BACHELOR OF BUSINESS ADMINISTRATION BANKING Banking III

Contact details: Regenesys Business School Tel: +27 (11) 669-5000 Fax: +27 (11) 669-5001 E-mail: [email protected] www.regenesys.co.za

This study guide highlights key focus areas for you as a student. Because the field of study in question is so vast, it is critical that you consult additional literature.

Copyright © Regenesys, 2023 All rights reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording or otherwise) without written permission of the publisher. Any person who does any unauthorised act in relation to this publication may be liable for criminal prosecution and civil claims for damages.

CONTENTS 1.

2.

3. 4.

RECOMMENDED RESOURCES ........................................................................................................... 1 1.1 BOOKS .............................................................................................................................................. 1 1.2 ARTICLES.......................................................................................................................................... 1 1.3 MULTIMEDIA ..................................................................................................................................... 2 INTRODUCTION TO THIS COURSE ..................................................................................................... 3 2.1 LEARNING OUTCOMES ................................................................................................................... 3 2.2 FINANCIAL MARKETS ...................................................................................................................... 4 2.2.1 INTRODUCTION TO FINANCIAL MARKETS ......................................................................... 4 2.2.2 EQUITY VS DEBT MARKETS ................................................................................................. 5 2.2.3 EQUITY (OR STOCK) MARKET ............................................................................................. 7 2.2.4 DEBT MARKETS ................................................................................................................... 10 2.2.5 CREDIT RATINGS................................................................................................................. 15 2.2.6 IMPACT OF INTERNATIONAL FINANCIAL MARKETS ON THE BANKING SECTOR........ 16 2.2.7 KEY POINTS ......................................................................................................................... 19 2.3 FOREIGN EXCHANGE AND TRADE .............................................................................................. 20 2.3.1 THE FOREIGN EXCHANGE MARKET ................................................................................. 20 2.3.2 FOREIGN TRADE AND THE BANKING SECTOR ............................................................... 26 2.3.3 CONCLUDING THOUGHTS.................................................................................................. 32 2.3.4 KEY POINTS ......................................................................................................................... 32 2.4 ASSET MANAGEMENT................................................................................................................... 33 2.4.1 DEFINING ASSET MANAGEMENT ...................................................................................... 33 2.4.2 ASSET CLASSES.................................................................................................................. 34 2.4.3 PRINCIPLES IN EXAMINING ASSET CLASSES ................................................................. 40 2.4.4 WHAT DO INVESTMENT BANKS DO? ................................................................................ 43 2.4.5 KEY POINTS ......................................................................................................................... 48 2.5 FINANCIAL PLANS AND ADVICE................................................................................................... 49 2.5.1 SOUTH AFRICAN INCOME TAX .......................................................................................... 49 2.5.2 FINANCIAL PLANNING AND INCOME TAX ......................................................................... 51 2.5.3 LEGISLATION AFFECTING FINANCIAL PLANNING (SOUTH AFRICA)............................. 52 2.5.4 EFFECTIVE COMMUNICATION ........................................................................................... 56 2.5.5 GETTING CLIENTS TO THE FINANCIAL PLANNING LEVEL ............................................. 62 2.5.6 KEY POINTS ......................................................................................................................... 64 REFERENCES ...................................................................................................................................... 65 GLOSSARY OF TERMS ....................................................................................................................... 69

List of Tables TABLE 1: DEBT VS EQUITY MARKETS .......................................................................................................... 6 TABLE 2: CREDIT RATINGS.......................................................................................................................... 15 TABLE 3: FOREIGN EXCHANGE TRANSACTIONS ..................................................................................... 21 TABLE 4: FINANCING FOREIGN TRADE ...................................................................................................... 29 TABLE 5: INCOTERMS (EXAMPLES)............................................................................................................ 30 TABLE 6: COMPARING A MONEY MARKET FUND AND MONEY MARKET ACCOUNT ............................ 36 TABLE 7: PENSION FUND ASSET ALLOCATION IN CERTAIN COUNTRIES ............................................. 38 TABLE 8: LEGISLATION AND FINANCIAL PLANNING................................................................................. 53

List of Figures FIGURE 1: FLOW OF FUNDS .......................................................................................................................... 5 FIGURE 2: ASSET CLASS RANKING ............................................................................................................ 35 FIGURE 3: SUPPLY AND DEMAND IN A QUOTE-DRIVEN MARKET .......................................................... 45 FIGURE 4: LISTENING AND FEEDBACK PROCESS ................................................................................... 59 FIGURE 5: COMMUNICATION TACTICS USED TO ENGAGE CLIENTS ..................................................... 62

1.

RECOMMENDED RESOURCES

Various resources are recommended to help you complete this course.

1.1 BOOKS These books are also recommended for this course: •

Arnold, G. (2014). FT Guide to Banking, Pearson

•

Schoeman, H. C. (Ed.). (2013). An introduction to South African banking and credit law (2nd ed). LexisNexis.

Please ensure that you order or download your textbooks before you start the course.

1.2 ARTICLES •

Bankenverband. (2015). Financing foreign trade. https://bankenverband.de/media/publikationen/16012015_Aussenhandelsfinanzierung_eng.pdf (Retrieved 13 January 2023).

•

Fin24. (2016). Limited allocation by SA pension funds to private equity. http://www.fin24.com/Money/Retirement/limited-allocation-by-sa-pension-funds-to-private-equity-20160419 (Retrieved 13 January 2023). 13 International capital market association. (2013). Economic Importance of the corporate bond markets. https://www.icmagroup.org/assets/documents/Media/Brochures/2013/Corporate%20Bond%20Markets%20Marc h%202013.pdf (Retrieved 13 January 2023).

•

•

Lamprecht, I. (2015). How pension funds could change their asset allocation. https://www.moneyweb.co.za/news/markets/pension-funds-change-asset-allocation/ (Retrieved 13 January 2023).

•

Le Roux, W. (2019). Why South African retirement funds should allocate to private equity. https://www.simekaconsult.co.za/connecting/why-south-african-retirement-funds-should-allocate-to-privateequity/ (Retrieved 13 January 2023).

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•

Organization for Economic Co-operation and Development. (2021). Trade finance in the COVID era: Current and future challenges. https://www.oecd.org/coronavirus/policy-responses/trade-finance-in-the-covid-eracurrent-and-future-challenges-79daca94/ (Retrieved January 13, 2023).

•

PSG. (2019). Introduction to collective Investments. https://www.psg.co.za/support/tutorials/introduction-tocollective-investments (Retrieved January 13, 2023).

•

Sharpe, S. A., & Zhou, X. (2020). The corporate bond market crises and the government response. https://www.federalreserve.gov/econres/notes/feds-notes/the-corporate-bond-market-crises-and-thegovernment-response-20201007.htm (Retrieved January 13, 2023).

•

Whiteseide, E. (2021). How do pension funds typically invest? https://www.investopedia.com/articles/creditloans-mortgages/090116/what-do-pension-funds-typically-invest.asp (Retrieved January 13, 2023).

1.3 MULTIMEDIA •

ASX. (2019). Investing – How to build an investment portfolio that meets your objectives [Video clip]. https://www.youtube.com/watch?v=_G-6gb6NsyU (Retrieved January 13, 2023).

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Friendly finance. (2010). Cross Rate Calculation [Video clip]. https://www.youtube.com/watch?v=PeP3C_KN_v8 (Retrieved January 13, 2023).

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International Trade Administration. (2021). Letter of credit [Video clip]. https://www.youtube.com/watch?v=cJa1U4FmYIM (Retrieved 13 January 13, 2023).

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Lincoln, T. (2015). Constructing your perfect share portfolio with Tim Lincoln [Video clip]. https://www.youtube.com/watch?v=2Bf_dggJD5w (Retrieved 13 January 2023).

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McGlasson, M. J. (2010), (Macro) episode 33: exchange rates [Video clip]. http://www.youtube.com/watch?v=xwtgByffoUw (Retrieved 13 January 2023).

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Moneyweek. (2011). What do investment banks actually do? [Video clip]. https://www.youtube.com/watch?v=xlYDonZLoHg (Retrieved 13 January 2023).

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Thangavelu, P. (2020). Investment banker [Video clip]. https://www.investopedia.com/articles/personalfinance/042215/what-do-investment-bankers-really-do.asp (Retrieved 13 January 2023).

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2.

INTRODUCTION TO THIS COURSE

In Banking III we consider the financial markets, and in particular we deal with equity and debt instruments and foreign exchange. This leads us to a discussion of asset classes and asset management – an important component of financial planning. In the final section we consider financial planning and advice. This is an extensive topic with a strong focus on legislation and on banking products, including wills. The objective of this course is to round off your core knowledge of the banking industry and to facilitate integrated learning.

2.1 LEARNING OUTCOMES On completing this course, you should be able to: • • • • • • •

Explain foreign trade as it applies to the banking sector; Discuss international law as it applies to banking; Understand the workings of financial markets and their impact on the banking sector; Discuss asset management within the banking environment; Compile financial plans and offer financial advice; Prepare legally compliant documents; and Understand the impact of international financial markets on the banking sector.

The number of notional learning hours set out in the table under each section heading provides guidance on how long to spend studying each section of this course. Set yourself a schedule to ensure that you spend a suitable period of time on each section, covering the required sections relevant to each assignment, and giving yourself enough time to prepare for the examination.

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2.2 FINANCIAL MARKETS Timeframe

Minimum of 40 hours

Learning outcomes Recommended book

•

Understand the workings of financial markets and their impact on the banking sector; and

•

Understand the impact of international financial markets on the banking sector.

•

Part 3, pp 261-334 in Arnold, G. (2014). Banking (financial times guides). Pearson Education Limited.

•

International capital market association. (2013). Economic Importance of the corporate bond markets. https://www.icmagroup.org/assets/documents/Media/Brochures/2013/Corporate%20Bond %20Markets%20March%202013.pdf (Retrieved January 13, 2023).

•

Sharpe, S. A., & Zhou, X. (2020). The corporate bond market crises and the government response. https://www.federalreserve.gov/econres/notes/feds-notes/the-corporate-bondmarket-crises-and-the-government-response-20201007.htm (Retrieved January 13, 2023).

Recommended articles

Section overview

Banks are one of the key participants in debt markets – they borrow money from these markets and in turn place their surplus cash in debt instruments to earn returns. Banks also facilitate the purchase and sale of client securities (ie act as brokers). They might also participate in proprietary trading (ie trade for direct gain instead of commission from processing client trades). The objective of this section is to look at financial markets, the role of the banking industry, and the distinctions between equity and debt markets. This section concludes with a discussion on the impact of international financial markets on the banking sector.

2.2.1

Introduction to Financial Markets

A financial system is where funds are transferred “from people who have an excess of available funds to people who have a shortage” (Mishkin and Eakins, 2012, p.42). This system comprises financial markets and financial intermediaries, and is important because it can promote: • • •

Greater economic efficiency (channel funds between lenders-savers and borrowersspenders; play a vital role in price discovery; and spread risk); Higher economic growth (poorly performing financial markets are one reason that many countries remain desperately poor); and Opportunities for personal, institutional, and social wealth.

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FIGURE 1: FLOW OF FUNDS

Lenders

Borrowers

Household sector

Money

Corporate sector General government sector

Financial intermediaries (indirect financing)

Money

Household sector Corporate sector

Indirect security

General government sector

Money

Foreign sector

Foreign sector Direct security

(Goosen, Pampallis & Van der Merwe, 2001)

While the flow of funds can pass directly from lenders-savers through a financial market to borrowers-spenders, they can also pass through financial intermediaries, for example: • • • •

Banks; Insurance companies; Pension fund companies; and Mutual funds or investment trusts.

The benefits of financial intermediaries primarily include: • • • •

2.2.2

Lower search costs; Spreading of risk (lend to a variety of borrowers); Economies of scale (lower average costs); and Convenience (bring lenders and borrowers together).

Equity vs Debt Markets

Both the equity and debt markets are important to economic activity because they are vehicles through which companies fund their business needs and expansion. The debt market, in particular, is important to governments and government institutions (eg Eskom), since it helps them to meet infrastructure demands and other policy challenges. Consider the definitions that follow.

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The equity market is where stocks (shares) are issued (in the primary market) and traded (in the secondary market). “It is one of the most vital areas of a market economy because it gives companies access to capital and investors a slice of ownership in a company with the potential to realise gains based on its future performance.” (Investopedia, 2015a) The debt market is where debt instruments are traded. “Debt instruments are assets that require a fixed payment to the holder, usually with interest. Examples of debt instruments include bonds (government or corporate) and mortgages.” (Federal Reserve, 2015)

Consider the key differences between equity and debt markets as shown in Table 1. TABLE 1: DEBT VS EQUITY MARKETS

Debt (or bond) market

Equity (or stock) market

•

Examples: bonds (government, municipal or corporate) and mortgages; treasury bills; and money market funds.

•

Issuing a bond increases the debt burden of the bond • issuer (government or company) because it must pay interest.

Equity financing allows a company to acquire funds (usually for investment purposes) without incurring debt (may or may not pay dividends).

•

Bondholders do not gain ownership of the company (or government) or have any claims to the future profits of the borrower – the borrower’s only obligation is to repay the loan with interest.

•

Investors who purchase equity instruments (eg shares in Apple) gain ownership of the business whose shares they hold (and the right to vote); they also have claims on the future earnings of the company.

•

Bonds are considered to be less risky investments for two reasons: o

Bond market returns are typically less volatile than stock market returns

o

Should the company run into trouble, bondholders are paid first before any other expenses are paid.

•

Examples: common stock shares (stocks are securities that are a claim on the earnings and assets of a company).

(Federal Reserve Bank, 2015)

The average person is more familiar with the equity market than with the debt market. However, the debt market is the larger of the two. One of the key reasons is that whereas only companies issue shares, governments, municipalities and companies issue bonds.

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Johannesburg Securities Exchange (JSE) The JSE’s equity market connects buyers and sellers interested in exposure to South African listed companies and dual listed companies from across the globe (in operation for more than 120 years). This market consists of the Main Board and the AltX Board (small and medium-sized high-growth companies) and uses a world class IT trading system. More than 800 securities are available on the JSE Equity Market with approximately 400 companies listed across the two boards (approximately 60 equity market member firms are authorised to trade on the market). (Johannesburg Securities Exchange, 2015a) South African Bond Market The South African bond market is a leader among emerging market economies. It is dominated by government-issued bonds. The vast majority of bonds are bought and traded by institutions like central banks, insurance companies, banks, and investment funds like sovereign wealth funds and pension funds. Government entities issue bonds for large capital projects and list them on the JSE Debt Board (formerly the Bond Exchange of South Africa. Listing the bond on the JSE Debt Board improves the entities’ ability to raise finance because it allows investors to sell the loan should they wish to. More than R1 trillion is currently listed on the JSE’s Debt Board and these instruments account for 90% of all liquidity reported to the JSE. (JSE, nd)

2.2.3

Equity (or Stock) Market

The equity market (also referred to as stock market) is one that gives companies a way in which to raise capital. It also provides investment opportunities for investors (individuals and companies). Some of the more common instruments are: • • • • • •

Ordinary shares; Futures in shares and futures in market indices; Forwards; Equity options; Warrants; and Preference shares.

Ordinary shares are the most common type of shares on the equity market. They give the investor “full voting rights at annual general meetings, dividends (should the company pay these), and a share in the residual economic value should the company unwind (after bondholders and preference shareholders are paid)” (Johannesburg Stock Exchange, 2015b).

