult and time consuming to get the financing she needed to prototype, test and launch her product, Oost asked the Australian public to pay $32.10 to pre-order one of the 10,000 units she needs to bring her product, 321 (named for the 3 litres of water it takes to make 1 litre of bottled water) to market by March 2010.

What’s the incentive?

For the giver, it often has little do with expectations of financial rewards, but is about experiencing the camaraderie of being a part of something with a shared purpose that you believe in. It can just be the chance to meaningfully and conveniently interact with a creative or topical endeavour.

In all different parts of our lives, the collective power of physically dispersed yet virtually connected individuals is becoming apparent. As people move from hyper-individualistic consumer behaviours to a group mindset of getting things done, an empowering dynamic emerges. Crowdfunding, whether it be via local communities or online networks, is bringing people together, making them more willing to leverage the old rule of thumb: there is power in numbers. In this sense, the appeal is more about the ‘crowd’ than the ‘funding’.

Supporters may be rewarded with financial returns, but creators and founders often inspire people to contribute by offering both tangible perks (t-shirts, experiential exclusives or first editions for example) and intangible benefits such as credit or updates on the project from the founder as the idea takes shape.

When 23-year-old singer/songwriter Allison Weiss launched her project on Kickstarter, she reached her goal of $2000 in just 10 hours. She thought it would take 60 days. More than 205 backers pledged $7711 for Weiss to make and press 1000 copies of her latest song in eco-friendly digi-packs. A couple of days after Allison met her goal, she posted a project update on the Kickstarter website titled ‘Phone Call with The One who hit the mark.’ It is an honest and charming Skype video chat with Jacquie, a young woman in Australia who made the pledge that pushed Allison over her $2000 target. They marvel over time zones and issues of hemisphere, and Jacquie worries that, as a new Allison Weiss fan, she’s not as deserving of the thank you call as some of Allison’s bigger fans.

Weiss is not signed to a record label, she doesn’t have a manager but has a large online fan following. People pledged because she has real talent but her ‘rewards’ were also unique and highly personal. For her backers she did a ‘celebratory marathon live stream’ where she played every song she’d ever written. It took four hours. As Weiss commented ‘it was like a huge party on the internet for me and all my backers.’ The role of rewards on crowdfunding sites such as Kickstarter is to create the feeling of a backstage pass to a special community that you want to join. Yancey Strickler one of the co-founders of Kickstarter explained to me, ‘The actual creative project itself is secondary to experience or warm glow you get from contributing. Plus, the intimate access to an artist in their early stages is like being able to say that you were at the Cavern Club when the Beatles first played.’

The primary benefit for the receivers is obvious; interest-free money to make their creative ideas a reality or to get paid for their talents. But they also talk about an unexpected bonus: when people are effectively turned into community ‘shareholders’ they become not just financially but emotionally vested in the project. Whether it is a restaurant like Comfort, a film like The Age of Stupid, a novel such as The Wonder City, or a water bottle like 321, these early funders are a fan base motivated to promote to their own network, build momentum and word-of-mouth. In other words, crowdfunding creates a critical mass of participants, customers or fans.

It creates a crowd.

For me, it matters what the crowd is gathering for. There are relatively few limits to the number and type of independent social enterprises and creative ventures this model can help get off the ground. In the same way, the internet has created infinite opportunities to matchmake sellers and buyers, we now have the platforms to efficiently match people with money to give, with projects that are of interest and need funding. This creates a vibrant marketplace of realised creativity, ambition and innovation generated by the idea of banking on community.

RACHEL BOTSMAN writes, consults and speaks on the collective power of community. She will be talking at TEDX Sydney at CarriageWorks on 22 May, 2010.

Tags: , , ,
Posted in BIG PICTURE, BUSINESS DESIGN, CUSTOMERS AND COMMUNITY | 8 Comments »

Stop charging interest: Australia must get to grips with Islamic banking

Tuesday, August 18th, 2009

There may be no such thing as a free lunch, but with Islamic banking banning riba – the charging of interest – it appears at first glance that there is something better: free money. Dr Neil Barnwell explores the inner workings of a banking system that bans interest payments.

