VOLUME NINE
THE OVERSEAS OPERATIONS OF THE STATE BANK

 

 

CHAPTER 19
THE OVERSEAS OPERATIONS OF THE STATE BANK

 

 

TABLE OF CONTENTS

19.1 INTRODUCTION 19-5
19.1.1 GENERAL 19-5
19.1.2 SCOPE AND FORMAT OF THIS CHAPTER 19-6

19.2 DIRECTION SETTING AND PLANNING FOR OVERSEAS OPERATIONS 19-7
19.2.1 BACKGROUND 19-7
19.2.2 THE STATE BANK ACT: THE PRINCIPLES OF BENEFIT TO SOUTH AUSTRALIANS AND THE STATE'S ECONOMY 19-9
19.2.3 LONDON OFFICE: THE MOVE TO LIMITED WHOLESALE OPERATIONS 19-10
19.2.4 LONDON OFFICE: THE INTERNATIONAL BANKING STRATEGY PAPER 19-11
19.2.5 1985-1990 STRATEGIC PLAN 19-13
19.2.6 1986-1991 STRATEGIC PLAN 19-15
19.2.7 HONG KONG OFFICE 19-17
19.2.8 OCTOBER 1986 JOINT BOARD/EXECUTIVE CONFERENCE 19-18
19.2.9 1987-1992 STRATEGIC PLAN 19-20
19.2.10 NEW YORK BRANCH 19-21
19.2.11 CAYMAN ISLANDS BRANCH 19-23
19.2.12 1988-1993 STRATEGIC PLAN 19-25
19.2.13 AUCKLAND BRANCH 19-25
19.2.14 1990-1994 STRATEGIC PLAN 19-32
19.2.15 THE BANK'S PROFIT PLANS 1985-1990 19-33
19.2.16 CONSIDERATION OF DIRECTION SETTING AND PLANNING FOR OVERSEAS OPERATIONS 19-36
19.2.17 CONCLUSIONS 19-43

19.3 GROWTH AND PERFORMANCE OF OVERSEAS BRANCHES 19-44
19.3.1 OVERVIEW OF OPERATIONS OF THE LONDON BRANCH 19-44
19.3.1.1 Principal Activities 19-44
19.3.1.2 Organisation Structure and Staffing 19-45
19.3.1.3 Prudential Control and Supervision 19-46
19.3.1.4 Business Plans and Financial Performance 19-46
19.3.1.5 Asset Quality 19-48
19.3.1.6 Observations on Operations and Performance of London Branch 19-49
19.3.2 OVERVIEW OF OPERATIONS OF THE HONG KONG OFFICE 19-49
19.3.2.1 Principal Activities 19-49
19.3.2.2 Organisation Structure and Staffing 19-50
19.3.2.3 Prudential Control and Supervision 19-50
19.3.2.4 Business Plans and Financial Performance 19-50
19.3.2.5 Asset Quality 19-51
19.3.2.6 Observations on Operations and Performance of Hong Kong Office 19-51
19.3.3 OVERVIEW OF OPERATIONS OF THE NEW YORK BRANCH 19-51
19.3.3.1 Principal Activities 19-51
19.3.3.2 Organisation Structure and Staffing 19-52
19.3.3.3 Prudential Control and Supervision 19-53
19.3.3.4 Business Plans and Financial Performance 19-54
19.3.3.5 Asset Quality 19-55
19.3.3.6 Observations on Operations and Performance of New York Branch 19-56
19.3.4 OVERVIEW OF OPERATIONS OF THE AUCKLAND BRANCH 19-56
19.3.4.1 Background 19-56
19.3.4.2 Principal Activities 19-56
19.3.4.3 Organisation Structure and Staffing 19-57
19.3.4.4 Prudential Control and Supervision 19-57
19.3.4.5 Business Plans and Financial Performance 19-58
19.3.4.6 Asset Quality 19-59
19.3.4.7 Observations on Operations and Performance of Auckland Branch 19-60
19.3.5 ASSET GROWTH IN THE BANK'S OVERSEAS OPERATIONS 19-60
19.3.6 NON-PERFORMING ASSETS 19-65
19.3.7 CONCLUSION ON OPERATIONS AND PERFORMANCE OF THE OVERSEAS BRANCHES 19-65

19.4 CONTROL AND SUPERVISION OF OVERSEAS OPERATIONS BY THE BANK BOARD 19-67
19.4.1 INTRODUCTION 19-67
19.4.2 INFORMATION AVAILABLE TO THE BANK BOARD 19-68
19.4.3 DELEGATED LENDING AUTHORITIES 19-84
19.4.4 PRUDENTIAL EXPOSURE LIMITS 19-85
19.4.5 TREASURY LIMITS 19-88
19.4.6 BANK BOARD DISCUSSIONS CONCERNING OVERSEAS OPERATIONS 19-89
19.4.7 CONCLUSIONS 19-92

19.5 CONTROL AND SUPERVISION OF OVERSEAS OPERATIONS BY MANAGEMENT 19-92
19.5.1 GROUP MANAGING DIRECTOR 19-92
19.5.2 CHIEF GENERAL MANAGER, INTERNATIONAL BANKING 19-93
19.5.3 CHIEF MANAGER OF EACH BRANCH/OFFICE 19-101
19.5.4 CONCLUSIONS 19-101

19.6 INTERNAL CONTROLS AND THEIR REVIEW 19-101
19.6.1 INTERNAL POLICIES AND PROCEDURES 19-101
19.6.2 GROUP INTERNAL AUDIT 19-102
19.6.3 WHOLESALE CREDIT INSPECTION 19-104
19.6.4 EXTERNAL AUDIT 19-107

19.7 REGULATORY AUTHORITIES 19-108

19.8 SOME ISSUES RAISED BY REVIEWS OF OVERSEAS OPERATIONS 19-120
19.8.1 LONDON BRANCH 19-120
19.8.2 HONG KONG OFFICE 19-128
19.8.3 NEW YORK BRANCH 19-129
19.8.4 AUCKLAND BRANCH 19-132
19.8.5 AUGUST 1990 REVIEW OF INTERNATIONAL BANKING OPERATIONS 19-133

19.9 CONCLUSIONS ON CONTROL AND SUPERVISION OF THE OVERSEAS BRANCHES 19-134

19.10 GENERAL SUBMISSIONS OF THE NON-EXECUTIVE DIRECTORS 19-137

19.11 CONCLUSIONS ON THE BANK'S OVERSEAS OPERATIONS 19-138

19.12 REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT 19-142
19.12.1 TERMS OF APPOINTMENT A 19-142
19.12.2 TERM OF APPOINTMENT C 19-142
19.12.3 TERM OF APPOINTMENT D 19-143

 

 

19.1 INTRODUCTION

 

19.1.1 GENERAL

This Chapter of the Report examines the overseas operations of the Bank, and the growth and development of these operations over the period from July 1984 to February 1991.

This Chapter also specifically examines:

(a) the "Charter" of the Bank in accordance with Section 15 of the State Bank of South Australia Act, 1983 as that "Charter" applied to the Bank's establishment of overseas branches;

(b) the relationship between the overseas branches and Head Office;

(c) the supervision and control of those branches by the Bank Board and management; and

(d) the financial performance of the overseas branches, including the levels of non-performing assets held by the overseas branches as at the end of the period under review.

The State Bank of South Australia's involvement in overseas markets dates from the time of the merger of the predecessor Banks in July 1984 when, as part of the merger, it took control of a minor retail banking() operation previously run by the Savings Bank of South Australia in London. In October 1985, the London branch closed its retail banking activities, and started wholesale banking() operations, refocussing primarily on treasury operations and corporate banking.

In 1987, the Bank developed overseas offices in Hong Kong, and, in 1988, in New York. In December 1988, the Bank acquired Security Pacific Bank New Zealand. This bank was renamed SBSA (NZ) Limited ("SBSA (NZ)") and formed the basis for the Auckland branch of the Bank's operations.

Representative offices were subsequently opened in Chicago and Los Angeles (United States) and in Christchurch and Wellington (New Zealand). By the end of the period under review, the Bank also maintained an off-shore "asset booking point" in the Cayman Islands for the New York operation and in Nassau to augment the Auckland operation.()

The preliminary investigation phase indicated that one of the primary causes of the Bank's financial position and associated losses arose from its lending activities both within Australia and Overseas. Overseas assets grew from $222.6M at 31 December 1985() to $5,270.0M as at February 1991(), by which time overseas assets represented 23.5 per cent of the Bank Group's total assets ($22,387.5M)() and 27.4 per cent of the Bank's Australian retail and wholesale assets ($19,209.1M).() Overseas operations gave rise to a significant proportion of the Bank's non-performing loans, especially London and Auckland branches. Accordingly, investigation of matters relating to the Bank's overseas operations is founded on Term of Appointment A. In addition, Terms of Appointment C and D have relevance in relation to matters reported in this Chapter.

In analysing the Bank's overseas operations, it is necessary to consider the statutory framework within which these activities took place and Sections 15 and 19 of the State Bank of South Australia Act, 1983 ("the Act") are relevant in this context. I am satisfied that the Act permitted the Bank to operate overseas but subject to these activities satisfying the principles set out in Section 15 of the Act.

19.1.2 SCOPE AND FORMAT OF THIS CHAPTER

The examination of the overseas operations of the Bank covered:

(a) London branch;

(b) Hong Kong office;

(c) New York branch; and

(d) Auckland branch.

These branches/offices represent the off-shore locations where significant operations of the Bank took place. There are other off-shore entities, namely, companies in the United States and Hong Kong, but these were established principally for local regulatory purposes and their activities have been treated as part of the main office operations in those particular locations. Certain aspects of the New Zealand operations, other than those arising in the Auckland branch, are examined in other Chapters of this Report.

Whilst Hong Kong office did not achieve "branch" status during the period under review, where this Chapter refers to a "branch" or "branches" the reference is to be taken to include Hong Kong office unless the context indicates otherwise.

The information in this Chapter is presented in the following segments:

(a) Direction Setting and Planning for Overseas Operations;

(b) Operations and Performance of Overseas branches;

(c) Supervision and Control of Overseas Operations; and

(d) Conclusions.

In this Chapter any reference to the Bank Board is, unless the contrary appears or is otherwise inconsistent with the context in which it appears, to be construed as a reference to the Bank Board as constituted at the time of particular acts or omissions as reported in the Chapter. Furthermore, any reference to "the Non-Executive Directors" is a reference to the following former Non-Executive Directors of the Bank: Mr R D E Bakewell, Mrs M V Byrne, Mr R E Hartley, Mr R P Searcy, Mr K Smith, Mr L Barrett, Mr K J Hancock, Mr W F Nankivell, Mr A R Prowse, Mr D W Simmons and Mr A G Summers.()

 

19.2 DIRECTION SETTING AND PLANNING FOR OVERSEAS OPERATIONS

 

19.2.1 BACKGROUND

As mentioned in the Introduction of this Chapter, when the Savings Bank of South Australia merged with the State Bank of South Australia in July 1984, the new State Bank assumed control of a minor retail banking operation in London, previously conducted by the Savings Bank of South Australia. This office continued to operate as a retail banking office until October 1985, when London branch commenced full wholesale banking operations, and discontinued its prior retail banking operations. From this point on, the Bank's overseas assets grew rapidly until, by February 1991, they reached $5,270.0M which, as noted above, was 23.5 per cent of the Bank Group's total assets and 27.4 per cent of the Bank's Australian (ie on-shore) retail and wholesale assets. The branches and representative offices established during the period July 1984 to February 1991 are as stated in Section 19.1.1 above.

Whilst the Bank's strategic direction overseas was decided by the Board on a "branch by branch" basis, it was also considered within the general framework of a January 1985 Board Paper entitled "International Banking Strategy" and the Bank's Strategic Plans and Profit Plans. "Strategic Plans" were prepared annually and covered five year periods. The Strategic Plans were presented to the Bank Board for approval around March of each year. Whilst these plans dealt with the Bank's overseas operations, financial detail in relation to overseas operations was generally limited to projections of total assets for off-shore operations, and there was little detailed financial and strategic analysis by individual location.

The following table indicates the Strategic Plans() that were prepared, the years covered by these Plans, and when the Strategic Plans were considered by the Bank Board:


Plan
Years

Bank
Board
Meeting

1985 - 1990

28 March 1985

1986 - 1991

27 March 1986

1987 - 1992

23 April 1987

1988 - 1993

24 March 1988

1990 - 1994

10 May 1989

"Profit Plans" were prepared annually and covered one year periods. The Profit Plans were presented to the Bank Board for approval around June - July of each year. Whilst these Plans also dealt with the Bank's overseas operations, in general, financial detail regarding overseas operations was limited to projections of total assets and, again, there was little analysis by individual location. Each of the Bank Board's decisions to open overseas branches, as well as the Bank's Strategic Plans and Profit Plans as they relate to overseas operations, are considered below.

Strategic issues relating to the Bank's overseas operations were also considered at a joint Board/Executive Conference held on 17 and 18 October 1986. The strategic implications for the Bank's overseas operations arising from this conference are considered in Section 19.2.8 below.

19.2.2 THE STATE BANK ACT: THE PRINCIPLES OF BENEFIT TO SOUTH AUSTRALIANS AND THE STATE'S ECONOMY

The Act gives the Bank power to carry on its business "within or outside the State" of South Australia.() The Bank also has power to "establish branches and agencies within and outside the State."()

These powers reside in the Bank Board as the "governing body" of the Bank() however, the Act imposes a number of requirements for the Bank Board to observe in exercising its powers. In particular, the Bank Board is required:

"... [in] its administration of the Bank's affairs ... [to] act with a view to promoting -

(a) the balanced development of the State's economy; and

(b) the maximum advantage to the people of the State,

and shall pay due regard to the importance both to the State's economy and to the people of the State of the availability of housing loans." ()

It was, therefore, incumbent on the Bank Board in considering the establishment of overseas branch operations to have regard to the requirements of this Section. Accordingly, in considering any proposal to establish an overseas branch operation, the Bank Board was required to consider the principles of the balanced development of the South Australian economy; the maximum advantage to the people of South Australia; and the importance to both the State's economy and to the people of South Australia of the availability of housing loans.

The Act also imposes a separate but reciprocal obligation on the Bank Board to "administer the Bank's affairs in accordance with accepted principles of financial management and with a view to achieving a profit." ()

In my opinion, the notions of benefit to the people of South Australia and the South Australian economy on the one hand, and the achievement of profit on the other are not necessarily mutually exclusive. In my view the Act imposes, in effect, a combined obligation that whatever the Board approves in the exercise of its powers and authorities in achieving the principles of benefit to the people of South Australia and the South Australian economy, must also be with a view to achieving a profit. I observe that the Board must act with a view to promoting both the balanced development of the State's economy and the maximum advantage to the people of the State. I am of the opinion that, for example, in the case of the Bank's overseas operations, the simple fact of the generation of a profit overseas is not of itself sufficient to satisfy the provisions of Section 15.

As will appear in the following Sections of this Chapter, a number of reasons for establishing overseas branches were advanced by management in Bank Board Papers, Strategic Plans and Profit Plans. Accordingly, the following Sections of this Chapter consider the strategic reasoning behind each decision to open an overseas branch or representative office, within the context of Section 15 of the Act and of the annual Strategic Plan and Profit Plan process. The general topic of Direction-Setting and Planning for the Bank is considered in detail in Chapter 4 - "Direction-Setting and Planning". This Chapter will focus on overseas operations but the issues reported on in Chapter 4 - "Direction-Setting and Planning" concerning the Strategic Planning process as such, should be borne in mind in considering these matters.

19.2.3 LONDON OFFICE: THE MOVE TO LIMITED WHOLESALE OPERATIONS

The Bank Board first considered the future of the London office at a meeting held on 27 September 1984. This was in response to a paper prepared by Mr D E Hosking (Chief Manager, International Banking).() This paper drew the Board's attention to the losses being incurred by the London office's retail operations() and stated that consideration was being given to the "development of a wholesale operation under the direction and control of Corporate and International Banking Division".

The Board Paper also recorded that an investigation was being made into an off-shore banking association of State banks and that the London office should:

(a) introduce a new accounting facility; and

(b) engage in limited wholesale banking activities.

The rationale for this move was put in this way:

"Upon introduction of the new accounting facility, it will be possible to raise foreign currency borrowings at competitive interest rates through Adelaide and book them in London, without incurring Australian withholding tax. This will place us in a fully competitive position to quote on foreign currency borrowings for domestic corporates and provides the opportunity to purchase assets and participate in risk proposals that can be placed directly on the books of London Office to produce fee income."

The Board, inter alia, resolved:

"Management be authorised to write asset/risk business on the books of London Office up to £E20M in the following categories -

(1) A class companies, subject to approval for each application.

(2) A and B class country risks of either a sovereign or statutory entity, to a total limit of £E20M under existing Credit Line approvals.