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This type of share also allows investors to benefit from capital growth, but conversely investors can experience a fall in the value of their shares. The objective of investing in ordinary shares is to achieve a return higher than that of regular savings accounts. However, with the promise of higher returns comes increased risk. Futures in shares and futures in market indices (eg the FTSE 100 index) give the investor the right to “buy (or sell) a number of shares or an entire index of shares at a fixed date in the future at a price agreed upon now” (Arnold, 2014:164). The investor incurs lower brokerage fees than actually trading in the underlying shares (liquid and easily traded).

Equity Index Futures (Johannesburg Stock Exchange) “Equity Index Futures are derivatives instruments that give investors exposure to price movements on an underlying index. Market participants therefore can profit from the price movements of a basket of equities without trading the individual constituents.” (Johannesburg Stock Exchange, 2015c) Examples include the FTSE/JSE Indices and the BRICS Indices.

Note that a derivative is a specific type of instrument that derives its value over time from the performance of an underlying asset such as equities, bonds, commodities, currencies, and market indices. The derivative itself is merely a contract between two or more parties, with the value being determined by fluctuations in the underlying asset. Investment banks participate in the derivatives market as brokers and also create new derivatives and market them to clients. They may also assist companies trying to hedge in these markets, for example an airline trying to fix the future prices of its aviation fuel. A forward contract is an agreement between two parties to undertake an exchange at an agreed future date at a price agreed now. The objective is to reduce uncertainty and assist both parties to plan production and budget effectively (Arnold, 2014, p.279).

Crisp (ie potato chip) producers Crisp producers buy as much as 80% of their potatoes up to two years forward. Once the forward agreements have been signed the crisp producers can budget accordingly. Of course the spot price of potatoes, due to bumper crops and an oversupply, might be cheaper than the agreed forward price. However, the reverse could also happen – floods and other severe weather conditions might create a shortage and drive the price up. Either way the crisp producer locks in the forward price. (Arnold, 2014, p.279)

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Unlike option contracts, forward contracts commit both parties to complete the deal. Equity options give the “right but not the obligation to buy or sell shares at a pre-agreed price sometime in the future” (Arnold, 2014, p.164).

Options are exchange-traded, standardised contracts in which one party has the right (but not the obligation) to purchase something at a pre-agreed strike price at some point in the future. The cost of buying an option is the seller's premium, which the buyer must pay to obtain the option right. The two types are: •

•

Call – the buyer of this option has the right (but not the obligation) to buy the asset at the strike price at a future date and the seller has the obligation to sell the asset at the strike price if the buyer exercises the option. Put – the buyer of a put option has the right (but not the obligation) to sell the asset at the strike price at a future date and the seller has the obligation to repurchase the asset at the strike price if the buyer exercises the option. (Marx, 2013)

Warrants give the holder the right to subscribe for a specified number of shares at a fixed price during or at the end of a specified time period.

For example, if a company has shares currently trading at R3, it might choose to sell warrants each of which grants the holder the right to buy a share in the company at say R4 over the next five years. If by the fifth year the share price has risen to R6 the warrant holders could exercise their rights and then sell the shares, immediately gaining R2 per share. (Arnold, 2014, p.164)

Preference shares are usually offered by companies at a fixed rate of dividend. However, if the company has insufficient profits the dividend paid may be reduced (to zero if necessary). The dividends on preference shares are paid before those of ordinary shareholders. Again, the bank often acts as a market maker in these products, the creator of many of them, as a broker for clients and as a proprietary trader (Arnold, 2014, pp.164-165).

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Mini Case Study – Oil and Gas Market

Read the following case study and then answer the questions. “The Nigerian oil and gas company Seplat made its unconditional trading debut yesterday [15 April 2014] as the first Nigerian company to ever have its ordinary shares dual listed on both the Nigerian and London Stock Exchanges. Standard Bank Group acted as joint global co-ordinator and joint book runner. Stanbic IBTC Capital Limited, a member of Standard Bank Group, acted as joint issuing house in Nigeria. “Proceeds of the initial public offering (IPO) will allow Seplat to further implement its business strategy, which includes acquiring new Nigerian assets and expanding its development programme, which is in line with the company’s ongoing growth aspirations. “Seplat intends to pursue an acquisition strategy in oil and gas focused on maintaining a balanced portfolio of assets in Nigeria with development opportunities and potential for exploration in order to add value by increasing production and cash flows in the near term.” To capture maximum investor attention in Nigeria and internationally, the Standard Bank Group “hosted Seplat in over 130 investor meetings during road shows in Nigeria, the UK, Europe, USA, South Africa and Asia”. “Seplat’s IPO has created a blueprint for future transactions in the region as the African equity capital markets enjoy a period of increasing investor attention, liquidity and capital inflow.” (Standard Bank, 2014) Questions 1. Discuss the impact of Seplat’s IPO on the company, the Nigerian economy, investors, and the banking industry. 2. Identify other examples of the banking industry’s participation in raising capital for companies (locally and internationally), eg Alibaba’s long-awaited IPO in 2014, which stands as the largest global IPO ever. Does raising capital for companies in this way fit with your impression of what banks traditionally do? Explain your response.

2.2.4

Debt Markets

In this subsection we consider: • • •

Money market funds; Treasury bills; and Bonds.

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Money market funds Money market funds are administered by financial institutions such as banks that benefit from economies of scale. The process is as follows (Arnold, 2014, p.263): 1. The individual buys shares in the money market fund. 2. Companies also deposit surplus cash in money market funds to obtain good rates of interest. 3. The financial institution invests in a portfolio of money market securities (eg repos issued by banks). 4. The investors earn a return (technically a dividend but in effect an interest rate). 5. Access to the money invested in the fund may be on a “same-day” basis. It is also possible for companies to arrange a “sweep facility” where money exceeding a certain balance in their account is automatically transferred at the end of each day to a money market account (paying more interest) and vice versa (ibid). Below is a summary of the purpose and investment strategy of a well-known South African money market fund:

Allan Gray Money Market Fund The purpose of this fund is to “preserve capital, maintain liquidity and generate a sound level of income”. It is suitable for investors who are highly risk-averse but seek returns higher than bank deposits, and need a short-term investment account. “The Fund invests in South African money market instruments with a term shorter than one year. These instruments can be issued by government, parastatals, corporates and banks. The Fund is managed to comply with regulations governing retirement funds.” (Allan Gray, 2015)

Treasury bills “Banks place a high proportion of their money in treasury bills (T-bills or treasury notes)” (Arnold, 2014, p.263). These are issued by government agencies to raise money for their state. Treasury bills are negotiable securities, and are easily traded in the secondary market should the investor need access to cash (relatively liquid). When issued by reputable governments, treasury bills are regarded as risk-free (ie there is little risk of default).

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UK Treasury Bills UK Treasury Bills are issued at weekly tenders by the Debt Management Office with a face value or par value of £100 and are sold at a discount to par with a maturity date of one month (28 days), three months (91 days), six months (182 days) or 12 months. They are sold by competitive tender to a small group of banks (around 28), which can sell them on in turn to other investors. The buyer (minimum £500 000) may redeem the bill at maturity or trade it in an active secondary market. The markets are very active so there is little risk that the holders cannot sell when necessary and the low transaction costs make them attractive investments. The holder of the bill makes a yield or investment return which is the difference between the price paid and the maturity value. Example: A six-month T-bill with a par value of £100 is currently trading at £98.50 (𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒) 𝑥 100 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 (£100 − £98.50) 𝑥 100 = 1.522843% £98.50

This does not represent the true annual discount rate, because the maturity of the bill is only six months (182 days), so the annual rate is calculated by multiplying by 365/182 days. To calculate the bond equivalent yield on the T-bill sold for £98.50 (a discount of £1.50): (𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒) 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑥 𝑥 100 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑣𝑎𝑙𝑢𝑒 𝐷𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 (£100 − £98.50) 365 𝑥 𝑥 100 = 3.054053% £98.50 182

(Arnold, 2014, pp. 263-264)

There is an inverse relation between treasury bill prices and interest rates. Investors purchasing treasury bills expect the security to offer the same rate of return as other instruments with similar risk and time to maturity, and therefore if two weeks after buying the treasury bill interest rates suddenly shoot up, then other similar securities will offer a much higher rate of return to maturity. Because there are now alternative investments offering much higher interest rates, the discount on the bill will grow larger as the price people are willing to pay falls, until the rate of return is the same as for other instruments in the market (Arnold, 2014, p.265).

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“There is an inverse relation between prices of money market securities in the secondary market and the effective interest rate to maturity: a rise in bill prices means interest rates fall, a fall in bill prices equals interest rate rises.” (Arnold, 2014, p.265)

Bonds Bonds (similar to loans) are issued by governments, government institutions and large companies. And like loans, bonds return interest payments to the many bondholders. The time to maturity for bonds is typically between five and 30 years. Generally there are: • •

Corporate bonds; and Government (and government entity) bonds.

Corporate bonds are used to raise money for large capital projects (eg a new manufacturing plant). Depending on the instrument, interest is fixed or floating (or may even be zero). Unlike shares, corporate bonds carry no claim to ownership and no dividends are paid to bondholders. The potential for variety and innovation is almost infinite.

Types of corporate bonds The most common type pays semi-annual or annual fixed coupons with a specified redemption date – known as straight, plain vanilla or bullet bonds. However, there are many variations on these: • • • •

Coupons every three months; Do not pay a fixed coupon (vary according to level of short-term interest rates); Interest rates linked to the rate of inflation; and Linked to the rise in the price of silver, exchange rate movements, and even to the occurrence of an earthquake.

An unusual example: Sampdoria (the Italian football club) issued a €3.5-million bond that paid “2.5% if it stayed in Serie B, 7% if it moved to Serie A and if the club rose to the top four in Serie A the coupon would rise to 14%”. (Arnold, 2014, p.270)

Government bonds are also needed for large capital projects (eg roads and power stations). As with corporate bonds, investors buy government bonds to earn regular interest payments and receive back the money they have lent after a predetermined period. Again, depending on the instrument, interest is fixed or floating (or may even be zero). Government bonds are typically more liquid and less risky than corporate bonds, but government bonds usually pay lower interest rates than corporate bonds. Both corporate and government bonds are considered to be less risky than buying shares (JSE, nd).

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Bonds – fixed interest The coupon is the stated annual rate of return on the nominal value (or face or par value) of the bond until the maturity date. At the maturity date the final amount is repaid. A coupon bond with $1,000 face value might pay, for example, the holder a coupon payment of $100 per year for 10 years, and at maturity date repay the holder the face value amount of $1,000. The coupon rate is then $100/$1,000 = 0.10 or 10%. Discount bond (zero-coupon bond) This type of bond is bought at a price below its face value (at a discount). The face value is repaid at the maturity date (no interest payments). For example, a discount bond with a face value of $1,000 might be bought for $900 and then in a year's time the owner would be paid the face value of $1,000. (Mishkin and Eakins, 2012, pp.79-80)

Everyone has a common interest in debt markets. These markets must work well for the private and public good. If these markets do not get it right, companies and citizens (who are both taxpayers and clients of the market) will suffer.

Bond Market

Read about the economic importance of the corporate bond markets, and then complete the tasks that follow: •

International capital market association. (2013). Economic Importance of the corporate bond markets. https://www.icmagroup.org/assets/documents/Media/Brochures/2013/Corporate%20Bond%20Markets%20March %202013.pdf (Retrieved January 13, 2023).

•

Sharpe, S. A., & Zhou, X. (2020). The corporate bond market crises and the government response. https://www.federalreserve.gov/econres/notes/feds-notes/the-corporate-bond-market-crises-and-the-governmentresponse-20201007.htm (Retrieved January 13, 2023).

Tasks: 1. Outline the importance of the bond market for: economic growth, governments, government institutions, companies, and investors. 2. The International Capital Market Association (2013) proposes bond funding for companies as an alternative to bank finance. Critically evaluate this proposal. 3. According to Sharpe and Zhou (2020), in times of unprecedented economic crisis, the federal/reserve bank becomes a ‘market maker of last resort’, do you agree with this statement?

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2.2.5

Credit Ratings

The three major credit ratings agencies are Moody’s, Standard & Poor’s (S&P), and Fitch. Broadly, the agencies’ debt ratings depend on: • •

The likelihood of payment of interest; and or Capital not being paid.

In some cases, the rating is given on the extent to which the lender is protected in the event of a default by the loan contract.

Government bonds from the leading economies have an insignificant risk of default, whereas unsecured subordinated loan stock has a much higher risk.

Consider the overview of ratings in Table 2, and then complete the desk research tasks. TABLE 2: CREDIT RATINGS

Investment Grade

Noninvestment grade, highyield or “junk” securities

Moody’s Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa Ca C n/a

S&P AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCCD

Fitch AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC

DDD DD D

Meaning Prime High grade

Upper medium grade

Lower medium grade

Somewhat speculative

Highly speculative

Substantial risks Extremely speculative May be close to default with little prospect for recovery In default

(Moody’s, S&P, Fitch, 2015)

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Desk Research

Table 2 provides a high-level view of the various ratings. For more extensive information about ratings for long- and short-term debt, go to these websites: 1. Moody’s, www.moodys.com (Retrieved January 13, 2023). 2. S&P Global, www.standardandpoors.com (Retrieved January 13, 2023). 3. FitchRatings, www.fitchratings.com (Retrieved January 13, 2023). Explore the websites to find ratings for different categories, eg banks, sovereign ratings, etc. Moody’s updates its bank rating methodology from time to time. Go to this link to find tutorials, videos and other useful information: https://bankratings.moodys.io/ (Retrieved January 13, 2023).

2.2.6

Impact of International Financial Markets on the Banking Sector

Central banks are responsible for keeping inflation stable. Before the crisis of 2008 this was managed by adjusting the interest rate at which banks borrowed overnight. Consider the following: •

•

If companies were growing nervous about the future (ie scaling back on investments) the central banks would reduce the overnight rates, which would reduce banks’ funding costs and encourage them to make more loans (keeping the economy from tending toward recession); but By contrast, if credit and spending were becoming excessive and inflation was rising, then the central banks would raise their interest rates.

When the 2008 crisis struck the big central banks (eg the US Federal Reserve and the Bank of England) slashed their overnight interest rates in an attempt to boost the economy. Even cutting the rate to zero failed to motivate a recovery. There was an urgent need for another tool to encourage banks to pump money into the economy – one such tool was quantitative easing (The Economist, 2015a).

To carry out quantitative easing central banks create money by buying securities such as government bonds from banks with electronic cash that did not exist before. The new money swells the size of bank reserves in the economy by the quantity of assets purchased – hence “quantitative” easing. (The Economist, 2015a)

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As with lowering interest rates, the objective of quantitative easing is to stimulate the economy by encouraging banks to make more loans.

Simply put – the idea is that banks take the new money and buy assets to replace the ones they have sold to the central bank. The effect is the rise in stock (share) prices and lower interest rates, which in turn boosts investment.

Banks across the globe use different tactics. The Bank of Japan focused its quantitative easing programmes on direct lending to banks.

The extended effects of quantitative easing Consider that quantitative easing means interest rates on everything (government bonds, mortgages, corporate debt, etc) are likely to be lower than they would have been without quantitative easing. It could be argued that when central banks sell the assets they have accumulated interest rates will soar, choking off the recovery (The Economist, 2015a). There is also some concern that the flood of cash has encouraged reckless financial behaviour. Further, there are some concerns that this spurge of money is finding its way to emerging economies that cannot manage the cash (ibid).