Over the last twenty years Islamic banking has emerged as an important part of the world’s financial system, with $600 billion worth of assets under management by Islamic financial institutions, and a market growing by as much as 20% a year since 2003. The sukuk market for Islamic bonds alone is worth $1 trillion, with Thompson Reuters reporting that borrowers in the Middle East, Japan, Western Europe, Africa and Asia produced 24 Islamic financing transactions in the first half of 2009 worth $8.2 billion.

Islamic banking follows the principles of the Qur’an and other accepted Islamic sources such as the Hadith. Products which conform to these principles are called Shariah-compliant.

While the selection of products at large Islamic financial institutions remains relatively narrow, some newly created Shariah-compliant instruments are beginning to rival those of conventional banks. The principles of Shariah – the moral and legal code that governs the industry’s development – impacts the underlying structure of its products and services, and ultimately serves as one its biggest selling points to investors.

At its core, Shariah specifies that money has no intrinsic value of its own and should be used as a tool for measuring the value of assets. On the deposit side, these instruments include profit sharing investment accounts (PSIAs), which give depositors the right to share in Islamic banks’ profits and losses. In addition, several money market, equity, real estate, private equity and infrastructure funds are now being offered.

But Australian financial institutions have yet to offer such products, or even start to seriously research the market. Recently, Australia’s Assistant Treasurer, Nick Sherry, noted the difficulty of being a major participant in the globalised world of finance without offering Shariah products.

With countries such as Pakistan and Saudi Arabia considering running their entire banking systems on Islamic principles, it’s hard to ignore this growing market.

Islamic finance grew in parallel with global trade with the Middle East and with a preference, by countries such as Saudi Arabia, to invest their surpluses according to Islamic doctrine. Although reliable statistics are hard to come by, there are estimated to be over 40 countries with Islamic banking systems, which host over 265 Islamic banks.

What is Islamic finance?

Although Shariah banking products finance similar types of transactions as conventional banking, and products range from small domestic loans through to sovereign bonds, there are differences in approach.

As interest is forbidden in Islamic banking, the time value of money is expressed in two forms. The first is a risk sharing agreement between borrower and lender where the bank provides financing which resembles equity capital rather than a fixed interest loan. The second is where the bank takes ownership of a good until an agreed amount has been paid by the purchaser.

In trade finance, the bank imports goods (which an importer wishes to purchase) on its own account, agreeing to sell them to the importer for a pre-arranged amount, which includes costs and a profit margin. This is called a murabaha sale.

Much the same principle applies in hire purchase type agreements. The bank has ownership and title passes when an agreed amount, including the cost of money, has been paid.

Another distinctly Islamic form of financing is the musharaka investment. The bank, instead of providing a loan at a fixed rate of interest, provides capital to purchase goods or undertake activities and becomes a partner in the business, sharing profits at an agreed rate. The shared profit becomes the return on capital.

Perhaps less distinctive is the sukuk market which covers the issuance of bonds and sovereign debt, such as that issued by the Indonesian government. Essentially, sukuk constitutes partial ownership in a debt, and an increasing number of companies and sovereign states are issuing sukuk bonds. Sukuk bonds are often tradeable on secondary markets.

Some more conservative Islamic scholars claim that trading in sukuk bonds is not Shariah-compliant as the Qur’an bans using money itself as a commodity of trade.

Another aspect of Shariah-compliant banking is the avoidance of investing in activities which facilitate haram (that which is forbidden by the Qur’an). This includes areas such as gambling, alcohol, pork production and sale of obscenity items.

It is important for any company thinking of entering the Islamic banking market to have their products certified as Shariah-compliant. All products should be examined by a Shariah Supervisory Board which has the authority to certify products. In our region, Malaysia has the most highly developed Islamic banking system, so it may be useful to draw upon their expertise in this area.

However, there are difficulties in introducing Shariah products in Australia. In particular, our entire financial system is based on the concept of interest payment as representation for the time value of money. Assistant Treasurer Sherry explains that our regulatory and taxation systems may need to be revised to cater for such products.

Tags: , , ,
Posted in BUSINESS DESIGN, EMERGING IDEAS, MONEY AND MARKETS | No Comments »