London Office assets be funded on a back-to-back basis." ()

19.2.4 LONDON OFFICE: THE INTERNATIONAL BANKING STRATEGY PAPER

The Bank Board first considered a comprehensive report on the strategic objectives of the Bank's international banking directions on 24 January 1985, when it had before it a paper entitled "International Banking Strategy" prepared by Mr Hosking (Chief Manager, International Banking) and Mr S G Paddison (Manager, Strategic Planning).() This paper had been "endorsed" by the Executive Committee on 18 January 1985.()

The International Banking Strategy Paper noted that a "coherent International operation based on the combined State Bank's initiative" () was "unlikely" and that it was "necessary for the Bank to establish strategic directions for the development of its international banking facilities". The principal strategic reason in favour of the paper's recommendations was stated as:

"The key to the provision of competitive service is the development of international representation giving us the ability to book transactions on an overseas branch".

The paper went on to observe:

"The International Banking Division while existing primarily to service the Bank's corporate customers must remain a cost effective operation ... Even with extensive marketing activity to accelerate the demand of South Australian corporates for our services, we could not reach activity levels that would make the projected offshore operations profitable on domestic business alone."

There is no indication in the paper that any assessment of demand had in fact been made and this conclusion is reinforced by the paper's own statement of a "strategic objective" being:

"To clarify the exact nature of existing South Australian corporate demand for international banking services ... this survey should include our existing S.A. corporate base as well as all subsidiary operations."

The Investigation was unable to find any evidence of such a "survey" being conducted.() Mr Barrett gave evidence to the Investigation that he had been told "that a survey had been made" although he could not recall who told him this.()

Mr Barrett also gave evidence that there was active discussion in the boardroom in relation to the International Banking Strategy paper to determine what benefits to South Australia there might be from establishing a wholesale banking operation in London. In relation to the rationale that the Bank would be servicing the needs of South Australian customers, Mr Barrett gave the following evidence:

"Question: ... Was there any probing by the Board as to the number, the identity of these particular customers that management was putting forward were requiring to be serviced?

Mr Barrett: No, not in - not in detail. I think a few names have been mentioned from time to time but I think - I think it is a difficult situation. Which comes first -having the operation or having the customers to service? ...

Question: So you saw this was an opportunity to attract further customers to the Bank?

Mr Barrett: Yes, that's right. Without the branch you could - you - you couldn't get the customer.

...

Mr Barrett: ... I think there was an expectation we would be able to attract customers once we established the operation."()

The paper went on to consider possible points of representation for branches or representative offices as London, New York, Hong Kong, Singapore and Tokyo. However, development of London was seen as the priority and the upgrading of London office to a wholesale banking operation was recommended.

The paper stated that it was "proposed" that other overseas representation be established "as soon as practicable after our wholesale unit in London is trading" and that "initial attention must focus on locations where most of our customers trade is conducted and where we can readily access financial markets." It was recommended that investigation into the "establishment of low cost representative offices in Hong Kong and New York commence within six months with the aim of opening in most countries in 12 and 18 months respectively of London becoming operational".

The paper contained as a "secondary recommendation" that:

"A small scale market research study be conducted to identify demand from South Australian corporations for international finance services and that this study provide the basis for a subsequent low key advertising campaign aimed at increasing market awareness of the Bank's services in this area."

The Bank Board resolved:

"To develop the International Division by giving priority to establishing a major offshore office in London capable of conducting a full range of wholesale banking activities and, subject to State Government approval and the concurrence of the Bank of England, the steps and timetable as set out in the paper be taken to relocate and upgrade the existing London office operation." ()

19.2.5 1985-1990 STRATEGIC PLAN

The 1985-1990 Strategic Plan was considered by the Bank Board on 28 March 1985(), some two months after the approval of the establishment of full wholesale banking operations in London office pursuant to the International Banking Strategy paper. This Plan reaffirmed the Bank's intention to develop substantial off-shore representation. Total assets in the London office were projected to grow from $38.0M as at June 1985 to $848.0M in June 1990, at which time, London would represent almost 10 per cent of the total assets of the Group ($8,640.0M).

The main rationale for the overseas strategy was that there were significant opportunities off-shore to build up business:

"A major part of the growth of International Division will be based around the development of our offshore representation, starting with London followed by New York and Hong Kong ... There is every reason to believe that business opportunities for Corporate can be dramatically expanded once we have substantial London representation. This business development will probably be focused around existing Corporate clients but will also be supported by a continuing emphasis on correspondent banking business."() [Emphasis Added]

The Plan also emphasised the need to ensure the profitability of the business to be written. One of the key objectives identified was to:

"... acquire all business available from ... overseas opportunities that:

- meet margin requirements;

- are within prudential, customer and industry limits; and

- do not expose the Bank to risk of political controversy." ()

While Section 15 is not specifically referred to in the Strategic Plan, the "Mission Statement" included the following matters directly relevant to Section 15:

"To promote the balanced development of the State's economy acting to the maximum advantage to the people of the State by:-

. maintaining our position as South Australia's leading financial services organisation;

. providing market leadership in retail and corporate banking services;

. providing finance to any credit worthy individual, business or community organisation.

To pay due regard to the importance both to the State's economy and to the people of the State of the availability of housing loans consistent with prudent banking practice.

...

To operate the Bank's affairs in accordance with:

. accepted principles of financial management;

. achieving a level of profit growth that would be adequate to ensure the ongoing progress of the Bank."

The Plan does not indicate how the recommendations relating to overseas expansion would achieve the principles enunciated in Section 15. It is implicit, however, that profits from overseas operations would assist in "[ensuring] the ongoing progress of the Bank".

The Bank Board resolved that the "objectives and aims contained in the 1985 Strategy Plan be approved in principle".

19.2.6 1986-1991 STRATEGIC PLAN

The 1986-1991 Strategic Plan was presented to the Bank Board on 27 March 1986.()

In this Strategic Plan, international expansion was a core strategic focus. The rationale was extended from that indicated in the 1985-1990 Strategic Plan and included:

(a) restricted growth opportunities in the domestic market, particularly in South Australia;

(b) increased competition in Australian financial markets following the entry of foreign banks; and

(c) the benefits of risk diversification.

The strategic thinking concerning overseas operations is encapsulated in the following extract:

"The business of the Bank may be carried out within or outside the State. However, until recently it had been limited almost exclusively to the State's boundaries.

As a result of growing competition, the acquisition of subsidiaries, and the emergence of new opportunities both interstate and overseas, the Bank will seek to win more business outside South Australia. Selective geographic expansion is a vital component of the Group's strategy." [Emphasis Added]

The Strategic Plan indicated that the Group's position in 1991 would include representation in London, Asia / Pacific, United States of America and New Zealand.

The Strategic Plan also contained five year balance sheet targets which projected total London assets as at June 1991 as $853.0M and total other overseas assets as $1,179.0M. This combined total of $2,032.0M represented some 16 per cent of total projected Group assets of $12,988.0M.

As a point of comparison with the 1985-1990 Strategic Plan, this Strategic Plan projected a lower rate of growth for the London branch with total assets as at June 1990 for London of $735.0M (previously projected $848.0M). Other overseas branch's total assets were projected to grow substantially to $983.0M, totalling $1,719.0M for all overseas branches. This represented 20 per cent of projected total Group assets as at June 1990 of $8,640.0M.

This substantial increase in overseas assets is consistent with the plan's strong emphasis on business growth. The Strategic Plan asserts that:

"The Bank will need to grow in order to:

. Meet the expectations of the shareholders, the Bank's Board of Directors and Management, and the community,

. Remain competitive in terms of resources, size, product and service range,

. Generate a growing stream of profits to satisfy both the internal and external needs of the organisation." ()

The Plan noted that the Bank's traditional areas in South Australia and the Northern Territory would be restricted in future due to, amongst other things, the limited potential and limited growth of the South Australian economy and population, the Bank's current high market share and the narrowing interest rate margin environment. The Strategic Plan then propounds a rationale for overseas expansion in the context of the principles set out in Section 15 of the Act, in the following manner:

"The Bank does not encounter a similar set of restrictions in the Corporate/International area, where it has, in fact, greater growth opportunities.

This strategy is based largely on strong Corporate/International business growth and growth in Treasury operations gradually throughout Australia and offshore. The objective is to achieve total assets of around $11 bn by June 1991. The proportion of wholesale assets will increase significantly. The strategy will enable the State economy and the people of South Australia to receive increased benefits as a result of the Bank's move outside S.A (Emphasis Added)." ()

The Bank Board Minutes relating to the 1986-1991 Strategic Plan state: "The 1986-1991 Strategic Plan ... [was] discussed at length." () There is no specific mention of any matters relating to the overseas branches/offices. The Bank Board "endorsed" the Plan.

The Statement of the Bank's "Mission" in this Strategic Plan was generally the same as that set out in the 1985-1990 Strategic Plan() but was altered in relation to profitability to read as follows:

"To operate the Bank's affairs in accordance with:-

...

- Achieving a growing level of profitability to ensure the ongoing competitiveness of the Bank." ()

19.2.7 HONG KONG OFFICE

The Bank Board approved the opening of the Bank's representative office in Hong Kong on 26 June 1986.()

The Bank Board Paper() proposing the establishment of the Hong Kong office noted that, prior to its preparation, a review of the International Banking Strategy had been undertaken "to ensure that the Bank's best interests as a whole are served by further development offshore".() The paper examines the Bank's London operations in the following terms:

"In London the activities of the Bank's branch come within the supervisory powers of the Bank of England. In exercising its powers the Bank of England lays down certain guidelines relating to the nature and location of risk pertaining to assets that the Branch takes onto its books.

These guidelines are established by the Bank of England without any reference to or consideration of the nature and location of the Bank's assets as a whole.

Consequently in order to comply with the requirements of the Bank of England a situation has been reached where the Bank is being forced to be prejudiced in selecting assets that London branch can hold and is being forced to forego opportunities that would otherwise be attractive. Exposure to individual entities is limited to 2% of London office's Balance Sheet and, in addition, the Bank of England applies stringent controls upon the Bank's operations there ...

The Bank of England is inflexible.

An alternative `booking centre' is thus required which will be free of the constraints currently inhibiting the growth of the Bank. This can be overcome by having a presence in Hong Kong ..."

The rationale put forward in the paper, however, went beyond merely overcoming the Bank's problems in achieving the growth objectives contained in the 1986-1991 Strategic Plan. This paper's rationale also incorporated a particular focus on Australia's position in the South-East Asian region, as indicated in the following extract:

". ... the Bank can immediately have an alternative to booking assets through London Branch. There are no similar restrictions regarding country limits as are advised to London by the Bank of England whilst other limits can be overcome by arrangement with the Commissioner of Banking.

. the Hong Kong office must stand ready to offer its corporate customers assistance and support with trade information and introductions especially regarding China and for the region generally ... thus fulfilling the Bank's obligations to at least one sector of the South Australian economy, as well as to the Bank's shareholder ...

. valuable Capital Markets intelligence can be gained by keeping in close contact with major participants in the Hong Kong market. More offers of participations will be received and the Bank's name will become better known within this market.

. corporate lending opportunities should be produced from close liaison with other Australian and New Zealand banks in Hong Kong ...

. Retail Banking can benefit from the involvement of the Hong Kong Office in the Government's Business Migration Programme".

The paper also included a five year financial projection for the office which showed that it would be profitable for the year ending June 1988 onwards. In addition, total assets for the Hong Kong office would grow from $215.0M as at June 1987 to $444.0M as at June 1991.

19.2.8 OCTOBER 1986 JOINT BOARD/EXECUTIVE CONFERENCE

A joint Board/Executive Conference was held on 17 and 18 October 1986. Directors in attendance at this meeting were Mr Barrett, Mr Hancock, Mr Bakewell, Mr Nankivell, Mr Searcy, Mr D W Simmons, Mr Smith, and Mr T M Clark. Fourteen executives and a number of other Bank officers were also present.

Tabled at this conference was a paper entitled "State Bank Long Term Development Options". In relation to corporate and international operations of the Bank, this paper notes that off-shore expansion:

"... represents an area of dynamic growth, but is subject to possible Offshore Banking Unit legislation. The Bank could easily increase its assets offshore to its limit of 20 per cent of the balance sheet (excluding New Zealand), by which time a review of the exposure limit may be necessary. Expansion will be through London Office and representation points in Asia, New Zealand and USA. Opportunities for corporate business in New Zealand are extensive."

Of particular relevance to overseas operations was a paper entitled "International Banking - Its Role in the Future". This paper described the general thrust of the Bank's international banking development as having two main objectives:

"1. International Finance: support Bank objectives for offshore growth within spread of risk and target profitability parameters.

2. Trade Finance: provide a full service trade finance facility to profitably support South Australian trade requirements."

The paper identified as one of Management's priorities, the management of off-shore exposure and stated:

"The Bank must also continue development of our ability to assess International Bank/Corporate risk exposure".

The paper went on to note, in relation to asset growth, that the Bank should:

"... continue to minimise risk by obtaining a wide spread of assets in a range of different countries, banks and industries. All asset development should be confined within conservative risk parameters with concentration on sovereign, bank and AAA-AA corporate risk. Higher yielding direct corporate assets should be acquired selectively to improve return on assets (emphasis added)."

As to off-shore points of representation, there was to be concentration on London, Hong Kong (representative office to be established in November 1986), New Zealand and New York, with other representation being established given that "the Bank has a requirement for a booking point to hold offshore assets on a tax effective basis".

The paper, which was presented by Mr T L Mallett (Chief Manager, International Banking), concluded by pointing to a number of significant benefits:

"Profitable growth opportunities for the Bank ... diversification of political and economic risk across the international economy ... enhance our ability to fully serve South Australian trade requirements ... development of technical expertise will be encouraged by Bank exposure to international financial markets. This expertise will enable the Bank to compete more effectively in the Australian financial market (emphasis added)."

19.2.9 1987-1992 STRATEGIC PLAN

The 1987-1992 Strategic Plan was considered by the Bank Board at a meeting held on 23 April 1987.()

In this Strategic Plan, the focus was again placed on growth in overseas operations. Attention was also given to profitability:

"Offshore representation will be a major element of the Bank's growth strategy to 1992, with the primary criterion for establishment being profit generation. In addition to being sources of profit, offshore offices will contribute to the Bank's wholesale funding, trade finance and corporate lending activities (emphasis added)." ()

In considering the State Bank Group's future position, the Strategic Plan noted that corporate/wholesale assets in the corporate and international areas would "by far exceed retail banking assets by 1992". Representation was noted as London, Hong Kong, New Zealand, United States of America and "possibly Tokyo".()

The rationale for the strategy was stated as:

"This will allow [the Bank] to further service the needs of larger corporate clients, to spread risk and to gain access to offshore capital markets and funding sources."

The five year summary balance sheet included in this Strategic Plan projected total overseas offices assets as at June 1992 as $2,250.0M out of a total group asset base of $13,887.0M.

In comparison to the 1986-1991 Strategic Plan, this Strategic Plan projected a higher rate of growth for overseas offices with total assets as at June 1990 of $1,862.0M (previously projected $1,718.0M). This represented 16 per cent of projected total Group assets ($11,421.0M).

The Bank Board resolved to "approve" the Strategic Plan.()

In this Strategic Plan, the Bank's "Mission Statement" underwent yet another modification, but, on this occasion, in the context of the Bank's overseas operations, the amendment was significant. The Strategic Plan stated that the Bank's "Mission" to promote the balanced development of the State's economy and acting to the maximum advantage to the people of this State, would be achieved, in addition to the means stated in the previous Strategic Plans, by:

"... increasing operations in selected markets outside South Australia, and achieving a growing level of profits from these sources."

In addition, according to the Strategic Plan, the Bank's affairs would be operated not only to achieve a growing level of profitability to ensure the ongoing competitiveness of the Bank but also "to satisfy shareholder demands for a reasonable return on their investment".

19.2.10 NEW YORK BRANCH

(a) The First Bank Board Paper: November 1987

On 26 November 1987 a paper was presented to the Bank Board() proposing the establishment of a New York branch in line with the International Banking Strategy presented in January 1985.() The benefits to the bank were noted in the Bank Board Minutes as including:

". A New York presence offering direct access to the world's largest lending market and enhanced opportunities to achieve growth goals for corporate lending.

. [the office would] support the Bank's own foreign exchange activities and provision of basic customer service by establishing a global foreign exchange network.

. Facilitation of an increasing number of opportunities available to the Bank to support the U.S. activities of South Australian and Australian corporates.

. Complete a natural international network.

. Improved access to sources of US dollar wholesale funds to support the funding of US dollar denominated assets.

. Provision of a contact and referral point for U.S. investment in South Australia as well as serving customer investment requirements in the U.S."