In 2014 when the US Federal Reserve “mooted the idea of tapering [gradually withdrawing from quantitative easing], interest rates around the world jumped and markets wobbled” (ibid).

The alternative to quantitative easing is for central banks to promise to keep overnight interest rates low over the long term, while scaling back on quantitative easing.

Quantitative Easing

1. Explain the concept of “quantitative easing”. 2. Discuss the possible strengths and weaknesses of a quantitative easing strategy, particularly those relating to banks.

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The impact of quantitative easing on Africa and its financial markets Through channels such as “global liquidity and global portfolio rebalancing”, quantitative easing by the US, UK and other leading economies has “impacted developing and emerging market economies”. Not only have these developing and emerging market economies experienced increased capital inflows, it has led to an appreciation of local currencies which in turn has weakened their export competitiveness (ibid). Further, the risks of a sudden end to quantitative easing or even reversals remain and consequently this has implications for Africa and its financial markets. When Dr Mthuli Ncube, African Development Bank chief economist and vice-president, was asked, “What effect could Fed tapering have on African countries that have issued bonds on international capital markets?” his response was:

“

By keeping benchmark interest rates at historical lows, quantitative easing has played a role in stimulating bond issuances by African countries on international capital markets. In 2013, subSaharan African countries were able to raise more than $5-billion. The following countries issued 10-year bonds that year: Rwanda issued $400-million with yield at issue of 6.88%; Nigeria issued $500-million at 6.63% yield; Ghana issued $750-million at 8% yield; and Gabon $1.5-billion at 6.38% yield. One of the advantages of Eurobonds are their lower costs – yields on Ghana’s domestic bonds reached 20% and those of Kenya and Nigeria ranged between 10 and 16%. (Ncube, 2014)

Ncube (2014) also notes that as the economies of developed countries normalised, emerging economies started to experience some instability; for example, through the devaluation of local currencies, the reduction or even reversal of capital flows and even sell-offs of emerging market assets.

• •

•

There is no one-size-fits-all solution. Given South Africa’s integration into global markets and the capital inflows it received during quantitative easing, it is more vulnerable than other African countries to the effects of tapering. However, it could also be argued that these effects would not be as severe if South Africa’s current account deficits were not so large and if it did not have such limited foreign currency reserves.

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2.2.7

Key Points

The objective of this section was to look at financial markets, the role of the banking industry, and the distinctions between the equity market and the debt market. Note that: • • • • • • •

A financial system is where funds are transferred from people who have an excess of available funds to people who have a shortage; While the flow of funds can pass directly from lenders-savers through a financial market to borrowers-spenders, they can also pass through financial intermediaries; Both the equity and debt markets are important to economic activity because they are vehicles through which companies fund their business needs and expansion; The debt market, in particular, is important to governments and government institutions (eg Eskom) since it helps them meet infrastructure demands and other policy challenges; The equity market (also referred to as stock market) is one that gives companies a way in which to raise much needed capital; The equity market also provides investment opportunities for investors; Typical financial instruments include: o o o o o o

• • • • •

Ordinary shares Futures in shares and futures in market indices Forwards Equity options Warrants Preference shares

Banks place a high proportion of their money in treasury bills, which are issued by government agencies to raise money for their state; Governments, government institutions and large companies take out bonds. Like loans, bonds return interest payments to the many bondholders; The three major credit ratings agencies are Moody’s, Standard & Poor’s (S&P),and Fitch; Central banks are responsible for keeping inflation stable; and To carry out quantitative easing central banks create money by buying securities such as government bonds from banks.

Students are encouraged to read widely to appreciate the importance of financial markets and their impact on economies and the banking sector. Useful sites include: • • •

The Economist (http://www.economist.com/) in particular the sections on “Business & Finance”, and “Economics” (Retrieved January 13, 2023). African Development Bank Group (http://www.afdb.org/) (Retrieved January 13, 2023) and Global Finance (http://www.gfmag.com) (Retrieved January 13, 2023).

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2.3 FOREIGN EXCHANGE AND TRADE Timeframe

Minimum of 30 hours

Learning outcomes

Recommended articles

Recommended multimedia

Section overview

2.3.1

•

Explain foreign trade as it applies to the banking sector; and

•

Discuss international law as it applies to banking.

•

Bankenverband. (2015). Financing foreign trade. https://bankenverband.de/media/publikationen/16012015_Aussenhandelsfinanzierung_eng .pdf (Retrieved January 13, 2023).

•

Organization for Economic Co-operation and Development. (2021). Trade finance in the COVID era: Current and future challenges. https://www.oecd.org/coronavirus/policyresponses/trade-finance-in-the-covid-era-current-and-future-challenges-79daca94/ (Retrieved January 13, 2023).

•

International Trade Administration. (2021). Letter of credit [Video clip]. https://www.youtube.com/watch?v=cJa1U4FmYIM (Retrieved January 13, 2023).

•

McGlasson, M. J. (2010), (Macro) episode 33: exchange rates [Video clip]. http://www.youtube.com/watch?v=xwtgByffoUw (Retrieved January 13, 2023).

As an introduction to foreign trade we begin this section with a discussion of the foreign exchange market. We consider a range of foreign exchange transactions and most importantly factors affecting exchange rates. Foreign trade finance is a core corporate business product for many banks. Your attention is focused on letters of credit and documentary collections, as well as trade finance.

The Foreign Exchange Market

The foreign exchange (forex) market is not a physical market – it consists mainly of banks and foreign exchange brokers that bring buyers and sellers of foreign exchange together (Marx, 2013, p.310). Most of these transactions occur in the interbank market (or wholesale market).

The Interbank Foreign Exchange Market (IFM) is the (direct) foreign exchange market where banks exchange different currencies. The interbank market is an important component of the foreign exchange market – it is the wholesale market through which most currency transactions are channelled.

The foreign exchange market is organised into two tiers: the wholesale and the retail tiers. The interbank market is the wholesale market, the retail market is where the small agents buy and sell foreign exchange.

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A SWIFT (Society of Worldwide Interbank Financial Telecommunications) code is a unique international identifier allocated to each bank to facilitate foreign exchange transactions (eg the SWIFT code for Barclays UK is BARCGB22). IBAN (International Bank Account Number) is used to identify an individual account involved in an international transaction. These, and other countryspecific codes, are essential for the smooth running of the international financial market.

Table 3 summarises some of the essential terminology of foreign exchange transactions. TABLE 3: FOREIGN EXCHANGE TRANSACTIONS

Type

Description

Currency codes

It is conventional to use the designated currency codes, eg ZAR (South African rand), USD (US dollar), CAD (Canadian dollar), JPY (Japanese yen), and GBP (British pound).

Bid, ask, and spread

Bid (or buy) and ask (or sell) are two different prices – the difference between these two is the spread. Market makers make a profit from the bid-ask spread (usually ranges between 0.03% and 0.07%). Typically the quote before the slash is the bid price and the two digits after the slash represent the ask price. Example: USD/CAD = 1.2000/05 Bid = 1.2000 Ask = 1.2005 According to the ask price, you can buy one US dollar with 1.2005 Canadian dollars. The market maker will buy one US dollar for a price equivalent to 1.2000 Canadian dollars. Note: whichever currency is quoted first is the base currency, ie the one in which the transaction is being conducted (eg one US dollar in our example).

Spot market foreign exchange transactions

The spot price of a currency is its price today – here and now – as opposed to any forward or futures-based price. “In practice, ‘today’ means today in the retail tier and two business days in the wholesale tier.” (Currency System, 2015)

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Type Forward contracts

Description Forward contracts are private agreements between two parties to exchange, at a specified future date, two currencies at an exact predetermined rate. For example, imagine that South African company XYZ needs to buy USD 1-million worth of specialised equipment in six months’ time. XYZ fears that the rand-dollar exchange rate will fall dramatically during those six months – which will make the equipment much more expensive in rands. So XYZ takes out a forward contract with bank B, in which B agrees to provide, on a date set six months forward, the amount of USD 1-million in exchange for a fixed ZAR amount based on today’s spot price and the interest differential (the difference between US and South African interest rates). XYZ thus has the security of knowing exactly how much it will pay for its equipment – in ZAR – in six months’ time. The bank meanwhile can profit through its ability to buy forward in USD at wholesale rates. Buying forward USD 1-million to cover its contract with XYZ, the bank may pay just ZAR 13.40 for each USD, whereas it has contracted XYZ to pay ZAR 13:50/USD. The 10 cents margin, multiplied by one million, will produce for the bank a ZAR 100,000 profit.

Futures

Currency futures contracts, like forward contracts, allow parties to exchange predetermined amounts of currency at a future date. And, again like forward contracts, they provide companies with a vehicle for hedging against currency swings. The main differences are that: •

Futures are exchange-traded, and can be bought and sold by any number of speculators; • Futures take the form of standardised rather than private contracts, and are largely guaranteed against default by the exchange’s clearing house (whereas forward contracts come with some risk of the would-be payer defaulting); and Futures may moreover be settled over a range of dates (whereas forward contracts typically stipulate a single date for settlement). (Adapted from Marx, 2013, pp.310-11) The following example demonstrates how a market maker operates.

Market maker example Bank A shows a two-way price in EUR/USD of 1.2839/42. Client A needs to sell €10-million and client B needs to buy €10-million against the USD. Bank A will buy from client A at 1.2839 and immediately sell to client B at 1.2842 realising a profit of the difference between 1.2839 and 1.2842 (or $0.0003). In this example, the market maker’s profit is 10-million x $0.0003 = $3 000. The difference of the $0.0003 is also referred to as a 3 pip spread. If we express the 3 pips as a percentage of the ask rate of the exchange rate, the costs amount to 0.0003/1.2842, which is 0.02%. (Marx, 2013, p.312)

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“A pip is a number value. In the Forex market, the value of currency is given in pips. One pip equals 0.0001, two pips equals 0.0002, three pips equals 0.0003 and so on.” (Forex, 2016) “A pip, short for point in percentage, is a very small measure of change in a currency pair in the forex market. […] A pip is a standardized unit and is the smallest amount by which a currency quote can change.” (Investopedia, nd)

As Marx (2013) points out, the $3,000 might appear to be a small profit for such a large transaction, but the daily turnover in the foreign exchange market is more than $2-trillion. This means that the foreign exchange market is a large profit centre for banks.

Liquidity in foreign exchange markets Liquidity is the amount of supply and demand in traded currencies. In large economies such as the US, UK, Europe and Japan the extensive foreign exchange flows together with the flow in financial assets (eg government bonds, shares) creates sufficient liquidity for market makers to offer small bid-ask spreads. With the increased used of technology the number of participants in the foreign exchange market is increasing daily, causing liquidity to increase and bid-ask spreads to narrow.” (Marx, 2013, p.312)

The bid-ask spread may increase during volatile markets (eg caused by unexpected changes to interest rates). During these volatile times market makers might find it difficult to match buyers (demand) and sellers (supply) because either the demand or supply side could temporarily withdraw its bids or offers in an attempt to wait for more favourable rates (Marx, 2013, p.312). Currencies regularly appreciate or depreciate against other currencies. If the USD/ZAR bid exchange rate increases from 11.8000 to 12.0000, the ZAR is said to have depreciated against the USD by 20 cents (or the USD is said to have appreciated against the ZAR by 20 cents). The percentage depreciation can be calculated as: (12.0000 – 11.8000) / 11.8000 = 1.69%. Two important messages are provided here about (1) the effect of supply and demand on exchange rates and (2) the manipulation of currencies by governments. Both of these are useful pointers in understanding the fluctuations in exchange rates.

Watch the following short video clip on exchange rates: •

McGlasson, M. J. (2010), (Macro) episode 33: exchange rates [Video clip]. http://www.youtube.com/watch?v=xwtgByffoUw (Retrieved January 13, 2023).

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Foreign Exchange Transactions

1. Refer to the internet or your daily newspaper and find examples of the key points discussed in this subsection: a. b. c. d.

Currency codes Bid, ask and spread Spot rates Forward rates

2. Explain the following concepts in your own words, and invent examples to support your explanations. To invent strong examples, you will need to engage in further reading and research. a. Currency forward contracts b. Currency futures

Factors that influence exchange rates Exchange rates are determined by supply and demand (for those currencies that are part of the floating exchange rate system). Consider that if there is an increase in demand for South African goods then there would tend to be an appreciation (increase in value) of the South African rand. If, however, market participants were worried about the future of the South African economy, they would tend to sell rand and this would lead to a fall in the value of the rand. With this in mind, we have selected some of the main factors that influence exchange rate behaviour (Marx, 2013, pp.318-319): •

The interaction between a country’s current account and capital account – a deficit in a country’s current account suggests that it is spending more on imports than it receives from exports; because it is selling its currency (to buy imports) in greater quantities than the foreign demand for its currency, the value of the currency will (in theory) decrease (the opposite will apply for current account surpluses). The currency of a country with a current account deficit could however remain stable (or even appreciate) if there is an appetite to invest in that country (ie a surplus on its capital account). This demand for currency would place upward pressure on its value, thereby offsetting the downward pressure caused by the current account deficit.

•

Relative inflation rates – countries with lower inflation rates tend to experience an appreciation in the value of their currencies and vice versa. When the inflation rate increases in a country this causes production to become more expensive, which in turn makes the country’s exports less competitive. The country is likely to experience fewer exports and, as described in the above point, the demand for currency will fall and consequently the currency will depreciate.

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•

Changes in relative interest rates – this is likely to influence investment in foreign securities, which in turn influence the supply and demand for currencies and therefore the exchange rates. As Marx (2013:318) points out, “in some cases the exchange rate between countries is also influenced by interest rates in other countries”, for example interest rates in Australia and New Zealand could be significantly higher than interest rates in the US and therefore eurozone firms with excess cash have alternative cash investment options (the supply of EUR for USD would be smaller than it would have been without the high interest rates in AUD and NZD currencies).

•

Speculation – if speculators believe that a currency will appreciate in the future they will demand more now and consequently the increased demand will cause the currency to appreciate.

•

Relative strength of other currencies – during 2010/11 the value of the Japanese yen and Swiss franc rose because markets thought them to be more secure than the currencies of several other major economies (including the US and EU). Despite the low interest rates and low growth in Japan, the yen appreciated in value.

Government policies also play a significant role in exchange rates. Consider these excerpts on the Swiss franc (Pettinger, 2011; The Economist, 2015b).

Swiss franc pegged against the euro Switzerland is the envy of many nations – it has “low unemployment, low inflation, low government borrowing and its total national debt is a mere 38% of GDP”. Its GDP per capita is also among the highest in the world. Switzerland is, however, a landlocked country with few mineral resources. It relies extensively on international trade and migrant workers to fill job vacancies in manufacturing, where it specialises in high-tech micro technology products. This reliance on international trade means that the value of the currency has to be carefully regulated (too strong a currency being detrimental to exports). Recently, the euro debt crisis caused many investors to look for a safe haven – a currency that would support solid investment. The Swiss economy has avoided many of the problems experienced in other euro countries and has consequently appealed to international investors, causing the Swiss franc to appreciate. This appreciation has created a significant amount of concern for Swiss policy makers – “Swiss residents were even travelling across the border into neighbouring countries to do their shopping with their strong Swiss francs”. This over-valued Swiss franc made Swiss exports less competitive and this was hard for Switzerland to absorb. Even tourists were finding it too expensive to visit Switzerland. The consequences – lower growth and the prospect of increasing unemployment.