The Board resolved to "establish a State licensed office in New York with the prime object of engaging in corporate lending and customer driven foreign exchange business". The Board also resolved to "establish a managed branch in the Cayman Islands to be used as an offshore asset booking point." () As with all of its overseas operations, the Bank funded its overseas operations by borrowings off-shore. Neither the Board Paper nor the Board Minutes examine this strategic move in light of Section 15(1) of the Act, however, the Report identifies some indirect financial benefits (eg potential to reduce international wholesale cost of funds). The paper recommending establishment of the New York branch, as presented to the Bank Board, did not include any reference to a significant number of matters addressed in the body of and in attachments to the corresponding Executive Committee paper. In particular, paragraph 3.2 of the Executive Committee paper noted:

"The principal strategic objective referred to in this paper involves credit risk diversification in U.S. markets and by its nature the New York wholesale corporate market requires loan participations that are medium sized (USD10-25M) ... the asset growth necessary to ensure successful achievement of strategic objectives in the establishment of a New York operation is significant."

Furthermore, Attachment B to the Executive Committee paper comprised the `New York Agency Business Strategy' which included the following:

"To achieve the returns necessary to justify activity in this market, the Bank must be prepared to consider innovative and complex transactions. Participation in complex structured finance transactions is central to the profitability of most successful small foreign banks in the U.S."

In evidence to the Investigation, Mr Mallett, who presented both Executive Committee and Board Papers, was unable to recall why the various deletions from the Executive Committee paper were made in the corresponding Bank Board Paper.() In my opinion, these were material matters that should have been communicated to the Board for its consideration regarding the opening of the New York office.

(b) The Second Bank Board Paper: June 1988

On 23 June 1988, the Bank Board considered a further paper relating to the establishment of a State licensed agency in New York.() This paper pointed out that Mr R Sewell had been appointed Executive Vice President - United States of America in March 1988, that suitable office premises had been located and that all documentation necessary to lodge an application for a State licensed agency had been prepared. The paper indicated that, in order to meet the target opening date of November 1988, it was necessary to lodge this application in early July 1988.

This paper annexed a five year financial projection for the New York branch which showed a rapid growth in assets for this office rising to $1,500.0M by the end of the fifth year of operation. In fact, New York branch's assets reached $1,750.0M by June 1990.

The financial projection for New York branch showed a net loss after tax of $0.726M as at the end of year one, but a cumulative profit after tax as at the end of year two of $1.9M, rising to a cumulative profit after tax as at the end of year five of $20.0M. The branch's actual outcome was a cumulative profit for the period November 1988 to February 1991 of $4.9M.()

The recommendations contained in this paper were approved and application in due course successfully made for the grant of a State licensed agency in New York.

19.2.11 CAYMAN ISLANDS BRANCH

At the same time as the Bank Board approved the establishment of a State licensed office in New York (namely, 26 November 1987), the Bank Board also approved the establishment of a managed branch in the Cayman Islands to be used as an "offshore booking point".

The Cayman Islands is made up of a group of three islands in the Caribbean with the capital Georgetown situated on Grand Cayman, the largest of the islands. The Cayman Islands are a British dependent territory and enjoy a substantial measure of self government. In the banking sphere, the Cayman Islands are one of the most popular off-shore financial centres with in excess of 500 banks and trust companies registered there.

The attractiveness to banks of the facilities available on Cayman Islands include:

(a) relative freedom from controls on international banking and trust activity;

(b) absence of exchange controls;

(c) absence of stringent regulation of liquidity ratios and capital requirements;

(d) profits may be retained off-shore and repatriated at will with the possible advantage of legally reducing or postponing payment of taxes in the home country of the parent; and

(e) interest can be paid without deduction of tax at source.()

The November 1987 paper noted the following as the:

"... principal benefits of an offshore booking office ...

. the lowered cost of funds resulting from the absence of reserve requirements

. the ability to hold assets that have selling restrictions in the U.K. and Australia

. the absence of taxation. ..."

In a paper presented to the Bank Board on 24 March 1988(), management sought the Board's confirmation of their approval of the establishment of a managed branch in the Cayman Islands. This paper, consistent with the November 1987 paper proposing the establishment of the New York branch, stated that the Bank intended to establish a Cayman Island office:

"... to fulfil the following requirements:

. a holding point for assets that have selling restrictions in the UK and Australia

. the absence of taxation, to maximise return in South Australia

. the absence of reserve and capital requirements. ..."

In Section 19.2.16 below, I consider evidence obtained from the Directors of the Bank as to the inference that might be drawn from the Board Papers that the Cayman Islands branch was being established to avoid prudential requirements in relation to the Bank's operations.

The March 1988 paper included the following statement:

"... South Australian Treasury has given their consent. The Reserve Bank of Australia is aware of our intentions ..."

In my opinion, this statement did not convey fully the importance of the communications between the Bank and the Reserve Bank. This issue is further dealt with in Chapter 15 - "The Relationship with the Reserve Bank of Australia" of this Report.

19.2.12 1988-1993 STRATEGIC PLAN

The 1988-1993 Strategic Plan was considered by the Bank Board on 24 March 1988.() In this Strategic Plan, the international emphasis was less marked than in former Plans. The Bank planned to have an active presence in Melbourne, Sydney, Perth, Wellington and New York as well as in London; and to establish regional lending offices in Manchester, Bristol and Southampton (United Kingdom). The Cayman Islands branch was to be "heavily used as a booking centre".() The Bank Board resolved to "approve" the Strategic Plan.

The statement of the Bank's "Mission" underwent a significant recasting in this Strategic Plan with the statement reverting to a virtual restatement of the plain words of Section 15(1) and (2) without the embellishments which had appeared in earlier strategic plans.

19.2.13 AUCKLAND BRANCH

(a) The April 1988 "Concept Paper"

The Bank effectively had been expanding into New Zealand from 1984 by means of loans or facilities in favour of New Zealand companies. These loans were managed out of Adelaide office, and, by 1988, the Bank had exposure of some $400.0M in New Zealand. Mr Mallett, stated that the principal reason initially for establishment of the Auckland branch was that "we should have people on the ground to manage that exposure."()

On 6 May 1988,() the Executive Committee considered a "Concept Paper" in relation to a recommendation put forward by Mr Mallett that the Bank establish a branch in New Zealand. This Concept Paper dealt with a broad range of issues including: strategic objectives; "environment" (economy, market, competition, threats and opportunities); forms of representation; and structure.

The following extracts from the Concept Paper are indicative of the tenor of the paper in relation to the New Zealand economy:

"The Lange Labour Government's policies towards restructuring the New Zealand economy ... are expected to result in a more competitive and flexible economy and business sector by the early 1990s. In the interim, however, the continuation of high interest rates relatively high inflation and an overvalued $NZ are likely to keep overall economic activity flat.

The international debt is high in relation to Gross Domestic Product and Exports but some stabilisation is expected as a consequence of public asset sales. The public sector deficit is being wound back but remains high relative to Gross Domestic Product, as does the public sector debt.

The evident confusion and disagreement within the Government surrounding the tax and other changes announced in December [1987] has been criticised by business and caused a further fall in confidence already adversely affected by the deteriorating state of the economy.

In 1988 and 1989 economic growth is expected by the Reserve Bank of New Zealand to be slow or negative."

On 15 July 1988, a paper entitled `Establishment of New Zealand Office' was presented to the Executive Committee for consideration for recommendation to the Bank Board.() This paper not only sought to establish the Auckland branch, but also recommended increasing the New Zealand country exposure limit to a total of $1,500.0M. This paper contained none of the economic information included in the May 1988 "Concept Paper".

(b) The First Bank Board Paper: July 1988

A paper entitled `Establishment of New Zealand Office', dated 20 July 1988, was presented to the Bank Board by Mr Mallett on 28 July 1988.() This paper sought the establishment of the Auckland branch with the "prime object of engaging in direct corporate and commercial lending, money market and foreign exchange business." This paper followed the lines of the July 1988 Executive Committee paper in that it contained none of the economic information included in the May 1988 "Concept Paper". The Executive Committee paper stipulated that corporate lending in New Zealand would continue to be the responsibility of head office. The Bank Board Paper, however, altered this arrangement and proposed that the Auckland branch assume full responsibility for New Zealand corporate lending as was the practice with London and New York branches. In due course, head office's existing portfolio of New Zealand assets was transferred to Auckland branch. This portfolio included a number of non-performing loans. This issue is dealt with in Sections 19.3.4.5 and 19.3.4.6 below.

In relation to the strategic rationale for the proposal, the Bank Board Paper observed:

"... principle (sic) objectives of the establishment of a New Zealand branch are consistent with the International Banking Strategy, viz:

. improve the Bank's diversification of both geographic and industry risk while broadening the range of customer services

. extend the Bank's international network

. expand opportunities for foreign investment in South Australia (emphasis added)".

Of the various strategic objectives indicated in the Bank Board Paper, commercial lending was highlighted as being the "charter" of the "major thrust of the New Zealand office".

On 28 July 1988, the Bank Board approved the establishment of the New Zealand office. At the same time, the Bank Board also approved the increase in the New Zealand country exposure to a total of $1,500.0M comprised of $500.0M direct exposure (eg loans made), $500.0M contingent exposure (eg undrawn credit lines) and $500.0M money market exposure (ie Treasury dealings).()

In their submission to the Investigation, the Non-Executive Directors stated:

"Moves into New Zealand were also seen as counter-cyclical, given that the likely outcome for the New Zealand economy in 1988 and 1989 was "slow or negative ... economic growth". The Board was aware of this."()

The investigation noted that Mr D Gobbett, the Bank's Chief Economist, presented regular economic overviews to the Bank Board; these overviews, however, did not specifically cover the New Zealand economy until February 1989.()

A number of Directors however asserted in evidence to the Investigation that prior to the Board's approval to the establishment of the Auckland branch, questions were asked of Mr Gobbett in relation to the New Zealand economy. This evidence is not contradicted by the evidence of Mr Gobbett.()

An application, to the Reserve Bank of New Zealand, for approval of the Bank's establishing a branch in Auckland was duly procured. Another event, however, was to overtake this application.

(c) The Acquisition of Security Pacific

On 27 October 1988, Mr Mallett presented to the Bank Board() a paper recommending that the Board authorise Mr Mallett to proceed with negotiations with an unnamed "major international bank" (later identified as Security Pacific Limited) for the purchase as a going concern of its New Zealand subsidiary. (This subsidiary was later identified as Security Pacific Bank New Zealand Limited).()

The Bank Board Paper noted that:

"... purchase of [Security Pacific] will enable State Bank to acquire personnel, premises, systems and (at our discretion) assets of up to $NZ700.0M, creating a fully operational and immediately profitable New Zealand branch, and accelerating our New Zealand business plan by approximately 3 years."

The paper concluded by stating that:

"The proposal outlined ... represents an outstanding opportunity for the Bank to acquire at no premium a fully operational, profitable New Zealand branch (emphasis added)..."

As with the first Board Paper seeking establishment of a New Zealand branch,() this paper was submitted to Board without any of the economic information and views expressed in the Concept Paper of May 1988. In addition, at the time that the Bank Board was first considering the proposal to establish a branch in New Zealand (ie 28 July 1988), Mr J B Macky (General Manager, Group Information Systems), was visiting New Zealand. In a memorandum to Mr Mallett, and copied to Mr Clark, dated 5 August 1988, Mr Macky reported on his findings of his New Zealand visit. Mr Macky's memorandum states:

"... the general impression is that many NZ'ers believe the New Zealand economy is headed for a major disaster. There is an overall pervading atmosphere of pessimism. The feeling is that Mr Douglas's policies are driving a lot of previously highly protected firms out of business and generating high levels of unemployment, without there being a clear direction from the government as to what is going to take its place and how this replacement is going to be achieved.

Those that I spoke to, when asked if there was an opportunity for another Bank to enter the market, all commented that they felt this would be very difficult because of existing loyalties."

Mr Mallett acknowledged receipt of this memorandum stating "read with interest". Given that commercial lending had been highlighted in the Bank Board Paper of 20 July 1988 as the "major thrust" of the Auckland branch, Mr Mallett's response to Mr Macky's memorandum, in my opinion, is cavalier to say the least.

Of even more concern is the fact that Mr Mallett and Mr Clark did not see fit to present Mr Macky's report (or any summary of it), or any of the economic information contained in the May 1988 "Concept Paper" to the Bank Board when it was asked to consider the acquisition of Security Pacific. I regard this failure, on the part of Mr Mallett and Mr Clark, as a dereliction of their duties to the Bank and to the Bank Board.

In evidence to the Investigation, the author of the Bank Board Paper, Mr Mallett, indicated that he saw no need to include information on the economic situation in New Zealand in the paper:

"... New Zealand was going through a difficult period. It was understood, recognised, publicly communicated in many forms by the Bank, by myself, by the Managing Director. It wasn't something that Daryl Gobbett was telling us was new, we knew it, but we were still prepared to establish in that market. It's a bit like saying today in South Australia that the South Australian economy's got severe problems. Big deal. We're still out there trying to write all the business we can. We know it, we recognise it but we're still actively out there trying to build the Bank, build our business ...()

I do not accept Mr Mallett's rationale as any answer to his failure to present economic information to the Bank Board. It is simply a presumption on his part as to what the Bank Board knew or did not know of the economic situation at the time prevailing in New Zealand. The failure on the part of Mr Clark and Mr Mallett to present economic information to the Bank Board in the Board Papers of 20 July 1988 and 27 October 1988, in my opinion, reflects, for reasons that are amplified hereunder, an attitude on their part that the Bank Board would simply "rubber stamp" whatever proposal was put forward to the Bank Board concerning overseas expansion of the Bank.

(d) The "Profitable New Zealand Branch"

The Bank Board Paper of 27 October 1988 advanced the following as the reason for sale by Security Pacific:

"... the seller is currently undergoing a program of rationalisation, on a global scale, in order to boost the price of its shares traded on U.S. stock exchanges ... despite the New Zealand subsidiary's profitability and consequent importance to the seller, it has no direct impact on the seller's global strategic goals and objectives (emphasis added)."

This same paper, however, notes that Security Pacific upgraded its prior merchant banking activities in New Zealand to a registered bank in February 1988, only some 8 months prior to the date of the Bank Board's deliberations. The question arises as to why there would be the sale of a profitable enterprise for no premium. This is not in itself outside of the parameters of commercial practice, and not necessarily unusual. Nonetheless, it would be expected that a reasonable business person would seek some independent comfort that there was no underlying reason that should be understood and/or examined.

On 27 October 1988, the Bank Board resolved() to approve that Mr Mallett proceed with negotiations. On 8 November 1988, Mr Clark and Mr Mallett signed, as Attorneys on behalf of the Bank, a Heads of Agreement with Security Pacific Limited, in relation to the purchase of Security Pacific Bank New Zealand Ltd. This agreement was expressed to be not intended to form a binding agreement, and was subject to execution of a formal Sale Agreement which was duly executed on 6 December 1988.

On 24 November 1988, Mr Mallett presented a paper to the Bank Board seeking confirmation of the acquisition of Security Pacific Bank New Zealand Ltd at a "total net cost to the Bank of approximately $A1.1M, being the net written down value of the fixed assets." () The paper went on to note:

"Budgets are currently being formulated to cover the period between purchase date and June 30, 1988. It is expected that the New Zealand operation will contribute $A1.0M during this time. It is predicted that within three years the operation will increase its return on equity from 8% to 15%."

Although the Bank was given a period of three months by Security Pacific to analyse its New Zealand subsidiary's receivables and then to purchase only those assets which met the Bank's lending criteria,() the Bank took only three weeks to review the portfolio.() The quality of the portfolio taken over by the Bank from Security Pacific will be dealt with later in this Report.() At least by May 1989 (ie less than six months from the date of the purchase of Security Pacific), Mr Mallett was reporting, to Mr Clark, non-accrual loans totalling $16.0M arising from the Security Pacific purchase.()

(e) Increase in the New Zealand "Country Limit"

The Bank Board Paper of 24 November 1988 not only sought "confirmation" of the acquisition of Security Pacific, but also the Board's approval to an amendment to the Bank's "country limit" in respect of New Zealand.

In support of the proposal, the paper noted:

"In view of the close economic relationship in both Commerce and Finance that is developing between the two countries, the level of sovereign and political risk that would normally be taken into account when assessing country lines is of only limited concern."

On 28 July 1988, when it approved the establishment of the Auckland branch, the Bank Board had also approved the New Zealand "country limit" exposure as a total of $1,500.0M comprising a maximum of each of $500.0M direct exposure, $500.0M contingent exposure, and $500.0M money market exposure. The proposal before the Board, on 24 November 1988, sought a maximum of all exposure (ie any one or more of direct exposure, contingent exposure or money market exposure) to New Zealand of 15 per cent of the Bank's total balance sheet. The attachment to the Bank Board Paper indicated total Bank assets as at 30 October 1988, of $10,654.0M, giving an immediate limit of $1,598.0M in respect of any one or more of these categories of exposure.

Given the Bank Board's previous approvals for country limits of 20 per cent of the Bank's balance sheet for all other overseas operations, the Bank Board's decision effectively permitted management, in accordance with delegated lending authorities, to expose a total of 35 per cent of the Bank's balance sheet from time to time in overseas operations.

On 24 November 1988, the Bank Board confirmed the acquisition of Security Pacific New Zealand and approved the recommendation that 15 per cent of the Bank's total assets be the "country limit" for New Zealand. The Board Minutes of 24 November 1988 indicate that Mr Clark and Mr Mallett had visited Security Pacific and that "the Board were advised that all had been impressed with the standing of Security Pacific in the market place in New Zealand and the quality of staff at Security Pacific". As noted in Sections 19.3.4.5 and 19.3.4.6 below, the loan portfolio of Security Pacific gave rise in a short space of time to significant non-performing assets.

19.2.14 1990-1994 STRATEGIC PLAN

The "1990-1994 Strategic Plan" was considered by the Bank Board on 10 May 1989. This plan covered the period 1989 to 1994, notwithstanding the year references in its title.

This Strategic Plan recognised the strategic limitations of the South Australian market, but, with the Bank Board's approval of the opening of the Auckland branch, proceeded to recognise Australia and New Zealand as the Bank's "main region of ... operations". The principles enunciated in Section 15(1) of the Act are, in this Strategic Plan, indirectly referred to in the statement of the "Group Vision" in the following way:

"The Bank has, however, grown beyond the abilities of the South Australian market to utilise fully its own and the subsidiary companies' capacity to provide financial services. This excess capacity is used in interstate and overseas markets to generate a greater return on South Australians' investment in their Bank.

This maximises the Bank's contribution to the State's revenue to the benefit of the whole South Australian community.

We selectively seek offshore expansion, through our representations in Great Britain, USA, New Zealand, Hong Kong and other areas."

Total group assets, in the Strategic Plan, were predicted to grow from $18,046.0M in 1989-90 to $36,028.0M in 1993-94, corresponding Bank assets growing from $15,215.0M to $30,396.0M. Total Treasury and International assets including New Zealand were predicted to reach $12,800.0M by 1993-94 with locations overseas as follows:

". New Zealand: Auckland, Wellington, Christchurch;

. USA: New York, Los Angeles, Chicago, Houston;

. Europe: London, Manchester;

. Asia: Hong Kong;

. Elsewhere as appropriate."

By the end of the period covered by this Report, the Bank had established representation in all locations identified above, with the exception of Manchester and Houston.

The Bank Board resolved to "approve" the Strategic Plan. The Bank Board Minutes reflect, at least indirectly, the Bank Board's thinking on the relevance of the Bank's overseas expansion to South Australians as follows:

"The Strategic Plan highlighted the Bank's primary commitment to South Australia, whilst utilising its own and subsidiary companies capacity to provide financial services interstate and overseas to generate a greater return on South Australians' investment in their Bank." ()

19.2.15 THE BANK'S PROFIT PLANS 1985-1990

(a) Introduction

During the period under review, the Bank produced annual "Profit Plans". These plans were, in effect, annual budgets.

The profit plans for the years 1985-1990 are consistent with the annual Strategic Plans in relation to the growth of overseas assets. These profit plans also give an insight into the Bank's expectations as to the profitability of its overseas operations during the period under review. As will be indicated later in this Chapter, however, the actual financial outcomes for the overseas branches, having regard to the level of non-performing assets reported by those branches as at February 1991, indicates the extent to which these expectations were not fulfilled.

(b) 1985-1986 Profit Plan

The 1985-86 Profit Plan which was approved by the Bank Board on 25 July 1985(), referred to the London book as a major source of growth with London branch advances, increasing by $310.0M to $350.0M. This growth would be funded solely in London.() The Plan states that:

"The main action plan on the international side is simply to build up business. This can be partly achieved by using the existing corporate base. Generally, there needs to be a greater awareness of the Bank's ability to handle the full range of international transactions ... emphasis will be placed on development of London Branch ..."

The budgeted profit for the overseas branches is not shown in this Plan.

(c) 1986-1987 Profit Plan

The 1986-87 Profit Plan was approved by the Bank Board on 24 July 1986.() This Plan again refers to the London and Hong Kong offices as being major components of asset growth for the Bank, with assets increasing by $475.0M to $882.0M:

"Expansion overseas is vital to the Groups asset growth and funding. As such our program proposes the development of international business in selected overseas markets."

The increase was to be funded entirely by the individual overseas branches. This Plan noted that Management was seeking to achieve a break-even point during 1986 in respect of its overseas operations.

(d) 1987-1988 Profit Plan

In presenting the 1987-88 Profit Plan to the Bank Board, on 23 July 1987, Mr Clark advised the Bank Board that "the emphasis this year will be concentrated on profitability, accepting if necessary the possibility of some loss of market share." ()

This Profit Plan stated that the Bank had dedicated personnel to research the potential of establishing a New York branch "if the feasibility prepared evidences profitable opportunities in that market".

The Plan predicted significant growth in overseas assets with management budgeting for a growth in overseas assets of approximately 127 per cent in the financial year from $750.0M to $1,700.0M "and with a profit lift of approximately 100 per cent". In particular, London office assets alone were predicted to reach $1,050.0M by June 1988.

The Bank Board approved the Profit Plan on 23 July 1987, and the Bank Board Minutes record that:

"The Managing Director advised the Board that offshore banking operations would be closely monitored to ensure that growth is achieved in a controlled manner.()

This undertaking by the Managing Director was vital given the significant asset growth projected for the overseas operations.

(e) 1988-1989 Profit Plan

The 1988-89 Profit Plan, which was approved by the Bank Board on 28 July 1988,() called for "continued growth in assets and profitability within the [State Bank] Group".

In submitting this Profit Plan, Mr Clark noted that establishment of the target profit of $97.3M for the Group ($65.8M for the Bank) had not been easy and in fact, the first cut of the profit plan produced a profit of only $24.0M. After various "cuts" and "reviews" the target profit was struck.

(f) 1989-1990 Profit Plan

The 1989-1990 Profit Plan was approved by the Bank Board on 27 July 1989.() This Plan noted that:

"Expansion of the Group's activities will occur through selected market niches within Australia and continued careful expansion of operations in the International arena."

(g) 1990-1991 Profit Plan

The 1990-91 Profit Plan was approved by the Bank Board on 23 August 1990.() In this Plan, the need to ensure that the off-shore operations were profitable was emphasised:

"Our offshore operation must in its own right generate financial advantage to the State of South Australia. To expand offshore the Bank must fully recognise the commerciality of the decision that it is exporting its services."

Management, however, saw that the Bank's Government Guarantee gave it a competitive edge:

"We pursue aggressive, controlled growth in major financial centres using the strong competitive position provided by our Government Guarantee and reputation as a high quality sovereign counterparty".

Total assets for the overseas operations (excluding United Banking Group) were forecast to grow from $5,080.0M as at June 1990 to $5,885.0M as at June 1991. There was to be growth in New Zealand (up $220.0M) and Hong Kong (up $480.0M - following its proposed upgrading to branch status). There would be a reduction in London assets (down $34.0M to $1,318.0M) but growth in New York (up $134.0M to $2,255.0M).

19.2.16 CONSIDERATION OF DIRECTION SETTING AND PLANNING FOR OVERSEAS OPERATIONS

The Bank's strategic planning processes are discussed in detail in Chapter 4 - "Direction-Setting and Planning" of this Report. For the purposes of considering the direction setting and planning of the Bank in relation to its overseas expansion, the starting point is Section 15 of the Act and the identification of the way in which the development and growth of the Bank's overseas operations satisfied the principles set out in that Section.

This second Section of this Chapter of the Report focused, not only on the specific decisions to open off-shore branches, but also the Bank Board's support for the strategy of overseas expansion via the approval of the more general Strategic Plans and Profit Plans which recommended continued growth of these operations.

Whilst many and varied strategic reasons were advanced in support of each of the decisions to upgrade London branch to wholesale banking operations and to open Hong Kong office and New York and Auckland branches, the recurring theme is that there was an opportunity identified by management and supported by the Board to grow the Bank's balance sheet and to diversify the Bank's risk profiles in these new markets. There was also a recognition that the South Australian market was saturated and that profits were ready to be made off-shore.

Prior to the opening of London branch's wholesale banking operations in October 1985, the Bank had no wholesale banking experience in off-shore markets. The operations of London branch prior to October 1985 were minor retail banking services; indeed they were described by Mr Mallett as a "mail redirection and plant watering service". ()

Prior to the submission of papers recommending opening of branches in New York and Auckland, Mr Mallett sent one of his senior staff members to conduct an initial survey of opportunities available to the Bank. These preliminary surveys were of limited scope as indicated by Mr Mallett in relation to the New York office:

"[The Bank's officer] went there to ... build up the Bank's knowledge of data base, premises, registry requirement, all those type of issues, talked to other banks that were there, and certainly gained an impression that there were opportunities there and make us aware of things we need to consider ...".()

The Non-Executive Directors made extensive submissions to the Investigation in relation to direction setting and planning for the Bank's overseas operations. In particular, they submitted that "consideration of any proposal before the Board was always tested against Section 15. That process was axiomatic."()

At the outset, the Non-Executive Directors pointed to Government support for the Bank's expansion overseas and to the argument that the Second Reading Speech to the State Bank of South Australia Act, 1983 gave a "mandate" for such expansion. The involvement of the Government in relation to the Bank's operations is not a matter to which I am required to direct attention by my Terms of Appointment. Accordingly I do not propose to make any further observation in relation to the role of Government. The Second Reading Speech did indicate the following as principles on which the legislative framework for the new bank was based:

"1. That the Bank should conduct its affairs with a view to promoting the balanced development of the State's economy and the maximum advantage of the people of South Australia. Bearing in mind the traditional emphasis on housing, the Bank shall also pay due regard to the importance, both to the State's economy and to the people of the State, of the availability of housing loans.

2. That the Bank should operate in accordance with accepted principles of financial management.

3. That the Bank should operate in conditions as comparable as practicable with those in which its private sector counterparts operate.

4. That the Bank should be able to become an active, innovative and effective participant in the South Australian economy and financial markets, with the flexibility to adjust to the changes which are a feature of these markets."

As the Second Reading Speech noted, the first two of the above principles appear significantly in Section 15 of the Act. The Second Reading Speech also noted that the third principle was reflected mainly in Section 6 (which confers on the Bank the powers of a body corporate) and Section 22 (which provides that the Bank shall make payments from any operating surplus to the General Revenue). The fourth principle was said to be embodied in Section 19 of the Act (which confers on the Bank power to carry on banking and other related business).

As noted above in this Chapter, various reasons were advanced by management in support of the proposals submitted to the Bank Board for approval of establishment of overseas branches.

In their Submission to the Investigation, the Non-Executive Directors said:

"In the view of the Board, perhaps the key reason for the Bank's overseas expansion was to ensure access to the international capital markets to assist fund raising, both to the Bank and its customers. The Board also recognised that to attract major Australian corporates as clients it was necessary to "be seen as international" or, at least, have an international capacity. In time, management would rely increasingly - and offer as justification time and again - the need to follow its customers offshore and provide them with all of the services they expected from their Bank. For the Board, this justification, while often repeated by management, remained a secondary consideration.

As the International Banking Strategy paper of January 1985 envisaged, it was also intended that the overseas branches of the Bank pay their way and this was one of the reasons why the Board accepted the principle of the Bank engaging in some domestic business in offshore markets consistent with and subject to the recommendations of management and their assurances that growth would be prudent and controlled."()

In his evidence to the Investigation, Mr Clark denied that he had, in particular, advanced as a reason justifying off-shore expansion the matter of following existing customers off-shore. Mr Clark also gave evidence that of all the various reasons advanced in support of overseas expansion, management did not present them in any order of importance.()

Mr Clark did support the evidence of the Non-Executive Directors as to the benefits of an off-shore branch in borrowing funds more advantageously. Mr Clark acknowledged that whilst an off-shore branch was not necessary to raise funds, he "believed that the presence offshore assisted in the raising of those funds at the very best rates." ()

In relation to the proposal to establish the New York branch, the Non-Executive Directors submitted:

"... a factor which was influential when considering the opening of the New York branch was the continuous trading opportunities allowed through the opening of an office (in) a different time zone."

One strategic objective which is consistent throughout the various Bank Board Papers relating to overseas operations is the opportunity to make a profit - by writing more business than was available within the South Australian market. In evidence to the Investigation, Mr Mallett (Chief General Manager, Corporate and International) emphasised that, as the manager responsible for the Bank's overseas operations, he had clear instructions as to the priority of profitability:

"What I do recall though was a very firm requirement of Tim Clark's ... that any offices of the bank opening outside of South Australia had to be profitable within their own right within 12 months. Now, by definition, the only way to do that was to write substantial business in the new market that you're going into." ()

But the Bank's overseas expansion was not without risks, as was appreciated by management:

"Just the whole exercise had risks, not just taking on more risky business. Just simply by going into a brand new market has risks ... you can gain competitive advantages for various reasons and you can take the business that no one else wants. Well, let's assume you're smart enough that you're not doing that, you can gain business by doing it cheaper than everyone else ..." ()

In evidence to the Investigation, Mr Mallett spoke of an "unwritten rule" as to the need to have a branch overseas profitable within 12 months:

"... The most important thing was profit because under the rules which says unless you could have an office that broke even within 12 months, no matter what your reasons were you couldn't open the office any way and you were not allowed to open beach heads. You are not allowed to open offices that were there for flag flying. You weren't allowed to have a look at the market and try it out. You had to go there and make money." ()

Mr Mallett's observations are borne out by the evidence to the Royal Commission of Mr Barrett (Chairman until June 1989):

"Question: What do you say about New York, what was your perception [of the reasons for going there]?

Mr Barrett: As it was presented to the Bank, this was to service customers from our Australian home base.

Question: Were there many?

Mr Barrett: I don't know the detail, no, I don't think there were many at that stage, but one principle the Bank had in mind was that any branch had to be financially independent, so they would be expected to generate a bit of profit on their own, they weren't to be a loss on the profit and loss account of the Bank, so would expect them to be self supporting financially.

Question: When you say "self supporting", wouldn't you expect a bit more than that, indeed wouldn't you expect something better than a little profit, which is your word.

Mr Barrett: At least self supporting, yes, but starting off in a small way, of course, and gradually building a base in which to make reasonable profits." ()

Mr Bakewell's evidence to the Investigation() is illuminating as to the approach taken by the Bank Board to the various proposals for overseas expansion submitted to them:

"... I can't remember any director particularly opposing the opening of the London - or with the increasing of the London development. As far as America was concerned, the Bank was on the up. There was a certain amount of enthusiasm. There was considerable discussion of where the office should be in America. Some directors felt Chicago was more appropriate or even Los Angeles was more appropriate than New York. I don't, frankly, remember any director opposing at that stage."

Mr Barrett gave evidence to the Royal Commission about the "prestige" of the Bank being seen as an "international bank":

"Question: Was it ever put to the Board, or seen by the Board as a matter of prestige, to have the State Bank flag waving or its emblem as showing in as many parts of the world as possible.

Mr Barrett: Yes, I don't know about as many parts of the world as possible, but we certainly saw benefits promoting South Australia, yes, promoting South Australia.

Question: What, as an advertisement for the State.

Mr Barrett: Yes.

Question: Who was putting that point of view, in particular, anybody.

Mr Barrett: Management, in particular.

Question: When you say Management, I suppose that really means Mr Marcus Clark, does it.

Mr Barrett: And his Executive Committee, his Corporate Banking people and Treasury people.

Question: ... Would it be fair to say that also, apart from what I'll call any flag waving aspect in expansions interstate and overseas, the Bank had a clear policy, supported by the Board, that it didn't want to be seen, didn't, in fact want to be, what I'll call a small regional bank, it wanted to be something more than that.

Mr Barrett: Yes." ()

In his evidence to this Investigation, however, Mr Barrett sought to explain his evidence to the Royal Commission on this matter:

"Mr Barrett: I think the word "prestige" there was in promoting South Australia, putting South Australia on the map. Nothing more than that. I think there was no great prestige in us having a branch there ipso facto, but only a matter of promoting South Australia. A lot of people wouldn't know where South Australia was."

In his evidence to the Royal Commission, Mr Clark agreed with the proposition that in relation to the establishment of the New York branch, there was "an element of keeping up with the Jones.()

So far as the decision to open the Auckland branch was concerned, certainly Mr Mallett, as the Chief General Manager responsible for the international operations of the Bank was concerned, the position was clear:

"Question: [The question is] whether it was as you may have perceived it to be almost a rubber stamp?