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In 2011, the Swiss policy makers pegged the value of the Swiss franc against the euro (ie CHF/EUR 0.83). To keep the Swiss franc undervalued, the Swiss authorities promised to: • •

Buy unlimited quantities of foreign currency – by selling Swiss francs and buying foreign currency, the value of the franc is kept low; and Keep interest rates at 0% as long as necessary – making it less attractive to save in Swiss banks. (Pettinger, 2011)

“On 15 January 2015, when the Swiss National Bank suddenly announced that it would no longer hold the Swiss franc at a fixed exchange rate with the euro, there was panic. The franc soared.” Whereas one euro had previously bought 1.2 Swiss francs, the euro fell to just 0.85 francs. A number of hedge funds across the world made big losses. The Swiss stock market collapsed. (The Economist, 2015b)

Swiss Franc Pegging

1. Carry out your own desk research into the pegging and unpegging of the Swiss franc. 2. Discuss the policy decisions made by Swiss policy makers between 2011 and 2015 and the impact on foreign trade, investors, and banks. 3. Reflect critically on government policies, exchange rates and the broader implications for banks internationally.

2.3.2

Foreign Trade and the Banking Sector

The banking sector facilitates international trade by providing trade services, financing and guarantees to both importers and exporters. Consider that while access to funding is important for domestic production (eg a wine farmer), without specialised funding (funding channels) and information (information channels), exporting and importing companies will find it difficult to achieve their foreign trade objectives.

“Countries with strong financial institutions tend to export relatively more, especially in financially vulnerable sectors.” (Claessens, Hassib and Horen, 2014)

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There is also evidence to suggest that exports and imports are stronger when foreign banks are present. Two key factors include (Claessens et al, 2014): • •

Trade finance; and Overcoming information asymmetries and other agency issues between importers and exporters.

Having a physical presence in both the importing and exporting countries means banks are better placed to acquire and process information related to risks on both the importer and exporter sides of the transaction (eg country risks, including different laws and regulations).

Foreign banks have also been found to “lower the overall costs and increase the quality of financial intermediation, increase access to financial services, and enhance the financial and economic performance of their borrowers” (Claessens et al, 2014). Of course, the presence of foreign banks can also be destabilising when the parent bank is hit by a shock (eg headquartered in a country experiencing a banking crisis itself). As Claessens et al (2014) point out, this can be especially risky when the foreign affiliate is not financed by local deposits.

Letters of credit (LCs) and documentary collections (DCs) Letters of credit (LCs) and documentary collections (DCs) are the two most important trade finance products for mitigating risk in international trade (Niepmann and Schmidt-Eisenlohr, 2014).

A letter of credit is “a written commitment from a buyer’s or importer’s bank (called the issuing bank) to pay a due amount into the seller’s or exporter’s bank (called the accepting bank, negotiating bank, or paying bank). A letter of credit guarantees payment of a specified sum in a specified currency, provided the seller meets precisely defined conditions and submits the prescribed documents (such as all import clearance documentation) within a fixed timeframe. Notably, the banking system does not take any responsibility for the quality of goods, genuineness of documents, or any other provision in the contract of sale.” (Business Dictionary, 2015a) A documentary collection is “an international trade procedure in which a bank in the importer’s country acts on behalf of an exporter for collecting and remitting payment for a shipment. The exporter presents the shipping and collection documents to his or her bank (in own country), which sends them to its correspondent bank in the importer’s country. The foreign bank (called the presenting bank) hands over shipping and title documents (required for taking delivery of the shipment) to the importer in exchange for cash payment (or a firm commitment to pay on a fixed date.” Notably, the banks involved in the transaction act only in a fiduciary capacity to collect payment – they are liable only “for correctly carrying out the exporter’s collection instructions”. (Business Dictionary, 2015b)

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Watch this short video clip that provides some insight into how banks get involved in the import-export process through letters of credit: •

International Trade Administration. (2021). Letter of credit [Video clip]. https://www.youtube.com/watch?v=cJa1U4FmYIM (Retrieved January 13, 2023).

Essentially, the value of risk mitigation through bank intermediation is offset to a degree by the cost of the intermediation. A letter of credit comes with a price and “tends not to be used in either the least risky or most risky situations” (Niepmann and Schmidt-Eisenlohr, 2014).

• •

Banks can reduce but cannot eliminate the risk of a trade transaction. Therefore the fees they charge rise with the remaining risk they take on. For the riskiest destination countries “bank fees are so high that exporters prefer cash-inadvance”. (Niepmann and Schmidt-Eisenlohr, 2014)

Letters of Credit Versus Documentary Collection

In your own words, distinguish between letters of credit and documentary collection.

Trade finance Foreign trade finance is a core corporate business product for many banks. We have selected the following publication by Bankenverband (2015) (the Association of German Banks – a leading trade association) to provide a comprehensive insight into financing foreign trade.

Read these publications and then refer to the key learning points in the table that follows: •

Bankenverband. (2015). Financing foreign trade. https://bankenverband.de/media/publikationen/16012015_Aussenhandelsfinanzierung_eng.pdf (Retrieved January 13, 2023).

•

Organization for Economic Co-operation and Development. (2021). Trade finance in the COVID era: Current and future challenges. https://www.oecd.org/coronavirus/policyresponses/trade-finance-in-the-covid-era-current-and-future-challenges-79daca94/ (Retrieved January 13, 2023).

Key learning points from the Bankenverband (2015) publication are summarised in Table 4 for discussion purposes.

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TABLE 4: FINANCING FOREIGN TRADE

Opportunities and challenges of foreign trade

•

•

Opportunities: A systemic view of foreign trade suggests that export and import transactions are not solely about products and services, their pricing, and delivery periods. Finance is an integral part of the process and may even provide importers and exporters with major competitive advantages (eg bank support in the form of payment and collection instruments, economic and political data on risks, and hedging mechanisms typically needed in foreign trade). Challenges: Buyers and sellers are residents in countries with different political and economic conditions, legal regimes, cultural traditions, and business practices. And, compliance with separate statutory export regulations may be required. o

o

Political risks include: payment delays, expropriation and damage to goods, conversion or currency risk, transfer risk (government intervention), and risk of a moratorium (temporary suspension of payments). Commercial risks include: risk of failure to sell, transport risks, legal risks (eg product liability), payment risk (unwillingness or insolvency), and currency risk.

Structured trade finance

• •

Short term (less than 12 months) and medium term (one to five years). Finance could cover extraction, production, processing, warehousing and trading (special collateral structure to support the value chain). Assessment of borrower’s balance sheet and history is important. Finance is geared to the merchandise and payment flows under the delivery contracts.

Long-term export finance

• •

Long term (more than five years) – difficult to predict risks over this timeframe. Forfaiting – assigning the entire contract resulting from an export transaction to a bank or specialist forfaiting company. The forfeiter takes on all the associated risks with the receivables but earns a margin. Project finance and export leasing.

• Credit cover (bank guarantees, private and statebacked credit insurance)

Hedging against interest rate risk and currency risk

• • • • •

Insurance to secure export transactions in the event they go wrong. Private and state-backed credit insurance. Bid bond (eg in case a bidder or exporter withdraws his bid after being awarded the contract under an invitation to tender). Advance payment guarantee. Performance guarantee (considered more effective than a contractual penalty).

• •

Warranty guarantee (ensures goods are free of defects and any defects are remedied). Hermes cover (state-backed export credit insurance managed by Euler Hermes and PricewaterhouseCoopers on behalf of the German government).

•

Approximately 70% of German companies use hedging instruments to protect themselves against fluctuations in interest rates (eg entering into an interest rate swap in which the floating interest rate is exchanged to a fixed rate, or purchasing of a cap for improved cost security). Forward exchange contracts to hedge against currency risk. Or a combination of the above. (Bankenverband, 2015)

• •

After reading the publication by Bankenverband (2015) and reviewing the key learning points given above, complete the following tasks.

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Trading Risks

1. Assume you are required to give advice to a German company that is planning to export goods to Lesotho. Discuss the possible political and commercial risks that should be considered. 2. Assume you are discussing long-term export finance with a client. Identify key discussion points and substantiate why these are important. 3. Explain the concept of credit cover and the types available both in Germany and in your home country.

Incoterms It is crucial that the terminology used in international trade contracts is absolutely clear and unambiguous, and so the International Chamber of Commerce has since 1936 issued sets of threeletter terms called “Incoterms” (short for “International Commercial Terms”). These terms are universally accepted and used, and will be updated in the forthcoming Incoterms 2020. Table 5 provides some examples of Incoterms. TABLE 5: INCOTERMS (EXAMPLES)

CPT

Carriage paid to

DAT

Delivered at terminal

DAP

Delivered at place

DDP

Delivered duty paid

CFR

Cost and freight

CIF

Cost, insurance and freight

Incoterms are not only convenient for clear communication across linguistic and cultural barriers; they also embody many principles of international commercial law, and their use is encouraged by international lawyers.

International Laws

1. Critically evaluate why international rules (such as those codified in the use of Incoterms) are necessary to protect importers, exporters and banks. 2. Identify other aspects of international law that facilitate (or constrain) international trade. Briefly explain these relating them to the banking sector.

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Read the following short case study and then complete the tasks at the end of it.

Mini Case Study – India

India: Foreign Trade Policy (Report from the World Bank, nd) Although India has steadily opened up its economy, its tariffs continue to be high when compared with other countries, and its investment norms are still restrictive. This leads some to see India as a “rapid globaliser” while others still see it as a “highly protectionist” economy. Till the early 1990s, India was a closed economy: average tariffs exceeded 200%, quantitative restrictions on imports were extensive, and there were stringent restrictions on foreign investment. The country began to cautiously reform in the 1990s, liberalizing only under conditions of extreme necessity. Since that time, trade reforms have produced remarkable results. India’s trade to GDP ratio has increased from 15% to 35% of GDP between 1990 and 2005, and the economy is now among the fastest growing in the world. Average non-agricultural tariffs have fallen below 15%, quantitative restriction on imports have been eliminated, and foreign investment norms have been relaxed for a number of sectors. India however retains its right to protect when need arises. Agricultural tariffs average between 30% and 40%, antidumping measures have been liberally used to protect trade, and the country is among the few that continue to ban foreign investment in retail trade. Although this policy has been somewhat relaxed recently, it remains considerably restrictive. Nonetheless, in recent years, the government’s stand on trade and investment policy has displayed a marked shift from protecting producers to benefiting consumers. This was reflected in its foreign policy (2004/09) which stated that “For India to become a major player in world trade … we have also to facilitate those imports which are required to stimulate our economy.” India is now aggressively pushing for a more liberal global trade regime, especially in services. It has assumed a leadership role among developing nations in global trade negotiations, and played a critical part in the Doha negotiations. Regional and Bilateral Trade Agreements: India has signed agreements with its neighbours and is continuing to seek new ones across the globe. World Bank Involvement: As a number of research institutions in the country provide the government with good, just-in-time, and low-cost analytical advice on trade-related issues, the World Bank has focused on providing analysis on specialised subjects at the government’s request (eg the Bank has been working with the Ministry of Commerce to assist India develop an informed strategy for domestic reform and international negotiations). Questions 1. 2.

Discuss how advice from banks regarding international trade with India might have changed since 1990. Draw on your other courses (own research or experience) to explain why India might have made the changes described in the text and how banks stand to benefit. © Regenesys Business School

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2.3.3

Concluding Thoughts

Banks are integral to the success of exports and imports, especially when the trading partners are far away in a country where contracts are hard to enforce. Trading partners mitigate their risks through, for example, specialised products such as letters of credit and documentary collections. Despite the banks facilitating these products, trade finance is not without its challenges. Therefore, businesses rely more and more on banking expertise to provide them with, for example, structured trade finance, credit cover, and hedging against interest rate risk and currency risk. The World Trade Organisation deals with global rules of trade between nations with the aim of ensuring trade flows that are as smooth, predictable and free as possible. Approximately 80-90% of world trade relies on trade finance (trade credit and insurance/guarantees). The World Trade Organisation plays an integral part in facilitating financial flows. Complete this section by visiting its website where you will find current news and research.

2.3.4

Key Points

In this unit we focused on foreign exchange and trade. Note that: • • •

The foreign exchange market is not a physical market – it consists mainly of banks and foreign exchange brokers that bring buyers and sellers of foreign exchange together; The foreign exchange market is organised into two tiers: the wholesale and the retail tiers; There are several types of foreign exchange transactions, including: o o o o

• • • • •

Spot foreign exchange transaction Forward foreign exchange transactions Currency swaps Currency futures

Exchange rates are determined by supply and demand; The banking sector facilitates international trade by providing trade services, financing and guarantees to both importers and exporters; Letters of credit (LCs) and documentary collections (DCs) are the two most important trade finance products for mitigating risk in international trade; Foreign trade finance is a core corporate business product for many banks; and Incoterms, provided and regulated by the International Chamber of Commerce, are not only convenient for clear communication across linguistic and cultural barriers; they also embody many principles of international commercial law.

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2.4 ASSET MANAGEMENT Timeframe

Minimum of 40 hours

Learning outcome

•

Discuss asset management within the banking environment.

Recommended book

•

Chapters 10 and 11 in Arnold, G. (2014). Banking (financial times guides). Pearson Education Limited.

•

Fin24. (2016). Limited allocation by SA pension funds to private equity. http://www.fin24.com/Money/Retirement/limited-allocation-by-sa-pension-funds-to-privateequity-20160419 (Retrieved January 13, 2023).

•

Lamprecht, I. (2015). How pension funds could change their asset allocation. https://www.moneyweb.co.za/news/markets/pension-funds-change-asset-allocation/ (Retrieved January 13, 2023).

•

Le Roux, W. (2019). Why South African retirement funds should allocate to private equity. https://www.simekaconsult.co.za/connecting/why-south-african-retirement-funds-shouldallocate-to-private-equity/(Retrieved January 13, 2023).

•

Whiteseide, E. (2021). How do pension funds typically invest? https://www.investopedia.com/articles/credit-loans-mortgages/090116/what-do-pensionfunds-typically-invest.asp (Retrieved January 13, 2023).

•

ASX. (2019). Investing – How to build an investment portfolio that meets your objectives [Video clip]. https://www.youtube.com/watch?v=_G-6gb6NsyU (Retrieved January 13, 2023).

•

Lincoln, T. (2015). Constructing your perfect share portfolio with Tim Lincoln [Video clip]. https://www.youtube.com/watch?v=2Bf_dggJD5w (Retrieved January 13, 2023).

•

Moneyweek. (2011). What do investment banks actually do? [Video clip]. https://www.youtube.com/watch?v=xlYDonZLoHg (Retrieved January 13, 2023).

•

Thangavelu, P. (2020). Investment banker [Video clip]. https://www.investopedia.com/articles/personal-finance/042215/what-do-investmentbankers-really-do.asp (Retrieved January 13, 2023).

Recommended reading

Recommended multimedia

Section overview:

2.4.1

This section provides an overview of asset management in the banking environment. We start by defining asset management and asset classes. We then move to some important principles in asset management, and discuss what investment banks do.