Mr Mallett: A done deal. I mean, we already had major involvement in New Zealand. I mean, this whole concept of someone telling us that the economy is stuffed. It's a bit late when you've got half a billion dollars worth of lending there." ()

Whilst economic information on countries put forward as the proposed target for overseas expansion was presented to Executive Committee in Executive Committee papers, no such information was put forward to Bank Board in the corresponding Bank Board Papers. In his evidence to the Investigation, Mr Mallett defended this discrepancy in the case of New Zealand, on the basis that the state of the New Zealand economy was understood by all.()

I do not accept this explanation by Mr Mallett, not least for the reason that it begs the question why he saw fit to present the information to the Executive Committee but not to the Bank Board. In discharging his duties to the Bank and to the Bank Board it was not open to Mr Mallett to make any assumptions about the level of knowledge about the New Zealand economy which the Bank Board may individually or collectively have had. The Bank employed experienced and senior economists presumably so that Management could obtain the benefit of their knowledge and experience. The inference is open to be drawn from Management's failure to present to the Bank Board the economic information which was presented in the "Concept Paper" of May 1988, that the economic views expressed did not suit Management's arguments and because they could have prompted the Board to probe Management on the wisdom of opening a branch in Auckland.

In Section 19.2.11 above, I referred to the proposal to establish the Cayman Islands branch. As noted in that Section, each of the papers submitted to the Board made it clear that the Bank was seeking to benefit from "the absence of reserve requirements". In their submission to the Investigation, the Non-Executive Directors said:

"At no time was it suggested to Mr Simmons, or any other Board member that the State Bank's activities in New York escaped the net of either Federal or State regulators."()

The Non-Executive Directors further said:

"As far as the Board were concerned, New York State Banking Regulations - and the scrutiny of all relevant regulators - applied to the New York operations of the State Bank in the same way as they applied to any other bank with an office in New York. Although transactions were to be booked through the Cayman Islands, the Board was assured by management that this procedure was lawful, normal and utilised by many domestic Australian and other international banks carrying on business in the United States."()

The above submissions were supported by evidence given by a number of the Directors as to their understanding of the phrase "absence of reserve requirements". The effect of the evidence of the Directors was that they did not understand the phrase to suggest that the Bank would, by adoption of the Cayman Islands branch as an off-shore booking centre, avoid the prudential scrutiny of the New York State banking authorities.

Nevertheless in excess of 95 per cent of the assets managed by New York branch were actually booked through the Cayman Islands and thus were not subjected to prudential supervision or any other form of scrutiny by the New York State banking regulators. In particular, the New York State banking department's Prime Asset Ratio ("liquidity") was therefore determined on some 5 per cent of the total corporate book under management of the New York branch.

New York branch was, in fact, subject to one review by the New York State Banking department, and this review covered a balance sheet of some $US 30.0M. At the same time, assets in excess of $US 700.0M sat off-shore (at least notionally) in the Cayman Islands.

19.2.17 CONCLUSIONS

On the basis of the matters reported above, and for the reasons indicated, I am of the opinion that the direction setting and planning process adopted by the Bank in relation to its overseas operations was appropriate. I emphasise that this conclusion relates to the "process" whereby the Bank Board approved specific proposals for the establishment of overseas branches in the broader context of an annual five year "look ahead" broad strategic analysis, and annual Profit Plans.

I am satisfied that the Bank Board did have regard to the Bank's "Charter" as set out in Section 15 of the Act, albeit that Section 15 of the Act was not specifically referred to in Bank Board Papers or Bank Board Minutes in relation to the proposals to establish off-shore branches. I am also satisfied that the Bank Board believed that the various reasons advanced by management from time to time in the specific Bank Board Papers, the Strategic Plans, and the Profit Plans, had a sufficient connection with the Bank's Charter such as to satisfy it. In this Chapter I do not propose to express a view as to whether I, personally, if I were in the place of the Bank Board, would see the reasons advanced by management as satisfying the Bank's Charter. Such a process, I suspect, could suffer too severely from the benefit of hindsight.

I am, however, of the opinion, that the Bank Board and management were significantly influenced by the arguments time and again advanced in the various Bank Board Papers, Strategic Plans, and Profit Plans, that off-shore expansion provided to the Bank the opportunity to grow its asset base and, in particular, its corporate banking asset base. In my view the drive for growth was apparent in the January 1985 International Banking Strategy Paper and the 1985 Strategic Plan. Whatever doubts any person may have entertained about the Bank's focus on asset growth overseas was clearly dispelled in the Bank Board Paper proposing the establishment of the Hong Kong office. In my view, the focus was deliberately to avoid the prudential requirements and growth restrictions imposed by the Bank of England. This was no secret. This was the plain and primary rationale for the establishment of the Hong Kong office as proposed in the June 1986 Bank Board Paper.

The evidence of the Non-Executive Directors, on the one hand, and Mr Clark and Mr Mallett, on the other, in relation to the reasons for the Bank's off-shore expansion is, in many respects irreconcilably conflicting. I am not in a position to reconcile those conflicts. Whatever may have passed between the Bank Board and management in relation to the rationale for overseas expansion, the plain fact of the matter is that asset growth with emphasis on corporate banking asset growth, was apparent on the face of the Bank Board Papers, the Strategic Plans, and the Profit Plans as the ostensible reason for the moves proposed.

But asset growth was not advocated simply for asset growth's sake. I am satisfied that asset growth off-shore did give the Bank a measure of risk diversification at least geographically. I am of the opinion, however, that the driving force behind asset growth was the opportunity to make profits and this again is clear on the face of the Bank Board Papers, the Strategic Plans, and the Profit Plans as noted above.

In the next Section of this Report I analyse the Bank's off-shore asset growth and the profitability of the bank's overseas operations.

 

19.3 GROWTH AND PERFORMANCE OF OVERSEAS BRANCHES

 

19.3.1 OVERVIEW OF OPERATIONS OF THE LONDON BRANCH

19.3.1.1 Principal Activities

From July 1984 to September 1985, London branch operated essentially as a "paying -receiving centre" (), which was not operating profitably and was, in fact, expected to produce a $0.2M loss for the year ended 30 June 1985.()

In August 1985, Mr Mallett was sent to London to assist in establishing the administrative procedures for the branch upon its commencement of wholesale banking operations.()

From October 1985, London branch provided corporate finance, and became an active dealer with the professional financial markets. London assets were funded by the London branch's own borrowings. Its treasury operations comprised both trading activities and risk management activities. London branch's treasury activities ceased in November 1990, whilst its risk management operations continued thereafter.

London branch's corporate finance activities focused predominantly on exposure to the United Kingdom property market.() From the beginning, the corporate finance portfolio carried a weighting in favour of property exposure with 30 per cent exposure to property being set by Head office. As will be noted in Section 19.7 below, the London branch's exposure to property was a matter of significant concern to both the Bank of England and the Reserve Bank of Australia; that concern was expressed on numerous occasions to Mr Clark, Mr Mallett and other Bank executives.

In late 1990, London branch moved into the area of "asset based lending" and away from real property secured loans. "Asset base lending" was the description applied to corporate lending secured against business assets and business cash flow.

19.3.1.2 Organisation Structure and Staffing

In the period since 1985, the London branch has had four Chief Managers:

(a) Mr R Wright (appointed April 1985);

(b) Mr M Wilcox (appointed April 1988);

(c) Mr T Lynn Todd (appointed September 1989); and

(d) Mr P Russo (appointed November 1990 - on secondment from New York).

Up until late 1990, London branch was responsible directly to the Chief General Manager, Corporate and International (previously Treasury and International) who was located in Adelaide. From November 1990, London branch reported to the Executive Vice President, United States of America.

In line with the Bank's restructure of its Treasury operations, from November 1990, London Treasury became part of Global Treasury reporting to the Group Treasurer in Adelaide.

19.3.1.3 Prudential Control and Supervision

The London operations are supervised by the Bank of England. The Reserve Bank of Australia also monitors the London operations by way of its regular meetings and correspondence with the Bank.

From the time of establishment of the London branch, regular meetings and correspondence occurred with the Bank of England. There were also periodic meetings and correspondence with the Reserve Bank of Australia involving senior management in Adelaide.

The matter of communication to the Bank Board of management's dealings with the Reserve Bank of Australia is dealt with in detail in Chapter 15 - "The Relationship with the Reserve Bank of Australia" of this Report. Specific issues raised by the Bank of England and the Reserve Bank of Australia in relation to London branch are dealt with in Section 19.7 below.

19.3.1.4 Business Plans and Financial Performance

In June 1985, projections were produced for London branch to June 1990.() The following table() compares 1985 forecasts of total assets with actual total assets and forecasted profits with budget and actual profit outcomes.



Year
Ending

1985
Projected
Total
Assets
(GBP’M)


Actual
Total
Assets
(GBP’M)


1985
Projected
Profit
(GBP’M)


Year’s
Budget
Profit
(GBP’M)


Year’s
Actual
Profit
(GBP’M)

June 1986

173.0

202.0

(0.537)

(0.677)

(0.459)

June 1987

227.0

338.0

(0.059)

0.870

0.266

June 1988

298.0

420.0

0.233

1.319

0.321

June 1989

391.0

573.0

0.815

0.599

1.196

June 1990

513.0

613.0

1.487

0.733

0.233

February 1991

-

724.0

-

1.500

(12.773)

London branch's reported loss of GBP 12.773M resulted essentially from specific provisions of GBP 12.865M being bought to book for the seven month period ended February 1991. Of this figure, specific provisions of GBP 4.064M were raised in February 1991 alone, as against a budget for specific provisioning for that month of GBP 0.064M.()

Briefing notes prepared for the London Strategic Planning Conference in April 1989, set targets over five years to double corporate assets and triple profits. Of particular note was the target for property exposure of GBP 170.0M in June 1990 out of total advances outstanding of GBP 400.0M (ie 42.5 per cent). This contradicts the policy stated in a letter dated 29 August 1990 from Mr Mallett to the Bank of England that "exposure to Property Risks including contingent liability exposure, at any time [is] not to exceed 30 per cent of "risk assets"".() There is no evidence that this latter target was incorporated into the Bank's 1990-1994 Strategic Plan.()

According to the management accounts for the year ended June 1989, net profit after tax and provisions was GBP 1.196M compared with a budget of GBP 0.599M. The positive variance over budget comprised:

(a)

Net income

+ GBP 1.2M;

(b)

Specific debt provision

- GBP 1.0M; and

(c)

Other

+ GBP 0.4M

The increase in net income related primarily to profits from trading/arbitrage whilst the provision arose in respect of one loan.

Management accounts for the year ended June 1990, showed a net profit, after tax and provisions, of GBP 0.233M compared with a budget of GBP 0.733M. The negative variance against budget comprised:

Some text in between here.

(a)

Net income

+ GBP 3.0M;

(b)

Specific debt provision

- GBP 4.0M; and

(c)

Other

+ GBP 0.5M

The increase in net income related primarily to profits from trading/arbitrage (GBP 1.5M) and net interest income (GBP 1.2M).

19.3.1.5 Asset Quality

By 31 March 1991, the exposure of London branch by industry was as follows:

Industry

GBP’S

$A’M

%

Property

193

444

40

Finance and investment

131

301

27

Public administration

54

124

11

Leisure

26

60

5

Transport equipment

11

25

2

Other

67

154

15

Total

482

1108

100

Whilst the exposure to property exceeds the maximum level noted in the letter to the Bank of England dated 29 August 1990 the significant factor in the portfolio carrying a 40 per cent property exposure was a loan of GBP 46.8M which the Bank had made on the basis of the exposure being "sold down," but was unable to do so. The high property exposure in the portfolio also came about because of distortions caused by London branch ceasing new corporate lending in December 1989. A memo dated 15 January 1991 from Mr Mallett to Mr Paddison, Director, Banking states:

"This business [corporate lending] has for all intents and purposes ceased. We are now managing the portfolio and while its overall quality is not as high as I would have liked, it is standing up with one or two exceptions to the current UK recession".

This memorandum went on to note the proposed strategy for reducing London branch's property exposure:

"Our current exposure to property is GBP 190 million or 34% of our earning assets. It is our intention to reduce this level to 29% by 30 June 1991 or earlier if such is possible and I have advised the Bank of England accordingly. For prudential purposes, it is further proposed to limit property to 20% of Corporate commitments, however, this is not possible in the short term".

By the end of February 1991, London branch's portfolio included eight non-performing accounts, with a total risk exposure of $125.0M. According to the report to the Bank Board on non-productive items as at 28 February 1991, the worst case risk/loss prognosis for London branch was a loss of $60.0M against which a specific provision of $25.0M was then held.

This Report indicated that there were four accounts within London branch designated "Problem Dimension 1 Accounts" totalling $84.2M. The report defined a "Problem Dimension 1 Account" as an account:

"...of significant concern. A high level of management input/account workout is required to limit our potential loss".

19.3.1.6 Observations on Operations and Performance of London Branch

On the basis of all the evidence available, I am satisfied that whilst the Bank devoted substantial assets to the operations of the London branch, the performance of that branch over the period under review indicates that it was not profitable. As at February 1991, London branch held significant non-performing assets.

The Group Operating Review for February 1991 listed "gross assets" for London branch at $1,487.0M. Non-performing assets reported for the same period at $125.0M represented some 8.4 per cent of the London branch's "gross assets".

The London branch's financial result for the period ended February 1991 was reported, in the Group Operating Review for that month, as a negative 3.23 per cent return on assets as against budgeted return on assets of 0.43 per cent.

19.3.2 OVERVIEW OF OPERATIONS OF THE HONG KONG OFFICE

19.3.2.1 Principal Activities

The Bank officially opened its representative office in Hong Kong in April 1987.

The main activities of the office have been a low level of lending for corporate and sovereign borrowers in the Asia/Pacific region, and the provision of off-shore property finance, chiefly in Australia and New Zealand, for corporate and private banking clients. In September 1990, the office was granted authority to take up a restricted banking licence, but this had not been taken up as at February 1991. The application for the licence was to enable the office to diversify its operations by providing deposit-taking facilities.

The policy of the office has been to target major corporate names in the Asian region for short to medium term funding, for use in their own operations. In addition, through the arrangement of mortgage finance to Asian investors purchasing real estate in Australia, the United Kingdom, and the United States of America, the office developed a private client list of around 200 Asian investors.

With respect to Treasury operations, due to the non-activation of the restricted banking licence, the Treasury activity in the office was limited to the distribution of commercial paper on behalf of Head Office.

By February 1991, the office had gross assets of $102.0M.()

19.3.2.2 Organisation Structure and Staffing

From the inception of that Office, the Director of Asian Operations in Hong Kong has been Mr I R Johnston.

The office acts as a representative office for State Bank of South Australia, and has a direct reporting line responsibility to Corporate and International division in Adelaide.

A limited company registered in Hong Kong was established in July 1987, by the name SBSA Asia Limited ("SBSA Asia"). This company is a 100 per cent owned subsidiary of State Bank of South Australia. The company was established because the representative office was not a legal entity under local law and was not permitted to own property or undertake fee-based services of a non-banking nature.

19.3.2.3 Prudential Control and Supervision

The operations of the Hong Kong office are regulated by the Hong Kong Commissioner of Banking.

19.3.2.4 Business Plans and Financial Performance

A business plan was drawn up in March 1990 by Ms M Yeung, Manager, Corporate Lending. The plan only covered corporate lending, and included an overview of the office's current strengths and weaknesses in this area, together with an analysis of potential opportunities and threats. It also considered market positioning, prospects for corporate lending and staffing levels. A business plan for the Treasury unit for 1990-91 was prepared in September 1990, covering the proposed development of the unit's operations.

As mentioned previously, there are two aspects to the Bank's operations in Hong Kong:

(a) the representative office; and

(b) SBSA Asia.

SBSA Asia

Total assets in this company increased from HKD 3.4M in June 1987 to HKD 48.8M in June 1988 to HKD 109.8M in June 1990.

Representative Office

The Hong Kong office report for January 1991 indicated portfolio levels of HKD 439.0M ($A 72.0M), for corporate lending and HKD 352.0M ($A 58.0M) for off-shore property finance. This compares with a balance of HKD 182.0M for off-shore property finance in March 1990.

At the same time, total outstandings of short-term commercial paper distributed by Hong Kong was the equivalent of $A 62.0M.

For the period ended February 1991, the Group Operating Review for that month reported that the Hong Kong office had achieved a net contribution to profits of $0.392M (as against a budgeted loss of $0.073M) which was a 0.58 per cent return on assets of $102.0M.

19.3.2.5 Asset Quality

Hong Kong operations have not been subject to the credit problems that have arisen in other business divisions of the Group. The February 1991 Report to the Bank Board on Non-Productive items showed one non-accrual account of $0.5M with a nil provision against this amount. Worst case loss prognosis was $0.2M. This item has only been noted on non-accrual reports in 1991. The one item reported was classified as a "Problem Dimension 1 Account".

19.3.2.6 Observations on Operations and Performance of Hong Kong Office

The operations of the Hong Kong office have not contributed to the Bank's financial position as at February 1991.

19.3.3 OVERVIEW OF OPERATIONS OF THE NEW YORK BRANCH

19.3.3.1 Principal Activities

The New York branch was established in November 1988. This branch has the capacity to provide full wholesale banking services, although it concentrates largely on corporate lending. It also engages in Treasury operations.

The primary role of New York Treasury is to raise funds to support the corporate lending activities. This is achieved via an active commercial paper program and interbank loans and deposits. In January 1990, New York Treasury established a trading function which included limited trading in futures and FRAs (forward rate agreements), but this activity ceased in 1990-91. In September 1990, the commercial paper program totalled $US 1,000.0M and was a provider of short-dated funds to Head Office.

A significant proportion of New York branch's lending activities involved a type of financing described by the Bank as "Highly Leveraged Transactions". In August 1990, the Internal Audit department reported that more than 40 per cent of New York branch's outstanding corporate commitment was made up of Highly Leveraged Transactions. These transactions are loans, where, after the loan is made, the borrower's debt to equity ratio equals or exceeds 3:1. In its report, the Internal Audit department noted that such transactions "generally carry a negative net worth [and] involve a high level of risk". As at 30 April 1990, Internal Audit department was reporting that the Bank had a total commitment of $US 260.1M to highly leveraged transactions of which $US 190.8M had already been drawn down.

In this same report, the Internal Audit department noted that the branch was involved in Mezzanine Financing which was noted as a "form of structured financing" [which] is unsecured [and] are attractive because they bring high returns". In the period December 1989 to May 1990, the New York branch had approved three Mezzanine Financing deals with a total commitment of $US 30.0M.

19.3.3.2 Organisation Structure and Staffing

The Executive Vice-President, Mr Sewell, took up his appointment with the Bank in March 1988 to commence planning of the new office, prior to opening in November 1988. He reported directly to the Chief General Manager, Corporate and International (formerly Treasury and International) and at February 1991 continued to hold this position.

In 1990, the New York branch was separated into five functional areas each reporting to the Executive Vice-President, United States of America. The areas were:

(a) Treasury;

(b) Corporate Banking;

(c) Corporate Finance;

(d) Operations; and

(e) Corporate branches (located in Chicago and Los Angeles).

Following the establishment in November 1990 of Global Treasury, the New York Treasurer formally began reporting to the Group Treasurer Adelaide in March 1991. An agreement was established between Global Treasury and New York for the New York office to continue to provide administrative support services for the New York Treasury function.

Since the opening of the New York branch, the Bank has established the following wholly owned subsidiaries in the State of Delaware, United States of America:

(a) SBSA Delaware Inc, was established to enable the issuance of commercial paper in the United States of America.() The company is guaranteed by State Bank of South Australia.

(b) SBSA Holdings Inc, was established to hold warrants which can be received through lending facilities and is currently inactive.()

As noted above, the Cayman Islands branch acted as an off-shore booking point for assets, and the vast majority of transactions originating from the New York office (about 95 per cent) have been made through the Cayman Islands, but for management reporting purposes, all transactions were shown as part of the New York office. All transactions were managed by New York office.

There were also representative offices in Chicago() and Los Angeles.()

19.3.3.3 Prudential Control and Supervision

The New York branch is supervised in the United States by the State of New York Banking department. At 30 September 1989, the department made an examination of the operations of the branch; however, as noted earlier in this Chapter, the scope of the examination was limited to the accounting records that reflect the New York operations only. The department did not inspect the records relating to the off-shore banking unit in the Cayman Islands through which the vast majority of transactions for the New York office are booked.

19.3.3.4 Business Plans and Financial Performance

In June 1988, a paper was submitted to the Executive Committee() relating to the establishment of the New York branch then targeted for November 1988. This paper contained a relatively detailed business strategy. The objective for the corporate lending side of the business was stated as:

"To selectively acquire U.S. corporate assets to diversify the credit profile of bank risk assets. To achieve a minimum average return on loan assets of 1.0% p.a. at a credit risk acceptable to the Bank."

The paper submitted to the Bank Board seeking its final approval to the establishment of a State licensed agency in New York() did not attach a business strategy. This Bank Board Paper stated the New York branch's "mission" in the following way:

"The New York Office focus over the planned period will be directed towards achieving the Bank's required strategic target as well as ROA objectives of 1% after tax, while maintaining prudent balance sheet qualitative and growth levels."

Other key initiatives included:

(a) Focusing initially on the East Coast, and then the Mid West and West Coast markets;

(b) Treasury operations to focus on capital markets; and

(c) Growth intended to be focused on the corporate market.

The growth of New York branch assets was spectacular as a comparison of projected total assets() with actual total assets indicates:


Year Ended

Projected
$M

Actual
$M

June 1989

375

700

June 1990

625

1750

June 1991

875

n/a

June 1992

1250

n/a

June 1993

1500

n/a

By February 1991, total assets amounted to $2,149.3M(), an 81 per cent increase on the June 1990 figure.

Profitability of New York branch was also quickly established ahead of initial projections after absorbing initial start up costs; with the branch reporting a profit of $US 0.2M for the period from establishment to 30 June 1989. In December 1988, Mr Sewell submitted a progress report to Mr Mallett which included projected profits for the New York branch. The following table compares December 1988 projected profits for the New York branch with actual outcomes:


Year

Projected
Profits
$US’M

Actual
Profits
$US’M

1989 - 1990

2.2

1.7

1990 - 1991

4.2

3.1 (February 1991)

In the February 1991 Group Operating Review, management reported a net contribution by New York branch to profits of $3.159M as against a budget of $2.692M. This represented a 0.22 per cent return on gross assets of $2,149.3M. The reported gross assets for New York were far in excess of the budgeted gross assets for that branch for the same period of $1,547.2M. The actual profit outcome to February 1991 allowed for loan loss provisions of $US 4.6M.

The eight months' result to February 1991 was above budget by $US 0.4M. The excess was achieved from:

(a)

Fees and commissions

+ $US 1.5M;

(b)

Specific provisions

- $US 0.5M;

(c)

Tax expense

- $US 0.5M; and

(d)

Other

- $US 0.1M

19.3.3.5 Asset Quality

By the end of February 1991, New York branch was reporting non-productive loans with a total risk exposure of $41.0M and a worst case loss prognosis of $15.0M against which specific provisions of $13.0M were held.() Of these non-productive loans, one account of $11.2M was classified a "Problem Dimension 1 Account".

19.3.3.6 Observations on Operations and Performance of New York Branch

The highlight of the Bank's experience in New York, is the spectacular growth in assets of the branch particularly in the eight month period July 1990 - February 1991 when the branch increased its assets by 81 per cent.

19.3.4 OVERVIEW OF OPERATIONS OF THE AUCKLAND BRANCH

19.3.4.1 Background

When the Bank acquired Security Pacific Bank New Zealand Limited in late 1988 its business and staff were taken up in establishing the Auckland branch. The name of Security Pacific Bank New Zealand Limited was changed to SBSA (NZ) Limited. In December 1988, the Bank's Auckland branch received Reserve Bank of New Zealand authorisation to commence banking operations.

19.3.4.2 Principal Activities

The branch provided wholesale banking services including corporate banking and Treasury activities, structured into three distinct areas: Treasury, Administration, and Corporate Banking. The main activity of the Auckland branch was the corporate loan book.

The New Zealand Treasury Section was responsible for providing the New Zealand branch funding requirements, interest rate risk management, currency risk management and liquidity requirements. Trading and arbitrage activities were also undertaken. Treasury was also responsible for managing and providing United Banking Group's liquidity requirements.

Over a period of some 12 months from the time of its establishment, the operations of the Auckland branch were significantly restructured. In January 1989, the branch assumed responsibility for the New Zealand country risk assets that originated in Australia. In June 1990, the branch also assumed responsibility for the on-balance sheet operations of Southstate Corporate Finance Limited. This company, a subsidiary of Beneficial Finance Corporation Limited, was principally involved in the Commercial Loan area. In December 1990, the branch took over the remaining Beneficial Finance assets in New Zealand.

After the Bank's acquisition of United Building Society, the branch was again restructured to undertake all of the Bank's wholesale and commercial banking operations in New Zealand, whilst the United Bank (as the United Building Society became) undertook the Bank's retail banking operations in New Zealand.

19.3.4.3 Organisation Structure and Staffing

The Chief Manager in Auckland in 1989 and 1990 was Mr D Hammond, who was directly responsible to the Chief General Manager, Corporate and International. The Sections reporting to the Chief Manager were:

(a) Corporate and Commercial Banking;

(b) Treasury;

(c) Operations; and

(d) Retail Operations (subsequent to United Bank acquisition).

The Senior Manager, Auckland Treasury reported directly to the Group Treasurer, Adelaide, following the establishment of Global Treasury in November 1990.

SBSA (NZ) Limited (the name to which Security Pacific Bank New Zealand Limited was changed) is a wholly-owned subsidiary of SBSA (NZ) Branch Holdings Limited which itself is a wholly owned subsidiary of the Bank. SBSA (NZ) Limited had four wholly owned subsidiaries as at 30 June 1990:

(a) SBSA (NZ) Investments Limited;

(b) SBSA Mortgage Investments Limited;

(c) Lontas Holdings Limited; and

(d) Taybrook Holdings Limited.

SBSA (NZ) Limited is registered in Auckland and has as a branch in Nassau which, as in the case of the Bank's Cayman Islands branch, operates as an off-shore booking point for assets. This Nassau branch was acquired as part of the purchase of Security Pacific Bank New Zealand Limited.

19.3.4.4 Prudential Control and Supervision

The Auckland branch is an "overseas person" under the terms of the (New Zealand) Overseas Investment Act, 1973 and the Overseas Regulations 1985. Accordingly, the branch required approval from the Overseas Investment Commission to carry on business in New Zealand. This consent was granted in December 1988. With this consent the branch is permitted to undertake merchant banking activities, and to operate a registered bank, which includes authority to engage in foreign exchange dealing. The operations of the branch in respect of the registered bank are also covered by the Reserve Bank of New Zealand Act, 1989 and the Banking Act, 1982 (New Zealand).

19.3.4.5 Business Plans and Financial Performance

A number of business plans for the Auckland branch were prepared. In the initial paper on the establishment of the branch, presented to the Bank Board in July 1988,() strategic objectives were set out, and a five year financial projection was appended. Following the acquisition of Security Pacific Bank New Zealand in December 1988, however, these projections were no longer applicable.

A detailed financial plan was then set out, in January 1989, for the period from acquisition to June 1989. This plan also took into consideration the transfer of $146.0M of New Zealand based assets from Head Office Corporate Banking division in January 1989. A further financial plan for the year to June 1990 was prepared in May 1989.

The transfer of the portfolio of New Zealand based assets from Corporate Banking division in Adelaide to Auckland branch resulted in a situation where the carrying costs for the non-performing portion of the portfolio would outweigh the net revenue earned from the balance of the portfolio. The significant problems created by this situation led to Mr Hammond (Chief Manager, New Zealand) making the following observations in a memorandum dated 1 May 1989 to Mr Mallett:

"The Corporate portfolio could hardly be described as "balanced":

(i) certain NZ country risk assets were extracted prior to transfer. There can be little logic in the "balanced portfolio" argument following this process;

(ii) the gross cost of carry for the non-performing portion of the portfolio will greatly outweigh the net revenue earned from the balance of the portfolio.

It was agreed between us that the NZ results would be measured on a zero free capital base assumption. The effect of the corporate transfer will be a significant negative gearing on NZ country risk. This situation will need to be carefully handled with the Reserve Bank authorities in both countries."

On 3 May 1989, Mr Mallett referred this issue to the Managing Director, Mr Clark, in the following way:

"With the advent of some very depressing news in regard to the potential payout of secured debtors of Equiticorp Holdings, and the decision made to transfer the entire Corporate Banking portfolio to New Zealand without account of its credit quality or level of non-accrual loans, has resulted in an unsustainable position for New Zealand Office in regard to both requirement for specific provisions and the cost of non-accrual loans.

...

[The] level of non-accrual loans on a new operation would effectively mean New Zealand will operate in an unprofitable manner for several years."

Further detail of the specific provisions required in relation to the transferred portfolio is reported below. As at 30 June 1990, SBSA (NZ) Limited had total assets of $NZ 2,000.0M and shareholders' funds of $NZ 27.0M.() The branch's asset growth was significant, given that, as at June 1989, total assets amounted to $NZ 1,000.0M, comprising essentially the assets gained upon acquisition (at net asset value in December 1988) of Security Pacific Bank (NZ) Limited amounting to $NZ 700.0M ($NZ 500.0M in corporate loans and $NZ 200.0M in liquid assets) and the further $NZ 146.0M in corporate loans transferred from Head Office in January 1989.

The branch recorded the following losses for the periods indicated:

(a)

Year ended 30 June 1989

($NZ 0.3M);

(b)

Year ended 30 June 1990

($NZ 11.5M); and

(c)

Eight months ended February 1991

($NZ 1.84M).

As noted above, the main item affecting the profit and loss account for SBSA (NZ) in 1989 and 1990 was the level of bad and doubtful debt provisions.

19.3.4.6 Asset Quality

A number of loans brought into the books of the Auckland branch from different sources have required provisions. In the memorandum noted above from Mr Mallett to the Group Managing Director, dated 3 May 1989, it was reported that at that time non-accrual loans, amounting to $50.0M, had arisen from these sources (Security Pacific - two loans totalling $16.0M; Corporate Banking Adelaide - five loans totalling $34.0M). These items have required specific provisioning: Security Pacific -$7.5M and Corporate Banking Adelaide - $6.8M.

By February 1991, Auckland branch's non-productive loans had risen to $119.0M with a total risk exposure (including non-productive equity plus interest uncollected or foregone) of $160.M and with specific provisions of $47.0M. Two loans give rise to half of the provisions:

(a) loan ex Security Pacific - provision of $10.7M against a loan of $11.4M; and

(b) loan ex Corporate Banking Adelaide - $12.7M provision against a loan of $14.1M.

The February 1991 report to the Bank Board on non-productive items listed 15 accounts totalling $72.0M as "Problem Dimension 1 Accounts".

19.3.4.7 Observations on Operations and Performance of Auckland Branch

It is difficult to analyse the underlying profitability of the Auckland branch because of the changes in the loan book. Above all, the assets acquired or transferred into the branch have in a number of instances given rise to the losses. At the same time, in addition to the provisions required, these losses have given rise to funding costs within Auckland branch.

19.3.5 ASSET GROWTH IN THE BANK'S OVERSEAS OPERATIONS

The asset growth in respect of the Bank's overseas branches during the period under review is, in my opinion, the most striking feature of the Bank's overseas operations. The Operating Reviews presented to the Bank Board clearly indicated the asset growth in relation to all of the Bank's overseas operations which, until the second half of 1990, continually outstripped budget and planning projections.

In the table shown in Section 19.3.1.4 above, I compare actual total assets with projected total assets forecast in June 1985 in respect of the London branch. As noted in Section 19.2.10 above, New York branch's assets reached $1,750.0M by June 1990 as against a five year asset projection, in June 1988, of $1,500.0M.

In the table below, I indicate the growth in income earning assets in respect of the Bank's overseas operations between June 1985 and December 1988.

Growth in Income Earning Assets - Overseas Operations

Period Ending

$A’M

June 1985

36.1

March 1986

346.4

June 1986

395.6

September 1986

782.6

December 1986

613.6

March 1987

690.0

June 1987

719.1

September 1987

852.5

December 1987

1,037.2

March 1988

968.9

June 1988

971.7

September 1988

1,088.7

December 1988

1,207.9

As is seen from the above table, by December 1987 the Bank's overseas assets level-off at around the $1,000.0M mark, and continue at around this figure until December 1988 by which time total off-shore assets are $1,207.9M. As from December 1988, however, the growth in the Bank's overseas assets is significant, as indicated in the following table:

Growth in Income Earning Assets - Overseas Operations

Period Ending

$A’M

December 1988

1,207.9

March 1989

2,173.8

June 1989

2,537.1

December 1989

4,426.3

June 1990

6,880.4

September 1990

7,999.7

After September 1990, the Bank's total assets overseas fall away to $6,459.9M as at December 1990 and $5,270.3M as at February 1991.()

The above asset figures represent the Bank's on-balance sheet asset growth. The growth in the Bank's off-balance sheet assets, in particular its contingent liabilities, was equally significant over the period under review.

As reported to the Bank Board in the Operating Reviews, the Bank's off-balance sheet contingent liabilities included the following items:

(a) Guarantees;

(b) Letters of Credit;

(c) Bill Endorsements;

(d) Foreign exchange transactions;

(e) Interest rate swaps;

(f) Cross currency interest rate swaps;

(g) Contingent swaps; and

(h) Interest rate futures.

The following table indicates the growth in the Bank's off-balance sheet "Total Contingent Liabilities" during the period under review.