Defining Asset Management

In the context of investment management, the term “asset management” means the management of clients’ investments by financial intermediaries such as investment banks. © Regenesys Business School

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The bank invests on behalf of its clients, giving them access to a wide range of traditional and alternative products. For example, to facilitate asset management, banks offer asset management accounts.

An asset management account is an account at a bank (or other financial institution) that “allows the account holder to place money for both banking and investment services. When money is placed into the account, it is automatically placed into a money market account, which carries a higher interest rate than normal cheque or savings accounts. The account holder can then direct money to various banking and investment services.” (Financial Dictionary, 2015b) Asset classes are a group of securities that: • • •

Have similar financial characteristics; Behave similarly in the marketplace; and Are subject to the same laws and regulations.

The four main asset classes are: • • • •

Cash and cash equivalents (money market instruments); Fixed-income (bonds); Property; and Equities (stocks or shares).

We discuss each of the above in more detail below.

2.4.2

Asset Classes

Each of the four main asset classes can be ranked in terms of risk and return as shown in Figure 2. Cash and cash equivalents rank the lowest in terms of risk and return, with equities ranking the highest.

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FIGURE 2: ASSET CLASS RANKING

Cash and cash equivalents Cash and cash equivalents are the safest asset class, but provide the lowest return over time. They include such investments as on-call deposits in banks and other short-term interest-bearing investments. This asset class provides a temporary shelter during periods of market volatility. People approaching retirement might choose this asset class over a riskier class such as equities, since retirees are likely to be more risk averse. Both money market funds and money market accounts are used within the cash asset class. Table 6 provides a useful comparison (Discovery Invest, 2015).

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TABLE 6: COMPARING A MONEY MARKET FUND AND MONEY MARKET ACCOUNT

Similarities and Differences

Money market fund

Money market account

Both usually invest in short-term, fixed income investments such as US Treasuries. By definition, short-term, fixed income investments are those with maturities of less than one year.

✔

✔

Both money market funds and money market accounts usually offer higher interest rates than traditional savings accounts (the short-term investment instruments used have the potential for higher returns).

✔

✔

Both types of investment offer flexibility and liquidity, typically allowing investors to draw their cash from an ATM.

✔

✔

The one key difference is that a money market fund is a collective investment scheme (unit trust fund) and not a bank account.

✔

Like other types of unit trust funds (and like equity and bond funds), money market funds incur expenses, which are passed on to the fund’s investors.

✔ (Discovery Invest, 2015)

The major risk in being invested largely in cash is that, over the longer term, inflation will drastically reduce your buying power. A cash investment that returns 4% per year is no barrier against an inflation rate of, say, 7% per year; your money is still losing 3% of its buying power (7% – 4% = 3%) year by year.

Fixed income (bonds) As we saw in the first section of this course, fixed income such as bonds are also interest bearing, but have a longer period of maturity. Governments, government institutions, municipalities, and corporates borrow money from investors by issuing them with debt instruments called bonds. These bonds provide a fixed income – the bondholder is entitled to an annual cash interest payment that is fixed at the time of purchase.

This asset class is relatively safe (ie offering a locked-in interest rate), but the investor is still exposed to some risk. If inflation or short-term interest rates rise during the period to maturity, the investor loses out (remember there is an inverse relationship between bond yields and interest rates). Fixedincome investments such as bonds are low-to-medium-risk investments and provide low-to-medium returns over time. A bond fund is a collective investment scheme that invests in various underlying bonds and debt instruments. They are often referred to as fixed-income funds. Bond funds typically pay periodic dividends that “include interest payments on the fund’s underlying bond holdings plus periodic realised capital appreciation” (Discovery Invest, 2015). Individuals approaching retirement are often advised to choose bond funds as part of their portfolio of investments.

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Property Property (real estate) includes a wide spectrum of investments from housing to office blocks and warehouses. Property is usually purchased and then leased out to create income. Although property should offer a steady income flow (after expenses) and the investor should benefit from capital growth, it is considered to be a high-risk asset class, with returns proportionate to this risk. Importantly, the property market can be adversely affected by a rise in interest rates and therefore it tends to have a low correlation with interest-bearing investments, especially cash – in other words, if you are invested in both cash and property, you are unlikely to see strong returns from both at the same time. There is a range of property investment options, some of which include (Discovery Invest, 2015): •

Direct investment (purchase of physical property) – investors must be certain about the earning potential of the property (in an over-speculated property market there may be many properties without tenants);

•

Listed property shares (we mention this here although these are similar to equities; when choosing to invest in listed property shares investors should be aware they will be exposed to the property market, which fluctuates with interest rates and the economy);

•

Property unit trust funds (a common method of accessing property investments; unit trust funds are exposed to a wide range of high quality properties; these funds are scrutinised for value by fund managers who are skilled at making informed decisions); and

•

Property syndicates (some of which have in recent years attracted much bad publicity, with properties being overvalued and investors defrauded).

Equities Equities are the highest-risk class of assets but attract the highest potential returns. When purchasing shares, investors are taking a direct stake in the profits (or losses) of companies. Companies are subject to many competing forces notwithstanding the economy itself. Although equities can be quite volatile in the short term, they are considered one of the best investments to achieve good long-term returns. There are different types of shares, which are broadly categorised as follows: •

Large-capitalisation stocks (referred to as large-cap stocks) – large and established companies (fall within the top 40 largest companies by market capitalisation listed on the FTSE/JSE All Share Index);

•

Middle-capitalisation stocks (referred to as mid-cap stocks) – medium sized companies that fall just behind the large cap stocks in terms of market capitalisation (listed on the FTSE/JSE All Share Index); and

•

Small-capitalisation stocks (referred to as small-cap stocks) – small companies with a market capitalisation less than R5-billion (listed on the FTSE/JSE All Share Index). These stocks are not traded as frequently as mid and large cap stocks, and so investor information is more limited. The small caps can be a source of high growth and high returns in an investment portfolio. © Regenesys Business School

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An equity fund is a collective investment scheme that invests primarily in stocks. A growth fund is one that includes stocks of high growth companies (or those whose earnings are expected to be on an upward trend). Value funds are those in search of value companies whose expected earning potential is higher than their current stock valuation. Investment banks offer a range of funds (eg general funds, mining and resources funds, and financial and industrial funds).

Pension funds It is useful to point out here that a pension fund contains a number of asset classes, a mix of: •

Defensive assets, ie primarily income producing assets such as cash and fixed-income securities; and

•

Growth assets, ie those that offer the potential for capital growth as well as income (they tend to produce higher returns than defensive assets on the longer term but have greater volatility, eg equity).

The OECD (Financial Services Council, 2014) carried out a comparative study of asset allocation in private pension plans (12 countries). The data is presented for discussion purposes in Table 7. TABLE 7: PENSION FUND ASSET ALLOCATION IN CERTAIN COUNTRIES

Country

Cash & deposits

Australia

18.4

Bills & bonds (public) 1.3

Canada

2.7

19.5

Chile

0.5

Denmark

0.4

Hong Kong

13.3

Japan

5.1

Korea (South) Netherlands Switzerland

57.8

1.1

1.3

17.0

UK

2.9

12.6

USA

0.9

9.4

Bills & bonds (private) 8.3

Loans Shares

Land & buildings

Mutual funds

Other

1.0

46.0

7.4

0.0

17.6

8.1

0.3

24.6

5.5

34.6

4.7

21.4

24.1

1.1

12.5

0.0

40.3

0.1

49.3

16.8

0.1

13.0

1.0

2.3

17.1

24.8

0.0

57.4

0.0

0.0

4.5

36.3

2.8

9.7

0.0

0.0

46.1

0.5

0.0

0.0

0.0

5.9

34.7

7.0

3.8

11.6

0.9

51.9

6.5

3.3

13.0

9.7

42.8

4.0

9.3

1.2

29.6

2.8

23.3

18.3

6.9

0.3

38.2

1.7

22.0

20.7

7.3

19.9

(OECD in Financial Services Council, 2014)

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There are some interesting observations from the above table (Financial Services Council, 2014): • •

• •

“The exposure to bills and bonds varies from less than 10% in Australia and Korea to more than 65% in Denmark. “There is also considerable diversity as to whether the bills and bonds are primarily issued by public administration or the private sector. Only Australia and Chile have a majority issued by the private sector, possibly indicating the lower level of government debt in these countries. “Considering cash deposits only, the variety is considerable, ranging from almost zero in several countries to 18% in Australia and 57% in Korea (South). “The exposure to shares also varies considerably ranging from less than 10% in Korea (South) and Japan to 46% in Australia and 57% in Hong Kong.”

Read more about South Africa’s pension funds and their asset allocation: •

Fin24. (2016). Limited allocation by SA pension funds to private equity. http://www.fin24.com/Money/Retirement/limited-allocation-by-sa-pension-funds-toprivate-equity-20160419 (Retrieved January 13, 2023).

•

Lamprecht, I. (2015). How pension funds could change their asset allocation. https://www.moneyweb.co.za/news/markets/pension-funds-change-asset-allocation/ (Retrieved January 13, 2023).

•

Le Roux, W. (2019). Why South African retirement funds should allocate to private equity. https://www.simekaconsult.co.za/connecting/why-south-african-retirement-fundsshould-allocate-to-private-equity/(Retrieved January 13, 2023).

•

Whiteseide, E. (2021). How do pension funds typically invest? https://www.investopedia.com/articles/credit-loans-mortgages/090116/what-do-pensionfunds-typically-invest.asp (Retrieved January 13, 2023).

Asset Allocation

1. Use the data in Table 7 to make at least three more interesting observations about (or comparisons of) pension fund allocations in the countries listed in the table. You may wish to include observations about regions or continents; for example, patterns in North America versus those in the Far East. 2. Do you agree that local pension funds in South Africa should change their asset allocation? Research the topic and justify your answer. 3. How do the asset allocations of pension funds in South Africa compare to those in the countries listed in Table 7?

It is clear that asset allocation varies widely between countries. Some developed economies such as Denmark have a stronger focus on fixed interest investments, whereas countries such as Australia and Hong Kong have a stronger focus on growth assets (ie shares). © Regenesys Business School

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Pension funds in South Africa The Pension Fund Act, 1956 governs the South African retirement fund market. The regulations under this act set maximum investment limits for the exposure to certain asset classes, for example equities and international assets. For emerging economies, international assets often provide a hedge against country-specific weakness. For example, when local conditions are poor in South Africa the exchange rate tends to depreciate, which makes the returns from the offshore assets more valuable in the base currency (ZAR) (Pfau in Wepener, 2014).

Some key learning points about asset classes: • • • •

•

2.4.3

Cash, as an asset class, has the lowest risk of losing capital, but the highest risk of losing purchasing power due to inflation. Bonds (and bond funds) are typically suited to investors looking for a relatively low-risk investment with a monthly income. Property, as an asset class, offers diversification and different performance characteristics. A share of stock is the smallest unit of ownership in a company. When owning shares one is a part owner of the company and thus dependent on the company’s performance (this can be diversified through owning a portfolio of shares or participating in equity funds). Pension funds provide a mix of asset classes, and typically vary from country to country.

Principles in Examining Asset Classes

Two important principles when examining asset classes are: • •

The time horizon; and Inflation.

Consider that in the short term, cash and bonds are somewhat safer. However, in the longer term they provide no protection against inflation. “This means that for long-term investment, they are actually riskier in terms of maintaining real buying power, while property and equities are safer.” (Savings Institute, 2015)

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Analysis of the South African experience An analysis of the four asset classes suggests that, over time, these asset classes are likely to produce the following real (after inflation) returns in the long run: • • • •

Cash: 0% to 1% Bonds: 1% to 3% Property: 2% to 4% Equities: 7% to 9% (Savings Institute, 2015)

Does this mean that the typical investor should put all his or her funds into shares? This asset management decision would subject the investor to significant short-term risk. The investor must consider his or her time frame, inflation, personal investment objectives, and risk tolerance when choosing asset classes. Another important investment principle is diversification. Diversification occurs when clients spread their investable funds across different assets. Diversification reduces overall variability (ie risk) of a portfolio of investments. A diversified portfolio should be “spread both between and within asset categories, so in addition to allocating funds among shares, bonds, cash equivalents and possibly other asset categories, one also needs to spread investments within each asset category” (Marx, 2014, p.273). As the timeframe becomes shorter (eg towards retirement) the asset allocations may change to provide a more comfortable level of risk. Strategic asset allocation is achieved at the inception of the portfolio, ie a base policy mix is established in the light of expected returns and risk. Then the asset class mixes are rebalanced (eg mix of shares) at regular intervals (monthly or quarterly). For example, the investor might have had exceptional returns on a particular share, causing the portfolio to become imbalanced. From time to time it might be appropriate to engage in short-term tactical deviations from the mix in order to capitalise on unusual or exceptional investment opportunities (ibid). As Marx (2014, p.273) points out “this flexibility adds a component of market timing to the portfolio”.

• •

The investor must be able to recognise when short-term opportunities have run their course, and then rebalance the portfolio to the long-term asset position. The tools include: economic forecasts, market assessments, and equity and bond research, all of which are typically analysed by qualified investment managers.

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Portfolio construction for equities ideally includes a spread of shares that minimises market risk.

•

• •

Risk associated with individual shares (ie unsystematic risk) can be reduced, but there are inherent market risks (ie systematic risks) that affect nearly every share and no amount of diversification can totally prevent. A well diversified portfolio reduces risk without sacrificing returns. The key to efficient diversification is combining asset classes that have low correlations (ie two assets that have low correlations are more likely to eliminate the risk of the combined assets).

In selecting individual securities to be included in a portfolio, it is necessary to calculate the risk and return associated with each one, and the correlation between the securities.

Constructing a Portfolio

Watch this video clip to understand investment profiles, investment strategies, picking shares according to objectives, and active portfolio management. •

ASX. (2019). Investing – How to build an investment portfolio that meets your objectives [Video clip]. https://www.youtube.com/watch?v=_G-6gb6NsyU (Retrieved January 13, 2023).

•

Lincoln, T. (2015). Constructing your perfect share portfolio with Tim Lincoln [Video clip]. https://www.youtube.com/watch?v=2Bf_dggJD5w (Retrieved January 13, 2023).

Tasks • •

•

What are the key learning points from the video? Review “Lincoln’s 9 Golden Rules”. Carry out your own desk research into other approaches to portfolio construction and management. Critically evaluate the importance of clients receiving intelligent, responsible, and sound advice. In your own words, explain the following statements: o o o

Diversification reduces volatility while maintaining return. As the correlation between two assets decreases, the benefit of diversification increases. Except under unusual economic circumstances, stocks and bonds tend to move in the opposite direction.

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2.4.4

What Do Investment Banks Do?

To complete this section, we have included a discussion on investment banks and bankers. Let’s take in the following short clips: •

Moneyweek. (2011). What do investment banks actually do? [Video clip]. https://www.youtube.com/watch?v=xlYDonZLoHg (Retrieved January 13, 2023).

•

Thangavelu, P. (2020). Investment banker [Video clip]. https://www.investopedia.com/articles/personal-finance/042215/what-do-investmentbankers-really-do.asp (Retrieved January 13, 2023).

There are two types of investment bank (Arnold, 2014, p.150): •

•

Large, global banks that perform all or most of the investment banking functions including proprietary trading, market making, mergers and acquisitions, new issues and underwriting, and structured products (eg Standard Bank Corporate and Investment Banking and JP Morgan); and Boutique investment banks that might advise companies on financing issues and mergers, but do not, for example, raise finance for corporates (eg Musa Capital, AfrAsia Corporate Finance).