Growth in Off-balance Sheet Business - Total Contingent Liabilities

Period Ending

$A’M(122)

June 1986

2,976.0

June 1987

9,920.0

June 1988

10,291.0

December 1988

22,430.0

September 1990

34,546.9

November 1990

36,693.7

December 1990

31,956.7

February 1991

27,220.2

The following table indicates, in a summary form, the profit/loss results for each branch (excluding Hong Kong):()

Year ended
30 June

London
GBP’M

New York
$US’M

Auckland
$NZ’M

1986

(0.459)

-

-

1987

0.266

-

-

1988

0.321

-

-

1989

1.196

0.2

(0.3)

1990

0.233

1.7

(11.5)

February 1991

(12.773)

3.1

(1.845)

Whilst the above table indicates the profit/loss result for each branch (excluding Hong Kong) expressed in straight GBP/$US/$NZ figures, the investigation had regard to the profitability of the overseas branches expressed as a return on average earning assets as indicated in the 1988, 1989 and 1990 Profit Plans.

The 1988 Profit Plan noted that average income earning assets for International division would grow from $1,059.0M (1987-1988) to $1,687.0M (1988-1989) and on the latter figure the division would contribute $1.7M to the Bank's Profit and Loss Account. This contribution represented an average earning on assets of 0.1 per cent.() As the Bank Board had noted that the Bank Group's return on assets target for 1988-1989 was 0.81 per cent(), it is apparent, given the approval of the Profit Plan, that the Bank Board was content for the International division to achieve a return on average earning assets of one eighth of that expected for the Bank Group as a whole. Indeed, the Profit Plan itself noted that the 1988-1989 return on asset projection was a 72.06 per cent reduction on the previous year's return on assets of 0.57 per cent.

However, even the projected return for the International division of one eighth of that expected for the Bank Group as a whole, as recorded in the 1989-1990 Profit Plan, was not achieved by a significant degree. As recorded in the 1989-1990 Profit Plan, the actual outcome for 1988-1989 was $0.2M, a return on average earning assets of 0.01 per cent.

In the 1989-1990 Profit Plan, net profit for the off-shore offices was forecast to be $8.9M, compared to an actual $0.2M in 1988-1989.() As indicated in the 1989-1990 Profit Plan, this represented a staggering turnaround of 3,704.7 per cent. How precisely this turnaround in profitability was to be achieved is not explained in the 1989-1990 Profit Plan, although the statement of the Group Strategy does note that one of the strategic objectives to be pursued through 1989-1990 included:

"... achieve outstanding group performance and balanced business growth through better penetration of the South Australian market, interstate expansion and selective offshore business development (emphasis added)."

This Profit Plan failed to offer any explanation for overseas operations' failure in the previous year to achieve anything more than one-tenth of the projected return on assets, which itself was approximately one-fifth of the prior year's() actual return on assets.()

In addition, the Profit Plan failed to explain the basis upon which maintaining overseas operations could be justified with a return of assets of 0.01 per cent for 1988-1989 as against Bank Group actual return on assets of 0.71 per cent in 1987-1988 and 0.72 per cent for 1988-1989.

As recorded in the 1990-1991 Profit Plan, the actual outcome for 1989-1990 in relation to the overseas operations was a loss of $6.396M. The Bank recorded, not the projected 3,704.7 per cent profit increase, but rather an actual 2,821.7 per cent loss against the recorded prior year's profit figure.

The 1990-1991 Profit Plan forecast a profit of $2.74M for the overseas branches, as against a loss of $6.396M for the financial year 1989-1990.() The 1989-1990 result was a substantial reversal of fortunes for the Bank which had, as noted above, forecast a net profit for the overseas branches of $8.9M.

Once again, there is no explanation in this Profit Plan:

(a) for the disastrous loss figure for the year 1989-1990, as against the previously projected substantial profit;

(b) in support of the continuation of overseas operations, given the negative return on assets for the year 1989-1990; and

(c) of how the Bank would turn a substantial loss into a projected substantial profit given that, in the previous year, the Bank had turned a projected substantial profit into an actual substantial loss.

In their Submission to the Investigation, in respect of the approval of the Profit Plans for the year ended 1989, 1990 and 1991, the Non-Executive Directors said:

"... it was in just this very period that a number of Board members began to have serious doubts about the wisdom of the Bank's offshore activities and the justifications which it had hitherto received from management."()

The Investigation heard extensive evidence from the Non-Executive Directors in relation to this matter, but even if these "serious doubts" were entertained at the time of the approval of the various Profit Plans, a matter, on which I am not persuaded from the evidence of the Non-Executive Directors, I am of the view that the Non-Executive Directors should not have approved the Profit Plans in relation to the Bank's overseas operations until such time as management had prepared and presented a detailed and substantiated review of these operations demonstrating, to their satisfaction the benefit to South Australia of the maintenance of these operations, and their future ability to achieve a profit. In my opinion, the Bank Board should not have simply relied upon assurances or justifications proffered by management, without the Bank Board positively satisfying itself that these assurances and justifications were well founded in fact and were proven to be consistent with the Bank's Charter under Section 15.

19.3.6 NON-PERFORMING ASSETS

By February 1991, London, New York, Hong Kong and Auckland were responsible for a total risk exposure to non-performing assets of $325.5M with a total worst case loss prognosis of $141.4M against which total specific provisions of $84.9M were held.() This total risk exposure represented 23.2 per cent of the Bank's total risk exposure ($1,400.3M) as reported to the Bank Board in the February 1991 Non-Productive Asset Review. At the same time the Bank's total overseas assets ($5,270.0M)() represented 27.4 per cent of the Bank's total income earning assets ($19,209.0M).()

So far as concerns the proportion of non-productive assets of the overseas branches to the Bank's overall non-productive situation, from the figures stated above, it can be seen that the overseas branches' reported non-productive asset situation is not disproportionate to that of the Bank's operations in Australia. With respect to the London branch, from the evidence and for the reasons stated in this Chapter, I am of the opinion that its non-productive asset position has arisen substantially out of an exposure to the United Kingdom property market in respect of which the London branch's portfolio had a deliberate bias.

19.3.7 CONCLUSION ON OPERATIONS AND PERFORMANCE OF THE OVERSEAS BRANCHES

In Section 19.2.17 above, I expressed a view that the bank deliberately pursued an aggressive asset growth strategy in relation to its overseas operations principally in order to access what the Bank perceived to be "profitable growth opportunities".()

The Bank's asset growth was apparent on the face of the Operating Reviews and the Profit Plans presented to the Bank Board. The growth in assets of the off-shore branches (well in excess of originally projected and/or budgeted asset growth figures) was similarly apparent.

I am of the opinion, that at least by July 1988 the Bank Board was on notice that the Bank's overseas branches were then operating at a level of profitability significantly below that applicable to the Bank's overall operations. This was apparent from the Operating Reviews, from the Profit Plans, and from the December 1987 Bank Board Paper reviewing London branch performance.()

The Non-Executive Directors gave evidence that they accepted management's statement that the overseas operations were still "in start-up phase" and therefore were not expected to be profitable. I am of the opinion, however, that the Bank Board could not have failed to see the correlation between the overseas branches' significantly inferior profitability at a time of over-budget asset growth. Whatever above-budget profits for the overseas branches may have been reported to the Bank Board in the Operating Reviews, in my opinion, such profit figures were achieved only by the Bank is pursuing an aggressive asset growth strategy in its overseas branches.

In my opinion, as at June 1988, the circumstances of the Bank's overseas operations called for immediate and definite action by the Board. In particular, I am of the view that the circumstances called for the Bank Board to direct management to conduct a full review of the justification for maintaining the Bank's overseas operations, and for a report on that review to be presented to the Bank Board in order for the Bank Board to determine whether or not the Bank should continue its overseas operations.

In their Submission to the Investigation, the Non-Executive Directors, in the context of the Bank Board's response to the significant lack of profitability of the overseas branches, posed the following "rhetorical question":

"What more can Non-Executive Directors do but demand that management readdress the rationale for an aspect of the business about which the Board has developed concerns, independently of any expressions of concern from management? "

In so far as this "rhetorical question" may be seen as suggesting that the Bank Board, in the face of its own concerns, should simply ask questions of management and uncritically accept the "assurances" given, then I do not accept this. Indeed, as noted below in Section 19.4.2 (b), the Minutes of a December 1987 Bank Board meeting indicated that the Bank Board was prepared to close down one specifically unprofitable aspect of the London branch's operations identified in the Bank Board Paper presented on that occasion.

In Section 19.8.5 below, I refer to evidence given by Mr Hartley and other Non-Executive Directors concerning an assertion that the Bank Board called for a full review of the Bank's overseas operations at around November 1989.

Even if I accepted this assertion on behalf of the Non-Executive Directors I am still of the view that action on the part of the Bank Board was called for at least in July 1988. In my opinion this action, should at the very least, have involved:

(a) a directive to management to conduct a full review of the Bank's overseas operations;

(b) the presentation to the Bank Board of a reasoned and substantiated report justifying the continuance of overseas operations, specifying profitability, and strategic goals, to be achieved by indicated deadlines;

(c) the establishing of a review mechanism for the Bank's achievement of those goals; and

(d) the modification, or closing down, of those operations if performance and strategic goals were not achieved.

In my view, this is the answer to the "rhetorical question" posed to the Investigation by the Non-Executive Directors.

In the next Sections of this Chapter, I consider aspects of control and supervision of the overseas operations of the Bank by the Bank Board and management.

 

19.4 CONTROL AND SUPERVISION OF OVERSEAS OPERATIONS BY THE BANK BOARD

 

19.4.1 INTRODUCTION

In my opinion, in order to adequately supervise and control the development and operations of the Bank's overseas branches, the Bank Board needed to ensure that appropriate levels of authority and systems of supervision and control were established, and were periodically reviewed, and so were relevant and effective. By approving the establishment of the branches and significant changes in their operations, the Bank Board would have been able to ensure that their development was in accordance with the Strategic Plans and Profit Plans approved by it.

Whilst routine supervision was conducted by the branch Chief Manager in each overseas location, the Chief Managers were subject to the supervision of the Chief General Manager, International Banking, by way of monitoring of the performance of each branch. In addition, loan commitments above certain levels required approval at Head Office by the Chief General Manager, International Banking, the Lending Credit Committee or, in respect of the most substantial transactions, the Bank Board itself, where the amount involved was outside the delegated lending authority of others.

Regular reports were made to senior management and the Bank Board on matters such as: office performance (monthly), balance sheet composition and size (monthly), and, in particular, asset quality. One particularly important source of information on problems and concerns arising in relation to the overseas operations were meetings and correspondence with the regulatory authorities, both in Australia and overseas. Issues raised by these authorities should have been promptly and fully communicated to the Bank Board by management so that the Bank Board could take whatever action it considered to be appropriate. As will be reported below(), Management failed to report, promptly and fully, on prudential consultations with the regulatory authorities.

As well as the process of direct supervision and control, assessment of the branches' operations should have been provided by functions independent of line management, eg Internal Audit and Credit Inspection.

19.4.2 INFORMATION AVAILABLE TO THE BANK BOARD

(a) Monthly Operating Reviews

Throughout the period under review, the Bank Board received information of varying degrees of coverage and detail in relation to the overseas branches in Monthly Operating Reviews and Quarterly Operating Reviews.

The overseas branches' performance against budget, and the Bank's off-shore exposure limit summary, were consistent features of the International Banking Section of the Operating Reviews. From time to time, operational matters concerning individual overseas branches were included, but, overall, the level of information on the operations of the overseas branches, apart from their performance against budget, was limited.

Set out hereunder is an indication of the level of information provided in the International Banking Section to the Bank Board in a sample of Operating Reviews:

(i) March 1986

The Review noted that London branch had achieved profitability on a monthly basis for the first time in March 1986, but that year-to-date losses were 14 per cent worse than budget.

(ii) August 1986

The Review noted that London branch had recorded a profit in excess of budget and that London branch's total balance sheet size exceeded budget by 44 per cent.

(iii) May 1987

This Review contained no commentary.

(iv) December 1987

The commentary on overseas operations noted that the "interest margin" for the half year was ahead of budget, as was "actual fee income".

(v) May 1988

This Review was in the same form as the review for May 1987 ie there was no commentary.

(vi) June 1988

This Review contained a quarterly performance summary in relation to International Banking. The commentary on off-shore operations noted that a separate report on London branch's results for March 1988 had been forwarded to the Executive Committee; that total income for the year ended June 1988 was 21.2 per cent below budget; and that expenditure for the year ended 30 June 1988 was 7.2 per cent below budget.

(vii) February 1989

The level of information in this Review was substantially increased to include an international operating result by branch. The Review included a summary of transactional volumes for assets offered, approvals obtained and business booked for each of the branches. General comments on the performance of Hong Kong, New York and London branches were included.

(viii) June 1989

This Review contained the same areas of coverage as those contained in the February 1989 Review. The commentary, in relation to London branch, identified a number of extraordinary items that were said to significantly reduce the branch's reported profit, namely, the reversal of income in relation to a swap transaction, and a specific provision of GBP 1.0M in relation to one particular account.

(ix) September 1989

This Review contained a commentary on the profit performance of each branch, together with profit and loss statements, management returns, reports on risk weighted assets, and a selection of key performance indicators.

(x) December 1990

This Review contained the same coverage and level of detail as that in the September 1989 review. This report noted that International Banking, including New Zealand operations, showed a management return loss for the six months to 31 December 1990 of $30.029M which was $30.817M below budget.

Up until February 1987, Operating Reviews contained a schedule of loan increases, approvals accepted/not accepted/declined for the London branch . This schedule provided information on the identity of the borrower, and the total value of the facility, together with a comment generally identifying whether or not the item was a corporate syndication, or a corporate advance. In addition, Operating Reviews, up until February 1987 included a London branch Balance Sheet. The London branch Balance Sheet, as at 28 February 1987, indicated that out of total assets of $729.0M, corporate advances and syndications totalled $263.2M.

Information relevant to the Bank's overseas operations was also included in the general financial information sections of the Operating Reviews. In particular, the growth in income earning assets in relation to the Bank's overseas branches was indicated. As an example of the information available, the December 1987 Quarterly Operating Review indicated the growth in income earning assets for the London branch office from June 1985 ($36.1M) to December 1987 ($1,037.2M).

It is apparent, from the examination of the International Banking Section of the Monthly Operating Reviews that, overall, the coverage of information was limited to financial analysis with virtually no reference to operational issues. In particular, there was no analysis of the nature of lending activity and exposure within portfolios to particular industries, for example, London branch's property exposure.

(b) Occasional Detailed Analyses of the Performance of Off-Shore Branches/Offices

From time to time, the Bank Board requested additional information about the performance of the overseas branches/offices. The following papers were presented to the Bank Board in accordance with such requests:

(i) August 1987

Paper on the Bank's operations in foreign exchange and money markets, including a description of the London branch Treasury operations. This paper stated the following:

"The background is some concern about foreign exchange and money market management in London and the potential generally for companies to experience problems in managing their foreign exchange and money market business. Also, it needs to be recognised that the Bank is now a major player in markets which have been characterised by:

- increased volatility in interest rates and exchange rates;

- growing concern by central banks and supervisory authorities about the adequacy of banks' prudential controls for managing risks; and

- the development of increasingly sophisticated and complex financial technologies e.g. swaps, futures, etc."

The paper went on to note that:

"The risks in foreign exchange can be tightly controlled if good internal prudential controls are in place and all dealing is managed and warranted within these limits."

The paper went on to make the following specific reference to controls in relation to London branch's foreign exchange and money market activities:

"... recent problems in London have been management problems rather than poor or inadequate controls. Essentially the controls/limits were not fully monitored and adhered to." ()

In my opinion, the above extracts from the Board Paper were a significant and timely reminder to the Bank Board of the vital importance of strong supervision, direction, and control, of banking operations conducted in remote locations, in particular, operations involving complex high risk activities in the Treasury area. This warning was clearly applicable to all operations conducted in London branch and any other overseas branch.

The Board Minutes note the Bank Board's approval of certain staff changes and title changes to senior executives.

(ii) December 1987

Paper on London branch operations. This paper "London Office-Report" () was presented in response to an undertaking, given at the November 1987 Bank Board meeting, to provide a report on London branch's performance with particular emphasis on its foreign exchange activity.

The report noted that:

"Adverse foreign exchange activity, eg losses and non budget performance have set the branch back GBP 640,000."

The paper went on to note a number of staff changes made in the London branch's Treasury area and stated:

"Despite good intentions, communications between Adelaide and London dealing rooms have not been as good as necessary in a volatile market. Efforts continue to improve this area."

In relation to the December 1987 paper, the Bank Board Minutes record that "in an endeavour to improve London Office profitability" a senior Treasury officer from Adelaide would spend a minimum of two months in London branch early in 1988 "to take operations into a permanent profit position or take the Bank out of inter-bank market making activity until such time as the Bank could re-enter it with assured profitability".

(iii) August 1990

Paper on "International Banking division" which provided details of the financial results and balance sheet structure, International Banking objectives, and details of off-shore operations.

The Bank Board Minutes of 26 July 1990 record an unnamed director's "concern" as to "the failure of Management to present a report on [overseas] operations.() On this occasion, a "specific report outlining a fundamental review of international operations" was to be presented at the next Board meeting, and the requested report was presented to the Bank Board at its meeting on 23 August 1990.