Global Banks

Identify examples of large global banks and boutique investment banks in your home country. Visit their websites and review their products and services. Reflect critically on why businesses might select one in preference to another.

Proprietary trading Proprietary trading occurs when an investment bank conducts trades on its own account instead of on behalf of a client. The three main objectives for proprietary trading are (Financial Dictionary, 2015c): • •

•

Allows the investment bank to profit from the trade. If the bank trades for a client then it collects only the commissions and fees from the client, not the profits; Allows the investment bank to build an inventory of securities, which is useful when clients want to place orders for securities in an illiquid market (ie the investment bank fills the order from its own inventory); and Allows the investment bank to make a market (see below) when it is assigned to ensure the liquidity for a particular security.

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Market making A market maker is an entity that is always prepared to buy and sell securities to provide liquidity to the market.

Market makers are able to satisfy the market demand for a security (eg shares in a particular company) and facilitate its circulation. Bid What the market maker buys at R100 What clients sell at

Spread Profit the market maker makes R10

Offer What the market maker sells at R110 What clients buy at

The market maker profits through the “spread”, which is the difference between the bid and offer prices.

Market makers profit through the market maker’s spread and not by betting on the direction of the security’s price (ie when investors are selling, market makers are buying, and vice versa). Market makers do, however, assume a high level of risk because they hold inventory. If the spread (gap) gets too wide, then clients will be lured away by better prices. This spread could be less than 1% of the value or it could be 20% or more. The major factor that influences the spread is supply and demand.

Some companies such as Apple or Marks & Spencer have millions of shares traded every day and so the market maker is not likely to have these shares for long (they go out of the door as fast as they come in) and therefore spreads can be around a tenth of 1%. Conversely, a small construction company might trade in lots of only a few hundred perhaps two to three times in a day. Thus the market maker has money tied up for days and the spread is likely to be greater.

The following example shows a quote-driven system at work (assume it is a company share) (Arnold, 2014:159). The demand curve shows that as the price declines the amount demanded to buy from the market maker rises. The supply curve shows rising volume offered by investors with higher prices. The clearing price is 199p: this is where the demand from clients wanting to buy and the supply of the securities from those wanting to sell is evenly matched. The market makers in this share will be taking a spread around this clearing price, so the true price to the buying client might be 199.5p, whereas the price that a seller to the market makers can obtain is only 198.5p.

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FIGURE 3: SUPPLY AND DEMAND IN A QUOTE-DRIVEN MARKET

(Arnold, 2014:159)

Using Figure 3, suppose that one of the market makers is currently quoting prices of 200p-201p (ie offering to buy at 200p and sell at 201p). He will experience a flood of orders from sellers, because investors will be will willing to sell 7 000 shares per hour if offered 200p. On the other hand, demand at 201p is a mere 3 000 shares. The market maker will thus end up buying a net 4 000 shares per hour if he takes all the trade. In fact, it is even worse than this for our market maker because the potential buyers can pick up their shares for only 199.5p from other market makers and so he ends up buying 7 000 per hour and not selling any (ibid).

Read your prescribed textbook to obtain a comprehensive understanding of the concepts. Investment banking and market trading activities are to be found in: Chapter 11, Arnold, G. 2014, Banking (Financial Times Guides), Harlow: Pearson Education Limited.

Explaining Concepts

Explain the following concepts: 1. Market maker; and 2. Bid-ask-spread as it applies to equities.

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Mergers and acquisitions The term “mergers and acquisitions” is used to denote the consolidation of companies. While a merge is a combination of two companies to form a new company, an acquisition is the purchase of one company by another (no new company is formed). Companies looking to expand or to streamline their businesses use investment banks for assistance. The investment bank can, for example (Arnold, 2014, p.153-154): • • • • •

Provide pure advice (without fund raising in the case of acquisitions); Assist with valuation and procedural matters in an acquisition; Raise finance for an acquisition; Sell off a subsidiary (ie a divestiture) and restructure a company’s debt; and or Help with the organising of a merger or joint venture (commercial enterprise undertaken jointly such as a major road-building contract).

The role of the investment bank could be either seller representation or buyer representation. Either way, one of the key objectives in mergers and acquisitions is to establish fair value for the companies involved. Investment banks may also study industry sectors and approach companies with their own strategic ideas for mergers and acquisitions.

Corporate events (new issues and underwriting) Investment banks play a significant role in the issuance of new government or corporate securities. They provide one or more of the following services: •

Advising on the: o o o o

•

Timing; Issue price; Volume of securities offered; and Terms.

Underwriting: o o

Purchasing some or all of the securities; and Reselling the securities to the public.

An investment bank undertakes substantial risks when underwriting a new issue, because it may not be able to resell the securities at a profit.

When an investment bank is forced to sell the securities in the new issue at a price lower than it paid to purchase them from the issuer (the company), the investment bank will suffer a loss of its own capital.

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Investment banks typically share the potential risks (and rewards) of new issues by forming a syndicate of investment banks.

Structured products In the past, investment banks offered a narrow range of high-quality debt and equity instruments. But with the rise of various financial innovations came structured products.

Structured products are “designed to facilitate highly customised risk-return objectives. This is accomplished by taking a traditional security such as a conventional investment-grade bond and replacing the usual payment features (eg periodic coupons and final principal) with non-traditional payoffs derived not from the issuer’s own cash flow, but from the performance of one or more underlying assets.” (Investopedia, 2015c) Some of the key benefits advertised by Barclays (2015) for structured products include: • • • • • •

Customised exposure to the underlying asset of the client’s choice; Access to a wide range of assets; Tailored products to suit client’s needs; Hedging to help insure against adverse movements; Access to a wide range of counterparties offering client value; and After-sales support, keeping the client’s portfolio as efficient as possible.

Meanwhile, some of the key risks include (ibid): • • •

•

If the issuer of the product fails to meets its obligations (eg because it is insolvent) the client may not receive what is due to him or her (or anything at all); Structured products will not necessarily outperform the underlying asset to which they are linked; Prices can fluctuate below the level at which the client originally invested, due to market forces such as interest rates (if the client sells the product before its maturity date, he or she may get back less than he or she invested, irrespective of the performance of the underlying asset; and Some structured products are significantly leveraged, bringing high risks as market movements (including falls) are strongly amplified.

Appropriately qualified (accredited) wealth investment managers sell these types of products to clients.

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2.4.5

Key Points

Asset management is an extensive field of study and business sector within the banking industry. It is also a specialised area when you consider the vast amount of money channelled into investments across the globe. Understanding business and client profiles and needs are essential to responsible and effective asset management. In the concluding section, we consider the compilation of financial plans and offering financial advice. Note the following key points from this unit: • •

In the context of investment management, the term asset management means the management of clients’ investments by financial intermediaries such as investment banks; The four main asset classes are: o o o o

• • •

A pension fund comprises a number of asset classes; The Pension Fund Act, 1956 governs the South African retirement fund market; When examining asset classes, two important principles are: o o

•

• • • • •

The time horizon Inflation

There are two types of investment banks o o

•

Cash and cash equivalents (money market instruments) Fixed-income (bonds) Property Equities (stocks or shares)

Large, global banks Boutique investment banks

Proprietary trading occurs when an investment bank conducts trades on its own account instead of on behalf of a client; A market maker is an entity that is always prepared to buy and sell securities to provide liquidity to the market; The terms mergers and acquisitions is used to denote the consolidation of companies; While a merge is a combination of two companies to form a new company, an acquisition is the purchase of one company by another (no new company is formed); Investment banks play a significant role in the issuance of new government or corporate securities; and In the past investment banks offered a narrow range of high-quality debt and equity instruments. However, with the rise of various financial innovations came structured products.

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2.5 FINANCIAL PLANS AND ADVICE Timeframe

Minimum of 40 hours •

Compile financial plans and offer financial advice; and

•

Prepare legally compliant documents.

•

Chapter 9 in Schoeman, H. C. (Ed.). (2013). An introduction to South African banking and credit law (2nd ed). LexisNexis.

• Prescribed article

PSG. (2019). Introduction to collective Investments. https://www.psg.co.za/support/tutorials/introduction-to-collective-investments (Retrieved January 13, 2023).

Section overview

In this final section our focus is on financial plans and advice. Various concepts relate to this task, including the implications of income tax, various pieces of legislation, wills and testaments, and communication tactics.

Learning outcomes Recommended book

2.5.1

South African Income Tax

Income tax is a tax levied on all income and profits received by a taxpayer. For example, tax applies to: • • • • • • • •

Income from business activities (eg employee and employer); Income from directorships; Income from trusts; Investment income; Rental income; Royalties income; Certain capital gains; and Annuities and pensions.

Taxpayers include individuals, companies and trusts. In financial planning, the form of tax associated with individual financial planning is typically “normal” income tax. In South Africa, for example, normal income tax would apply to:

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•

A natural person whose gross income exceeds the income tax threshold for that person for the year of assessment, typical thresholds being (for example): o o o

•

R70 700 (for a person below the age of 65 years); R110 200 (for a person aged 65 years or older but not yet 75 years); or R123 350 (for a person aged 75 years or older).

With the proviso, however, that if a person earns under R250 000 for a full year from one employer (total salary before income tax) and has no other sources of additional income (eg interest or rental income) and no deductions that he or she wants to claim (eg medical expenses, travel, or retirement annuities) then he or she does not need to submit a return. (Adapted from SARS, 2015a)

Corporate tax includes tax paid by companies (or close corporations) and trusts on their annual income. Most of the state’s revenue is derived from income tax (both personal and corporate tax). Other taxes include indirect taxes (eg property tax) and primary value-added tax (VAT).

Income tax collection in South Africa The year of tax assessment covers a period of 12 months. For individuals, the 12-month period is from 1 March to 28 (29) February each year. For companies, the year of assessment may vary (eg 1 January to 31 December). Income tax returns are available annually and must be completed and submitted timeously. The tax season for individuals commences on 1 July: •

• •

Individual (ITR12) and trust (ITR12T) returns (non-provisional taxpayers) – last working day of September for postal submission (hard copies) or the last working day in November for eFiling (electronic copies); Individual (ITR12) and Trust (IT12TR) returns (provisional taxpayers) – have until the 31 January to submit their completed income returns to SARS; and Company (IT14) returns – must be completed and submitted within 12 months after the financial year-end of the company.

You should refer to the latest publications from SARS (available on their website, https://www.sars.gov.za/ for example: • • • •

Taxation in South Africa (Legal & Policy) for the current year (eg 2015/2016 or latest) Comprehensive guide to the ITR12 return for Individuals Comprehensive guide to the ITR12T return for Trusts Comprehensive guide to the ITR14 return for Companies

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Changes to Legislation

Read the following excerpt and then complete the tasks. “From 1 March 2015, individuals, regardless of age, were permitted to invest up to R30 000 per annum, with an overall lifetime limit of R500 000, into ‘tax-free investments’. “With effect from 1 March 2017, the R30 000 limit increased to R33 000 per annum. The eligible products include exposure to money market instruments, equities and property investments. The allowed composition of the tax-free investments as well as the entities that may administer such investments have been designated by notice by the Minister of Finance. “A withdrawal followed by a return to such an investment as well as transfers between products do not count towards the annual contribution limit. “Where a taxpayer contributes in excess of the annual or lifetime limit, a penalty of 40% of the excess contribution is levied.” (BDO, 2007) Questions 1. 2.

Based on the above changes to legislation, discuss how financial planning advice might change. “Where a taxpayer contributes in excess of the annual or lifetime limit, a penalty of 40% of the excess contribution is levied.” Explain this statement in your own words, using plain English – as if explaining the information to a person who has no financial background.

2.5.2

Financial Planning and Income Tax

Financial planning must consider income tax implications, for example the profits (or losses) from equity investments, and dividends tax. The objective is to minimise tax liability. While tax planning is an important element in any financial plan, it is important not to let the tax implications prevent financial planning decisions – virtually all investment decisions have some tax consequences. Tax avoidance Everyone is allowed to avoid paying tax if legally possible; for example, by saving in a tax-free savings account. There are also tax-saving advantages to putting money into a pension scheme, or claiming legitimate allowances. However, tax is open to abuse, particularly bending the rules of the tax system to gain an advantage that SARS never intended. Financial planners have an ethical and moral obligation to operate within not only the letter of the law but also the spirit of the law (Milligan, 2014).

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In a recent article (ibid), taxpayers in the UK are advised to look out for these warning signs: • •

Schemes that promise to get rid of a person’s tax liability for little or no real cost; Tax benefits or returns that are out of proportion to any comparable economic activity, expense, or investment risk; Schemes that involve arrangements that seem very complex given what the individual wants to do; Artificial or contrived arrangements; Money going around in a circle back to where it started; Offshore companies or trusts involved for no sound commercial reason; Tax havens or territories with banking secrecy are involved; Schemes that contain exit arrangements designed to side-step tax consequences; and Secrecy or confidentiality agreements.

• • • • • • •

Tax Evasion and Avoidance

1. 2.

Identify recent tax avoidance (or evasion) scandals associated with financial planning. What are the lessons learned (for banks and their clients)?

2.5.3

Legislation Affecting Financial Planning (South Africa)

The following South African legislation or phenomena relate to financial planning (not covered in the Banking I and II courses): • • • • •

Collective Investment Schemes Control Act, 2002; Medical Schemes Act; Estate Duty Act; Capital gains tax; Marriage: o o o o

•

Marriage Act, 1961 Matrimonial Property Act, 1984 Recognition of Customary Marriages Act, 1998 Civil Union Act, 2006 (same-sex partners)

Various forms of business ownership.

We have provided an overview for discussion purposes. However, students should familiarise themselves with the legislation in greater detail (refer to the links provided). Other legislation has already been covered in Banking I and II (eg the FAIS Act) but should be considered within the scope of financial planning.

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TABLE 8: LEGISLATION AND FINANCIAL PLANNING

Collective Investment Schemes Control Act, 2002

A collective investment scheme (CIS) is “an investment product that allows many different investors to pool their money into a portfolio” (unit trusts were the first such schemes in SA). A collective investment scheme can include several asset classes, ie money markets, bonds, equities, and property. Collective investment schemes are suitable for “investors with little funds and who may not have the time, money or expertise to make the investments themselves”. The assets of a collective investment scheme must be managed by a registered CIS manager (ie registered with the Financial Services Board) in terms of this act (Financial Services Board, 2015). https://www.fanews.co.za/documents/coll_inv_schemes_control_act_452002.pdf (Retrieved January 13, 2023).

Medical Schemes Act, 1998 (as amended)

The purpose of this act is to consolidate the laws relating to registered medical schemes and to provide for: •

The establishment of the Council for Medical Schemes

•

The appointment of the registrar of Medical Schemes

•

Make provision for the registration and control of certain activities of medical schemes

•

The protection of members’ interests

•

Measures for the co-ordination of medical schemes

•

Incidental matters

Students should refer to the Council for Medical Schemes for the latest news and information pertaining to this act (Council for Medical Schemes, 2015). https://www.gov.za/sites/default/files/gcis_document/201409/a131-98.pdf (Retrieved January 13, 2023). Estate Duty Act, 1995 (Administered by SARS)

Estate duty is levied and collected from the estate of every person who dies on or after 1 April 1995 in terms of this act. Estate duty is charged at the rate of 20% upon the taxable amount of the estate calculated in terms of the Estate Duty Act. The estate is liable for estate duty (paid by the executor of the estate). Where an insurance policy was paid to a beneficiary directly, the beneficiary is liable for the proportionate share of the estate duty payable. Duty assessed must be paid within one year of date of death (or on the date prescribed in the notice of assessment) (SARS, 2015b). https://www.sars.gov.za/types-of-tax/estate-duty/ (Retrieved January 13, 2023).

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Capital gains tax (Administered by SARS, the Income Tax Act refers)

Applicable to individuals, trusts and companies and forms part of income tax. A capital gain occurs when a person disposes of an asset for proceeds that exceed its base cost. Capital gains are taxed at a lower effective tax rate than ordinary income, not all assets attract capital gains, and certain capital gains and losses are disregarded. https://www.sars.gov.za/types-of-tax/capital-gains-tax/ (Retrieved January 13, 2023).

Marriage Act, 1961; Matrimonial Property Act, 1984; Recognition of Customary Marriages Act, 1998; and Civil Union Act, 2006 (same sex partners)

Marriages are governed by these four acts. It is also possible, in South Africa, to marry according to religious requirements, eg marriages according to Muslim or Hindu rites. Men and women can be married by way of customary (indigenous) law and same-sex marriages are also recognised. There are three different types of marriages: •

In community of property (joint estate)

•

Out of community of property with the accrual system

•

Out of community of property without the accrual system

If spouses do not conclude an antenuptial contract before their marriage, they are automatically married in community of property. Antenuptial contracts must be signed before the date of marriage and must be registered in the Deeds Office (Webbers, 2015). https://www.golegal.co.za/wp-content/uploads/2016/12/Marriage-Act-25-of-1961.pdf (Retrieved January 13, 2023). http://www.wylie.co.za/wp-content/uploads/MATRIMONIAL-PROPERTY-ACT-NO.-88-OF1984.pdf (Retrieved January 13, 2023). http://www.justice.gov.za/legislation/acts/1998-120.pdf (Retrieved January 13, 2023). http://www.saflii.org/za/legis/consol_act/cua2006139.pdf (Retrieved January 13, 2023). Different forms of business ownership

The following forms of business operate in South Africa: •

Sole trader or sole proprietor (one person owns the business)

•

Partnership (two to 20 partners who own the business together)

•

Close corporation (from 1 May 2011 no new CCs; not more than 10 members)

•

Company (new Companies Act, 2008 effective 1 May 2011)

•

Co-operatives (Co-operatives Act, 2005; owned and run by its members)

For information on ownership types go to the SARS and CIPC websites. http://www.sars.gov.za/Pages/default.aspx (Retrieved January 13, 2023). http://www.cipc.co.za/index.php/legislation/regulations/ (Retrieved January 13, 2023). © Regenesys Business School

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Role-Play

Read this communique from PSG on collective investment schemes and then carry out the role-play that follows: •

PSG. (2019). Introduction to collective Investments. https://www.psg.co.za/support/tutorials/introduction-tocollective-investments (Retrieved January 13, 2023).

Assume you have a client who is interested in participating in a collective investment scheme. With a partner, roleplay how you would give advice on this investment option. This is an integrated task, which means that you should draw on learning from prior courses to complement what you have learned in this course. Guidelines 1. Explain the concepts. 2. Outline the advantages and disadvantages. 3. Discuss the possible options and how these might (might not) meet the client’s particular needs.

Will and testament A last will and testament is a legal document that details how a client’s estate should be divided up when he or she dies, and so is part of financial planning. It sets out (PSG, 2015): • • • • •

Who will be in charge of the estate as executor (ie to carry out its distribution); The specific responsibilities and powers the executor will have; Who will inherit what property; How the property of the estate will ultimately be transferred to the beneficiaries; and In the case of minor children, who will serve as their guardian until they become adult.

The objective of this legal document is to protect (ibid): • • •

The family’s financial future and inheritance (including other named beneficiaries); The family against debt liabilities (eg from client’s business); and The estate from estate duty.

A power of attorney is a document in which one person (the principal) appoints another to act as an agent on his or her behalf (ie confers authority on the agent). These are routinely granted to allow the agent to transact on behalf of the client, for example, to execute share transactions, or to maintain a safe-deposit box. The principal can revoke the power of attorney at any time (Legal Dictionary, 2015). A power of attorney is terminated when the principal dies or becomes incompetent.

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A durable power of attorney (or enduring power of attorney) differs in that it continues the agency relationship beyond the incapacity of the principal. Two types exist (ibid): • •

Immediate – takes effect as soon as the durable power of authority is executed; and Springing – comes into effect when a certain event occurs (eg disability of the principal).

“Because no judicial proceedings are necessary once a durable power of attorney is in place, the principal saves time and money and avoids the stigma of being declared incompetent.” (Legal Dictionary, 2015a)

A power of appointment is a power conferred on a nominated person to dispose of the testator’s property. This is done by nominating and selecting one or more third parties to receive it (eg cars, household items, the right to receive dividend income). A power of appointment may only be transferred in writing such as “by deed, trust, or will” (Legal Dictionary, 2015b).

Read the following chapter in Schoeman (2014) to understand the full context of the law regarding succession (when a person dies). •

Chapter 9 in Schoeman, H. C. (Ed.). (2013). An introduction to South African banking and credit law (2nd ed). LexisNexis.

Legal Terms

1. Explain the concept of power of attorney using examples of when this might be necessary in financial planning. 2. Explain the concept of law of succession. 3. Discuss why clients are encouraged to include a will and testament as part of their overall financial planning.

2.5.4

Effective Communication

While banking, including financial planning, requires a significant amount of financial and legal expertise, it also requires appropriate: • • •

Verbal communication (interactive listening and feedback); Nonverbal communication (body language); and Written communication (electronic and hard copy aids and legally compliant documents).

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These skills, together with compliant banking practice, knowledge and expertise, engender trust. During the recent financial crisis (since 2008), trust has featured regularly in media headlines. Some argue that a paradigm shift in client trust has taken place on a global scale because of the financial crisis, namely “the crisis has brought to light the essential role of trust in banks and financial institutions” (Gritten and Shim et al in Järvinen, 2014). The interest in client trust is growing, and while trust is commonly considered a necessary element of every business transaction, this is especially relevant in banking and financial advice.

• • •

Trust is central in all long-term relationships, not least of all in the financial sector. Relationships are built on the foundation of trust. There is a strong association between consumer trust, relationships and purchase likelihood. (Järvinen, 2014)

Järvinen (2014) notes the most common characteristics connected to client trust are “honesty, reliability, fulfilment, competence, quality, credibility and benevolence [goodwill]” and it is therefore important to understand and respond to all the cognitive processes that go on in a client’s mind when he or she is deciding whether or not to trust.

“Consumer trust in banks and in banking services is based on consumer experience and is dependent on the ability of banks to behave in a reliable way, observe rules and regulations, work well and serve the general interest.” (Järvinen, 2014)

Here we include a short subsection to draw attention to verbal, non-verbal, and written communication – keep in mind the underlying objective of building trust.

Verbal and nonverbal communication Hughes and Youra (2014) argue that banking “conversations” are limited – with clients having the ability to complete more and more transactions through digital channels the opportunities to have conversations are restricted. And therefore, “when the opportunity presents itself to speak to a living, breathing person – you need to seize it”. When the opportunity to speak to a client arises, it is no longer a simple transaction; it is an opportunity to engage in a “meaningful, needs-based conversation” (ibid). Interactive listening The face-to-face channel offers significant opportunities to engage with the client, specifically the opportunity to listen and give feedback. Hearing is a passive process, whereas interactive listening requires paying attention to what is being said (the verbal and content level of the message) and the manner in which it is conveyed (the nonverbal or relational level of the message). © Regenesys Business School

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The content level refers to factual information about, for example, an investment opportunity (what it is about). The relational level determines how the participants understand their relationship (ie the level of trust). (Steinberg, 2007:75)

The relational level is influenced by several factors, including tone and register. Tone is the ability to change the meaning of words you use. This is done through changing your pitch (quality of sound), intonation (rise and fall of the voice), volume (loud or softly-spoken), and tempo (speed).

Tone (pitch, intonation, volume, and tempo) Say the following pair of sentences: • •

“That’s interesting.” (Using a monotone shows a lack of interest although the spoken words should indicate otherwise.) “That IS interesting.” (Emphasising the word “IS” shows a more genuine interest in what the client is saying.)

It is often said that 60%-80% of all interpersonal communication is nonverbal. When clients first meet bank employees, particularly those who are going to give them financial advice, they rely on signals (cues) to assess whether they can trust the advisers (eg type of handshake, strength of eye contact, pauses, attentive looks). Feedback can be verbal (acknowledging a concern that a client has) or nonverbal (a smile or a shrug). Feedback is important because it lets the client know how well his or her needs are being understood. Most importantly, the feedback you get from the client tells you how well you are meeting the client’s expectations – feedback is two-way. The cyclical process shown in Figure 4 is useful in a consultant-client conversation. Both interactive listening and feedback are important to the entire process.

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FIGURE 4: LISTENING AND FEEDBACK PROCESS

Sensing and attending

Understanding and interpreting

Responding

Recording and remembering

(Adapted from Steinberg, 2007:76-77)

Sensing and attending means actively listening to what is being said (and what is not being said), both verbally and nonverbally. Unfortunately, we are prone to selective listening – a negative consequence. For example, you might exclude what you perceive to be unimportant based on your own financial needs rather than the client’s. Understanding implies that you are able to assign the intended meaning to the content of the message and interpreting means that you able to ascertain the emotional meaning the client ascribes to the message.

Understanding and interpreting is an important stage in interactive listening because it enables you to evaluate meaning for correctness and validity and then respond appropriately to the customer. (Steinberg, 2007:77)

Recording and remembering are stages in the process that enable you to reflect (pause and think). Just as we have selective hearing, we also have selective remembering. Reflective thinking enables a more critical evaluation of the unique context in which the client seeks assistance. Recording is important – all conversations and advice given is recorded on the client file. The fourth stage is responding. This is where you provide official feedback to the client – this is where the client will evaluate the extent to which he or she has been heard. It is the stage that will reinforce whether you have completed the prior three stages effectively. © Regenesys Business School

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The listening and feedback process is both an iterative (looping back to check) and ongoing (repetitive) one, rather than a linear process.

Desk Research Communication

1. Carry out your own desk research on communication, focusing on the key concepts of: a. b. c. d.

The communication process; Perception, listening and feedback; Nonverbal communication; and Language and communication.

2. Reflect critically on the application of the above to the banking industry. 3. How does the communication process support the underlying objective of building trust? And support a long-term (loyal) relationship between bank and client?

Written communication Written communication might have many words but it also has a nonverbal dimension (eg a printed birthday card may seem less sincere than a handwritten one). With the extensive use of technology the written word also extends to aids. For the purposes of this section, we confine ourselves to: • •

Electronic aids in financial planning; and Legally compliant texts.

Electronic aids The modern trend is to encourage clients to use electronic banking options (eg electronic statements rather than hard copies and online applications) with easy-to-use tools (eg online calculators). Benefits accrue to both the bank and the client – speed, services are easily accessible (anytime and at any place) to most clients, and it reduces administrative costs, which benefit both the bank and its clients. The Electronic Communications and Transactions Act, 2002 has significantly enabled regular transactions and communications, helped to develop a national e-strategy including encouraging egovernment services, and has assisted in providing a more inclusive banking experience. A whole new industry called “m-commerce” (commercial transactions conducted electronically by mobile phone) has also been enabled.

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Electronic Aids

Identify the electronic aids used by your bank. In your opinion, how effective are these aids (ie strengths and weaknesses)?

Legally compliant text management Mullon (2006) emphasises six elements that must be considered if a company wants to ensure that its documents meet the Electronic Communications and Transactions Act (ECT Act) in terms of authenticity, reliability and originality: 1. Policies – must have well-designed and implemented policies. 2. Duty of care – how people do their jobs, how authority is delegated, and the separation of responsibilities to reduce collusion and the potential for fraud. 3. Procedures – cover all aspects of imaging from the time documents arrive at the organisation, are prepared, scanned, indexed, stored, retrieved and reproduced. 4. Enabling technology – including image enhancement, character recognition, and digital signature technology. 5. Audit trail – a full audit trail to track every transaction by all users on the system. 6. Fully documented processes – maintained in properly documented and detailed procedure manuals and maintenance schedules.

Legal Compliance

Select two examples of documents that are legally compliant. Identify examples of how a document might not be legally compliant and the resulting consequences (for the bank and the respective clients).

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2.5.5

Getting Clients to the Financial Planning Level

To conclude this section we suggest the following communication tactics to facilitate effective client engagement – getting clients to the financial planning level. FIGURE 5: COMMUNICATION TACTICS USED TO ENGAGE CLIENTS

Frame the discussion

• Display knowledge about the bank's products and services • Demonstrate an interest in improving the customer's financial well-being • Articulate the overall benefits of partnering with the bank

Basic Assistance

• Ask questions to better understand the customer's needs • Advise the customer on the best products and services • Clearly explain how specific products and services benefit the customer

Holistic focus

Financial vision

• Know your customer's overall financial goals before discussing specific products • Consider all the customer's other financial products • Discuss how various products and services fit the customer's overall lifestyle and life stage

• Envision how the customer's financial needs may change over time • Ensure that the customer can clearly see his or her financial potential • Help the customer see his or her financial needs differently

(Adapted from Hughes and Youra, 2014)

In framing the discussion, there are foundational elements of conversation that everyone in the bank, from the tellers to management, can use every time they talk with clients. Consider that a change in interest rates is nearly always seen as a negative event, but a manager could explain the benefits to the client. These conversations may be routine or more complex – the objective is to establish that the bank knows what they are talking about and that they are intent on acting in the best interests of their clients even under seemingly adverse circumstances.

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Hughes and Youra (2014) refer to basic assistance as getting to know the clients better – making the conversations about the clients and their needs. They argue that “increasing the specificity and usefulness of offers” rather than attempting to sell everything to everyone will lead to more loyal and lasting relationships with clients. When talking about a holistic focus the approach shifts toward the bank employees who specialise in certain products and services. This is where the bigger life goals including asset management take effect. This is also where the bank has an opportunity to demonstrate how products and services support lifestyles and life stages. The benefits of the products and services are related to the client in a very personal manner. At the level of financial vision, the bank employees help the clients to view their financial lives in new and different ways – they impart important knowledge that will help clients to envision how their lives will change over time, and how to leverage products and services to reach their financial potential. It is at this level that trust must be established through a genuine interest in the clients. And, as Hughes and Youra (2014) emphasise, the bank has to “earn the right to have these very indepth conversations”.

Communication Tactics

1. Identify four opportunities in your bank to use the financial planning tactics described above. 2. Reflect critically on why financial planning activities (the fourth level) are beneficial to the bank and its clients. 3. Identify a client and help him or her to complete a financial planning process (if a client is not available select one of your colleagues). Document the process and reflect critically on your ability to move the client through the levels: a. b. c. d.

Frame the opening discussion Provide basic assistance Enable a holistic focus Provide a financial vision

4. Not all clients want to engage in comprehensive financial planning with their banks (ie the fourth level – a financial vision). Discuss how the bank can, however, satisfy client needs at the other three levels.

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2.5.6

Key Points

In this final section we focused on financial plans and advice. Note the following key points: • • • • • • • •

Income tax is a tax levied on all income and profits received by a taxpayer; Taxpayers include individuals, companies, and trusts; Corporate tax includes tax paid by companies (or close corporations) on their annual income; Financial planning must consider income tax implications, for example the profits (or losses) from dividends tax; Various items of legislation govern financial planning; Banking is one of the most legislated and regulated industries; A last will and testament is a legal document that details how a client’s estate should be divided up when he or she passes away, and as such also forms a part of financial planning; While banking including financial planning requires a significant amount of financial and legal expertise, it also requires appropriate: o o o

•

Verbal communication (interactive listening and feedback); Nonverbal communication (body language); and Written communication.

The following communication tactics are important to facilitate effective client engagement: o o o o

Framing the discussion; Basic assistance; Holistic focus; and Financial vision.

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3.

REFERENCES

Allan Gray. (2015). Allan Gray Money market fund. https://www.allangray.co.za/fundpages/money-market-fund/ (Retrieved January 13, 2023). Arnold, G. (2014). Banking (financial times guides). Pearson Education Limited. ASX. (2019). Investing – How to build an investment portfolio that meets your objectives [Video clip]. https://www.youtube.com/watch?v=_G-6gb6NsyU (Retrieved January 13, 2023). Bankenverband. (2015). Financing foreign trade. https://bankenverband.de/media/publikationen/16012015_Aussenhandelsfinanzierung_eng.pdf (Retrieved January 13, 2023). Barclays. (2015). Structured products. https://wealth.barclays.com/en_gb/home/wealthmanagement/what-we-offer/investing/investment-products/structured-products.html (Retrieved January 13, 2023). BDO. (2017). Financial and taxation directory. https://www.bdo.co.za/getmedia/6d18ae88-90c540f9-8613-bfb333fa3461/201-BDO-Budget-23-Feb_web-2.aspx (Retrieved January 13, 2023). Claessens, S., Hassib, O., & van Horen, N. (2014). How foreign banks facilitate trade in tranquil and crisis times: Finance or information? http://www.imf.org/external/np/seminars/eng/2014/trade/pdf/VanHoren.pdf (Retrieved January 13, 2023). Council for Medical Schemes. (2015). Medical schemes act. https://www.medicalschemes.com/Content.aspx?130 (Retrieved January 13, 2023). Currency system. (2015). Foreign Exchange Markets and Terminology. http://currencysystem.com/kb/13-138 (Retrieved January 13, 2023). Discovery invest. (2015). Fundamentals. https://www.discovery.co.za/discovery_coza/web/linked_content/pdf s/invest/choose_your_investment/fundamentals_asset_classes_combined.pdf (Retrieved January 13, 2023). Fin24. (2016). Limited allocation by SA pension funds to private equity. http://www.fin24.com/Money/Retirement/limited-allocation-by-sa-pension-funds-to-private-equity20160419 (Retrieved January 13, 2023). Friendly finance. (2010). Cross Rate Calculation [Video clip]. https://www.youtube.com/watch?v=PeP3C_KN_v8 (Retrieved January 13, 2023). Economist. (2015a). What is quantitative easing? http://www.economist.com/blogs/economistexplains/2015/03/economist-explains-5 (Retrieved January 13, 2023).

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Economist. (2015b). Why the Swiss unpegged the franc. http://www.economist.com/blogs/economist-explains/2015/01/economist-explains-13 (Retrieved January 13, 2023). Federal Reserve. (2015). What are the differences between debt and equity markets. http://www.frbsf.org/education/publications/doctor-econ/2005/october/debt-equity-market (Retrieved January 13, 2023). Financial dictionary. (2015a). Hedge. http://financial-dictionary.thefreedictionary.com/Hedge (Retrieved January 13, 2023). Financial dictionary. (2015b). Proprietary Trading. http://financialdictionary.thefreedictionary.com/Proprietary+Trading (Retrieved January 13, 2023). Financial Services Council. (2014). Asset allocation of pension funds around the world. https://fsc.org.au/resources-category/research-report/1360-mercerresearch/file (Retrieved January 13, 2023). Goosen, W., Pampallis, A., & Van der Merwe, A. (2001). Banking in the new millennium. Juta. Hughes, J., & Youra, B. (2014). Bankers: Want more sales? Have better conversations. https://news.gallup.com/opinion/gallup/173258/bankers-sales-better-conversations.aspx (Retrieved January 13, 2023). Investopedia. (2015a). Equity market. http://www.investopedia.com/terms/e/equitymarket.asp (Retrieved January 13, 2023). Investopedia. (2015b). Security. http://www.investopedia.com/terms/s/security.asp (Retrieved January 13, 2023). Investopedia. (2015c). Structured products. http://www.investopedia.com/articles/optioninvestor/07/structured_products.asp (Retrieved January 13, 2023). Investopedia. (2019). Asset management account. https://www.investopedia.com/terms/a/assetmanagement.asp (Retrieved January 13, 2023). Investopedia. (n.d.). What is a pip and what does it represent? https://www.investopedia.com/ask/answers/06/pipexplained.asp (Retrieved January 13, 2023). International capital market association. (2013). Economic Importance of the corporate bond markets. https://www.icmagroup.org/assets/documents/Media/Brochures/2013/Corporate%20Bond%20Mar kets%20March%202013.pdf (Retrieved January 13, 2023).

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International Trade Administration. (2021). Letter of credit [Video clip]. https://www.youtube.com/watch?v=cJa1U4FmYIM (Retrieved January 13, 2023). Johannesburg Stock Exchange. (2015a). Equity market. https://www.jse.co.za/trade/equity-market (Retrieved January 13, 2023). Johannesburg stock exchange. (2015c). ‘Equity Index Futures’. https://www.jse.co.za/trade/derivative-market/equity-derivatives/index-derivatives/equityindex-futures-and-options (Retrieved January 13, 2023). JSE. (n.d.). ‘Government Bonds’. https://www.jse.co.za/trade/debt-market/bonds/governmentbonds Lamprecht, I. (2015). How pension funds could change their asset allocation. https://www.moneyweb.co.za/news/markets/pension-funds-change-asset-allocation/ (Retrieved January 13, 2023). Legal dictionary. (2015a). ‘Power of Attorney’. http://legaldictionary.thefreedictionary.com/Durable+power+of+attorney (Retrieved January 13, 2023). Legal dictionary. (2015c). ‘Probate’. http://legal-dictionary.thefreedictionary.com/Probate+Process (Retrieved January 13, 2023). Le Roux, W. (2019). Why South African retirement funds should allocate to private equity. https://www.simekaconsult.co.za/connecting/why-south-african-retirement-funds-should-allocateto-private-equity/(Retrieved January 13, 2023). Lincoln, T. (2015). Constructing your perfect share portfolio with Tim Lincoln [Video clip]. https://www.youtube.com/watch?v=2Bf_dggJD5w (Retrieved January 13, 2023). Marx, J. (Ed.). (2013). Investment management (4th ed). Van Schaik Publishers. McGlasson, M. J. (2010), (Macro) episode 33: exchange rates [Video clip]. http://www.youtube.com/watch?v=xwtgByffoUw (Retrieved January 13, 2023). Merriam-Webster. (2019). Power of appointment. https://www.merriamwebster.com/legal/power%20of%20appointment (Retrieved January 13, 2023). Milligan, B. (2014). Tax avoidance: What are the rules? http://www.bbc.com/news/business27372841 (Retrieved January 13, 2023). Mishkin, F. S., & Eakins, S. G. (2012). Financial markets and institutions, Global edition (7th ed). Moneyweek. (2011). What do investment banks actually do? [Video clip]. https://www.youtube.com/watch?v=xlYDonZLoHg (Retrieved January 13, 2023).

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Mullon, P. (2006). The six elements of legally acceptable electronic documents. Predictive Communications for Metrofile. https://www.itweb.co.za/content/Pero37ZlYrpqQb6m (Retrieved January 13, 2023). Niepmann, F., & Schmidt-Eisenlohr, T. (2014). International trade, risk and the role of banks. http://www.freit.org/WorkingPapers/Papers/TradePatterns/FREIT780.pdf (Retrieved January 13, 2023). Organization for Economic Co-operation and Development. (2021). Trade finance in the COVID era: Current and future challenges. https://www.oecd.org/coronavirus/policy-responses/tradefinance-in-the-covid-era-current-and-future-challenges-79daca94/ (Retrieved January 13, 2023). Pettinger, T. (2011). Swiss France pegged against the euro. http://www.economicshelp.org/blog/3169/economics/problems-of-swiss-economy-2/ (Retrieved January 13, 2023). PSG. (2019). Introduction to collective Investments. https://www.psg.co.za/support/tutorials/introduction-to-collective-investments (Retrieved January 13, 2023). SARS. (2015a). Do I need to pay tax? https://www.sars.gov.za/types-of-tax/personal-income-tax/ (Retrieved January 13, 2023). SARS. (2015b). Estate duty. https://www.sars.gov.za/types-of-tax/estate-duty/ (Retrieved January 13, 2023). Savings Institute. (2015). Overview of asset classes. https://savingsinstitute.co.za/resources/overview-of-asset-classes/ (Retrieved January 13, 2023). Schoeman, H. C. (Ed.). (2013). An introduction to South African banking and credit law (2nd ed). LexisNexis. Sharpe, S. A., & Zhou, X. (2020). The corporate bond market crises and the government response. https://www.federalreserve.gov/econres/notes/feds-notes/the-corporate-bond-market-crises-andthe-government-response-20201007.htm (Retrieved January 13, 2023). Steinberg, S. (2007). An introduction to communication studies. Juta and Company. Thangavelu, P. (2020). Investment banker [Video clip]. https://www.investopedia.com/articles/personal-finance/042215/what-do-investment-bankersreally-do.asp (Retrieved January 13, 2023). Wepener, C. (2014). Optimal asset allocation for retirement funds: A South African perspective. https://open.uct.ac.za/bitstream/item/8740/thesis_com_2014_com_wepener_cw.pdf?s equence=1 Whiteseide, E. (2021). How do pension funds typically invest? https://www.investopedia.com/articles/credit-loans-mortgages/090116/what-do-pension-fundstypically-invest.asp (Retrieved January 13, 2023). © Regenesys Business School

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4.

GLOSSARY OF TERMS Term

Bonds

Explanation Bonds (similar to loans) are taken out by governments, government institutions and large companies. And like loans, bonds return interest payments to the many bondholders. (Arnold, 2014)

Cross rate

An exchange rate between two currencies computed by reference to a third currency usually the USD.

Debt market

The debt market is where debt instruments are traded. “Debt instruments are assets that require a fixed payment to the holder, usually with interest. Examples of debt instruments include bonds (government or corporate) and mortgages.” (Federal Reserve, 2015)

Derivative

A derivative is a specific type of instrument that derives its value over time from the performance of an underlying asset such as equities, bonds, commodities, currencies, and market indices. (Arnold, 2014)

Equity market

The equity market is where stocks (shares) are issued (in the primary market) and traded (in the secondary market). “It is one of the most vital areas of a market economy because it gives companies access to capital and investors a slice of ownership in a company with the potential to realise gains based on its future performance.” (Investopedia, 2015a)

Forward

A forward contract is an agreement between two parties to undertake an exchange at an agreed future date at a price agreed now. (Arnold, 2014)

Futures

Futures give the investor the right to “buy (or sell) a number of shares or an entire index of shares at a fixed date in the future at a price agreed upon now.” (Arnold, 2014)

Hedging

A strategy designed to reduce investor risk using, for example call options, put options, shortselling, or futures contracts. A hedge helps to lock in profits. An example of a hedge would be if an investor owned a share and then sold a futures contract that allows him or her to sell that share at a set price on a future date regardless of what the market price of the share is on that future date. Essentially, it is used to combat uncertainty. (Financial Dictionary, 2015a)

Incoterms

Incoterms (International Commercial Terms) are three-letter terms (for example “DDP”, standing for “delivered duty paid”) provided and regulated by the International Chamber of Commerce. They embody many principles of international commercial law, and are convenient for clear communication across linguistic and cultural barriers.

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Term Letter of credit

Explanation A letter of credit is a written commitment from a buyer’s or importer’s bank (called the issuing bank) to pay a due amount into the seller’s or exporter’s bank (called the accepting bank, negotiating bank, or paying bank). A letter of credit guarantees payment of a specified sum in a specified currency, provided the seller meets precisely defined conditions and submits the prescribed documents (such as all import clearance documentation) within a fixed timeframe. Notably, the banking system does not take on any responsibility for the quality of goods, genuineness of documents, or any other provision in the contract of sale. (Business Dictionary, 2015a)

Market capitalisation

Commonly referred to as the “market cap”. It is the market value of a company’s issued share capital (ie the number of shares multiplied by the current price of those shares on the stock market).

Option

Options are exchange-traded, standardised contracts in which one party has the right (but not an obligation) to purchase something at a pre-agreed strike price at some point in the future. (Marx, 2013)

Ordinary shares

Ordinary shares are the most common type of shares on the equity market. They give the investor “full voting rights at annual general meetings, dividends (should the company pay these), and a share in the residual economic value should the company unwind (after bondholders and preference shareholders are paid).” (Johannesburg Stock Exchange, 2015b)

Preference shares

Preference shares are usually offered by companies at a fixed rate of dividend. However, if the company has insufficient profits the dividend paid may be reduced (to zero if necessary). The dividends on preference shares are paid before ordinary shareholders. (Arnold, 2014)

Primary and secondary markets

The primary market deals with the issuing of new securities by companies, governments, or public sector institutions. The money earned from the selling of new securities in the primary market goes directly to the issuing company. The secondary market deals with the securities that are already issued in the primary market – the investors who purchased the newly issued securities in the primary market sell them in the secondary market (ie to other investors).

Repo (Repurchase Agreement)

A type of short-term borrowing (loan) used in the money markets where the seller of a security agrees to buy it back at a specified price and time. The seller pays an interest rate (called the repo rate) when buying back the securities. “Central banks often use repos to boost money supply, buying Treasury bills or other government paper from commercial banks so the banks can boost their reserves, and selling the paper back at a later date. When the central bank wants to tighten money supply, it sells the paper first, and buys it back later – this is called a reverse repo, an agreement to lend securities rather than funds.” (Financial Times Lexicon, 2015)

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Term Securities

Explanation A financial instrument that represents “an ownership position in a publicly-traded corporation (stock or share), a creditor relationship with a governmental body or a corporation (bond), or rights to ownership as represented by an option.” (Investopedia, 2015b)

Trusts (South Africa)

“A trust is formed when the founder (also referred to as a donor or settlor) places cash or other assets under the administration and control of trustee(s) to or for the benefit of a beneficiary or for a specified purpose.” (SARS, 2015b) Under South African Law there are three types of trust: 1. An “ownership trust” – the founder or settlor transfers ownership of assets or property to a trustee(s) to be held for the benefit of defined or determinable beneficiaries of the trust. 2. A “bewind trust” – the founder or settlor transfers ownership of assets or property to beneficiaries of the trust, but control over the property is given to the trustee(s). 3. A “curatorship trust” under which the trustee(s) administers the trust assets for the benefit of a beneficiary that lacks the capacity to do so (eg a curator placed in charge of a person with a disability). (SARS, 2015b)

Warrant

Warrants give the holder the right to subscribe for a specified number of shares at a fixed price during or at the end of a specified time period. (Arnold, 2014)

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