The Board Minutes indicate the Bank Board's "concern ... that there were a number of non-financial reasons which were given to support the banking operations at offshore offices. It was considered that the Bank should review its offshore operations more in line with financial returns rather than non-financial." () The Minutes also record that Mr Mallett advised the Board "that the two major reasons for international operations were that the International Banking division was profitable and that it also enabled risk diversification for the Bank."

The circumstances surrounding the Bank Board's request for this paper are dealt with further in Section 19.8.5 below.

(iv) September 1990

Overview of New York branch. This review contained no mention of the involvement of the New York branch in highly-leveraged loan transactions (described to the Investigation as loans to corporate bodies with gearing ratios at or in excess of 3:1)(), or Mezzanine (subordinated) Financing. This latter form of financing is potentially higher risk than the majority component of the portfolio which is "senior" or non-subordinated debt. This report states that no loss of principal or interest was expected on the only non-accrual loan in the portfolio. Nevertheless as noted above, New York branch, by February 1991, was reporting a total non-productive loan risk exposure of $41.0M, a worst case loss of $15.0M, against which specific provisions of $13.0M were held.

The Board Minutes indicate that the Bank Board was advised by Management that "the general thrust of the United States activities had now been modified with internal restrictions being placed on real estate and other areas directly affected by the decline in the economy or consumer confidence. Growth was projected towards portfolio management for the coming year, rather than asset building and that this would further assist the group in the overall risk management." ()

(v) May - October 1990

The minutes for the Bank Board meeting held on 26 April 1990 indicate that "a more detailed report on the UK property market would be provided for the next meeting". The report, dated 4 May 1990, contains the following observations on the Bank of England's concerns with the United Kingdom Property Market:

"The Bank of England has been quoted as saying "we do not see property as a major supervisory risk", however, it is well known that they have made noises indicating they are worried about the U.K. banks levels of exposure to the property market (currently around GBP 32 billion) and it has been confirmed that the Bank of England has been monitoring banks property exposure quite closely. Whilst the Bank of England is urging prudence it also points out that 1990 is not following the pattern of the early 1970s since "the distribution of lending is very different". It goes on to say the risk is spread across a wide range of banks with London branches of strongly capitalised foreign banks making up a significant proportion; rather than concentrated amongst the fringe banks as in the 70s. Risks are also being covered or laid off in other parts of the financial markets (ie indemnity insurance) (Emphasis added)."

Mr Mallett was aware of the Bank of England's concerns and of the Bank Board's request for information. He was under an obligation to ensure that this report was submitted to the Bank Board but failed to discharge this obligation. This failure deprived the Bank Board of the opportunity to assess the report and, as it saw fit, to give appropriate directions to Management to ensure that adequate controls were in place in relation to the Bank's risk exposure in this market.

The Bank Board Minutes of 25 October 1990 record that "an updated report on London Branch would be provided for directors at the next meeting". The Bank Board Minutes do not record any such report being presented at the Bank Board meetings on 14 November 1990 or 22 November 1990.

(c) Reviews by the Group Managing Director, presented on a Periodic Basis

During most of the period under review, the Group Managing Director made an oral presentation to the Bank Board at its monthly meetings. As from April 1990, these reviews were presented in the form of a Board Paper. In addition, Mr Mallett generally attended during the Bank Board's deliberations on matters relating to the overseas branches.

As recorded in the Bank Board Minutes or in the Bank Board Papers, the Group Managing Director's reviews occasionally included information about the overseas operations, but the amount of information given regarding these operations was minimal. For example, the Group Managing Director's review of September 1990, contains four paragraphs referring to:

(i) the change in reporting lines for London branch;

(ii) the reaction of the London Chief Manager to this change;

(iii) a request for an external review of the London Treasury operations; and

(iv) the Credit Inspection Unit visit to London.

There was no mention of the other branches.()

In my view, is was incumbent on Mr Clark to provide regular and detailed reports on the Bank's overseas operations in order to enable the Bank Board to fully appreciate the risk profiles existing in the operations conducted by the overseas branches, and to determine for itself whether or not the Bank Board should give appropriate directions to Management in order to protect the interests of the Bank. He failed to do so.

(d) Quarterly Reports from Group Internal Audit

These reports were first made in respect of the September quarter in 1989; but as was noted in the June 1990 report, "due to previous limitation of Internal Audit staff, there was very little coverage of International Banking. With the new staff being in place now, a full program is being launched." () The issue of Internal Audit coverage is considered further below. The Internal Audit quarterly reports did, however, provide an outline of the audits of the overseas branches and the findings of those audits. The major points raised related to weaknesses of controls and procedures. It was also noted in the reports that the Bank's control systems improved over the period.

(e) Listings of Non-Productive Loans

The Bank Board received details of the Bank's non-productive loans. In 1989, these reports were presented on a quarterly or six-monthly basis, and did not separately identify those loans that related to the overseas operations. From 1990 onwards, the reports were presented monthly and separately identified loans by business area and office. From August 1990 onwards, however, the Board Minutes indicate that the Bank Board was becoming more interested in the Bank's non-productive loans with specific requests for more information about the status of these loans being made in August 1990 (), September 1990() and January 1991.() Board Minutes, in relation to the August 1990 meeting, indicate the Bank Board's noting the tabled listing of the Bank's non-productive loans as "one of the most important papers upon which they needed to focus attention".

The Investigation observed that, in general, there is little specific comment by the Bank Board Minuted on non-productive loans.

(f) Special Presentation to Bank Board by Mr Mallett

During October and November 1988, Mr Mallett made a formal presentation to Mr Searcy, Mr Nankivell, Mr D W Simmons, Mr Summers, Mrs Byrne, Mr Barrett, Mr Bakewell, and Mr Clark, and provided to each of these directors formal material in a booklet entitled "Treasury and International Division". An invitation to attend one of these presentations was extended to Mr Hartley but, he was unable to attend. Mr Mallett made these presentations, on a one-on-one or one-on-two basis, on several occasions over this period, and, in each instance, the director or directors concerned had an opportunity to ask questions in relation to the Bank's overseas operations.

The booklet presented to directors contained information in relation to the following matters:

(i) names and position designations of senior officers in Treasury and International division;

(ii) Treasury department organisational structure, dealing room staff, and functions and principal objectives;

(iii) New York branch personnel, principal objectives, five year financial projection, and strategic development plan;

(iv) London branch personnel, principal objectives, five year financial projections and strategic development plan; and

(v) Hong Kong office personnel, principal objectives, and strategic development plan.

The principal objectives of London branch were stated to include:

"To provide services in the United Kingdom supportive to the activities of the Bank's operations in Australia, particularly to the Bank's International Treasury and Corporate Banking activities.

To establish a viable and profitable business base in the United Kingdom (Emphasis Added) ..."

The strategic development plan for the London branch stated the following:

"... London Office will position itself within the U.K. market as a comprehensive wholesale banking operation ...

Marketing will be targeted towards corporate business which is underserviced by the U.K. clearing banks.

The core activity of the U.K. operations will continue to be corporate lending (Emphasis Added)."

Most significantly, the presented booklet suggested that corporate lending exposure to property would be limited to 20 per cent of total assets, whereas in fact Management's policy was for a 30 per cent limit. As noted above in Section 19.2.4, the International Banking Strategy paper of January 1985 pointed out that the Bank of England required industry and similar risk concentration exposures to be appropriately spread with no more than 20-25 per cent of branch assets to any particular region or industry. Mr Mallett should not have presented this booklet to directors containing as it did a statement which, to his knowledge, was wrong.()

So far as New York branch was concerned, the booklet stated that the principal objectives of the New York branch included the following:

"To engage in corporate lending and customer driven foreign exchange business.

To establish a U.S. domestic Commercial Paper Program according to U.S.$ funding needs.

To establish a profitable business base in the United States ..."

The strategic development plan for New York branch stated that:

"... The New York Office will access the following markets:

. direct corporate lending markets in Australia and the U.S.A.

. syndicated corporate lending markets in the U.S.A.

. inter-bank/corporate money market

. credit enhancement;

. trade finance (at a later date)".

As noted in Section 19.5.2(c) below, from the time of the November 1987 Executive Committee paper proposing the establishment of the New York branch, Mr Mallett contemplated the involvement of that branch in Highly Leveraged Transactions. In my view, it was misleading for this Section of the booklet, dealing as it did with the business strategy proposed for New York branch, to omit a reference to that branch's involvement in Highly Leveraged Transactions.

On this matter, as well as that referred to above regarding property exposure in the United Kingdom, Mr Mallett was in error in presenting a document to directors that was, in my opinion, seriously misleading.

Notwithstanding, the deficiencies in the booklet as presented to directors, the document did, in a general sense, indicate the nature of the activities conducted in the overseas branches, and it was clearly open to the Board collectively, and directors individually, if so minded, to make further inquiry into and obtain further detail in relation to, the operations then being conducted in the overseas branches, as well as activities proposed to be conducted in those branches.

(g) Directors' Visits to Overseas Branches

During the period under review, certain directors were regular visitors to the Bank's overseas branches. The Non-Executive Directors gave evidence that, with the exception of Mr D W Simmons' visit, as Chairman, to New Zealand (with Mr Bakewell as Deputy Chairman) in March 1990, Mr D W Simmons' visit to London and New York in October 1990, and Mr Searcy's visit to London in mid 1989 (with management), none of the Directors' overseas visits was funded by the Bank.

The Bank Board Minutes contain the following references to directors reporting to the Bank Board on their overseas visits:

(i) 22 October 1987

The minutes note that Mr D W Simmons and Mr Bakewell visited London branch and had met approximately 20 staff members, that morale was "exceptionally high" and that Mr D W Simmons and Mr Bakewell were "impressed with the staff in London Office".

(ii) 26 May 1988

The minutes note that Mr Bakewell visited London branch and Mr Bakewell "advised that the appointment of Mr Murray Wilcox had had a positive effect and that the office appeared to be running smoothly".

(iii) 29 August 1988

The minutes record Mr Bakewell's visit to Hong Kong office and his meeting with the Manager, Mr Johnston.

(iv) 27 October 1988

The minutes record Mr Bakewell's visit to London branch, who reported that he had "found that morale was still high".

(v) 23 February 1989

The minutes record Mr Bakewell's visit to Hong Kong office.

The minutes also record Mr Summers' visit to London branch, who reported that "in his opinion, the premises should be upgraded".

(vi) 25 May 1989

The minutes record that Mr Bakewell "briefly reported on his recent visits to London, New Zealand and Hong Kong offices".

(vii) 22 June 1989

The minutes record Mr Barrett's "recent promotional visit to New Zealand".

(viii) 26 October 1989

The minutes record the visit to London branch by Mr D W Simmons and Mr Bakewell, and that Mr Bakewell "advised directors of the high level of morale that was present amongst staff".

(ix) 22 February 1990

The minutes record Mr Bakewell's visit to Hong Kong office and that he "commented favourably on the branch's current operation".

(x) 22 March 1990

The minutes record Mr D W Simmons' and Mr Bakewell's "most successful visit to New Zealand [which] had provided an opportunity to meet key staff in the New Zealand operation as well as enabling discussions to be held with the Bank's auditors and solicitors in New Zealand and also the Governor of the Reserve Bank".

The minutes also record the Chairman's (Mr D W Simmons') observations on the surplus of commercial property in Auckland, the extent of non-accrual loans in Auckland arising from transactions which were undertaken prior to a full branch office being established, the current flatness of the New Zealand economy, and the need for the Group operations to be more cohesive.

(xi) 26 April 1990

The minutes record Mr Bakewell's visit to London and Hong Kong branches.

(xii) 12 September 1990

The minutes record that a report was given in relation to the visit to New Zealand by Mr Hartley and Mr Prowse.

(xiii) 25 October 1990

The minutes record Mr D W Simmons' visit to London branch and his concern "that Treasury operations were exposing the London portfolio to foreign currency exchange risk".

The minutes also record Mr Bakewell's visit to New Zealand.

(xiv) 14 November 1990

The minutes record Mr D W Simmons' visit to London branch and:

"That he had recently met with the external auditors of London and that they had expressed concern over operations. In addition, he advised that the Bank of England and the Reserve Bank of Australia had commented that the portfolio in London had a high level of exposure to the property market."

Whilst the above list indicates Directors' visits to overseas branches as recorded in the Bank Board Minutes, the submission of the Non-Executive Directors points out that Mr D W Simmons and Mr Bakewell visited the London and New York offices in October 1990; Mr D W Simmons visited New Zealand between 13 and 15 August 1990 to inspect the operations of the United Building Society; and Mr Hartley visited London in December 1990.() In addition, Mr Smith gave evidence of his visits to the London branch throughout 1986 whilst he occupied the position of the Director of State Development, and Mr Barrett gave evidence that he visited London for the opening of the London branch in October 1985, and personally called on the Bank of England and the Reserve Bank of Australia representative in London.()

(h) The Bank Board's Interstate and Off-Shore Advisers

The idea of appointing "advisers" to assist the Bank Board was initially raised by the Group Managing Director in July 1989. The Bank Board Minutes for the Bank Board's meeting on 27 July 1989() record that the purpose for appointing advisers was "to assist local branches and provide input to the Bank's Board on operations interstate". The Bank Board resolved to approve that the Bank seek out advisers in Sydney, Brisbane, Melbourne, Perth and Auckland.

At the Bank Board meeting of 26 April 1990, Mr Clark foreshadowed that a paper would be presented to the next meeting of the Bank Board recommending appointments of advisers to the Bank's offices in Brisbane, Perth, Auckland, London and New York.

The Bank Board Minutes record that:

"Collectively, this group would be in a position to provide independent advice to the Board as required."

This matter was further considered by the Bank Board at its meeting on 24 May 1990, the minutes for which note() that:

"Since [July 1989] the Sydney office had developed an excellent relationship with Mr Studdy [a director of Beneficial Finance] which highlighted the significant advantages which were to be derived from the employment of interstate advisers. The position also enabled directors to have a formal contact with an adviser in each of the interstate and international offices ..."

The Bank Board resolved that Mr Clark approach a number of named individuals with a view to appointing them as advisers to the Bank Board. The only named persons to be approached were potential advisers in Victoria, Western Australia, New Zealand and Queensland. The Bank Board Minutes do not record at either this, or any subsequent meeting, that the Bank Board pressed Management to approach individuals to accept the position of adviser for the London, New York or Hong Kong branches, and Management did not bring this matter back before the Bank Board.

In my opinion, Mr Clark should have brought this issue back to the Bank Board, given his knowledge, in particular, of the Bank's property exposure in the London branch, and the concerns of the Bank of England and the Reserve Bank in relation to that exposure. In the same context he was aware of the high risk lending activity of the New York branch.()

(i) The Bank Board's Requests For "Quarterly Reports"

At its meeting on 26 November 1987, in relation to the proposal to establish a New York branch, apart from approving in principle the establishment of New York operations, the Bank Board also requested quarterly reports from March 1988 onwards, as well as a report in June 1988 "where a critical path decision would need to be made whether to continue development of New York Office." The Investigation did not identify any specific "Quarterly Reports" being presented to the Bank Board as directed.

At its meeting on 29 August 1988, directors requested "details of the Bank's overseas operations."() The minutes go on to note that:

"It was agreed that [a report] would be provided to Board on a quarterly basis with the first reports being provided to the October Board meeting."

An examination of the Bank Board Minutes indicates that the requested report was not tabled at the October 1988 Bank Board meeting, nor at any time thereafter.

On 21 December 1989, the Bank Board noted the recent appointment of Mr Lynn Todd as Chief Manager of London branch, and that "a quarterly report would be provided to the Board detailing performance achieved". The Bank Board Minutes do not record any such quarterly report being presented to the Bank Board.

In evidence to the Investigation, Mr Clark expressed his belief that such requests were satisfied by the Quarterly Operating Reviews which contain more information than the Monthly Operating Reviews.()

19.4.3 DELEGATED LENDING AUTHORITIES

All delegated lending authorities required the approval of the Bank Board. In January 1986, London branch's initial delegated authority level was set at GBP 0.5M.() By September 1990, the Bank's delegated lending authorities had reached the following levels:()

(a) London branch Credit Committee

GBP 1.0M;

(b) New York branch Credit Committee

$US 2.0M;

(c) Auckland branch Credit Committee

$NZ 3.0M;

(d) Chief General Manager, International

$16.0M;

(e) Leading Credit Committee

$25.0M; and

(f) Sub Board

$60.0M.

There were no separate delegated lending authorities identified by the Investigation for the Hong Kong office.

The January 1986 delegation to London branch specified the following terms so far as concerned relevant security to be taken and review of the facility:

"Security: Any facility to be approved under this delegation is to be secured by first class tangible security, with valuation margins, following those laid down in the Bank's standing instructions.

Review: Facilities approved are to be reviewed on an annual basis, or more regularly should there be any evidence of deterioration in the safety of the Lending. It is also a requirements (sic) that any deterioration in lending be promptly reported to Head Office." ()

The paper seeking approval for the delegated lending authority for London branch() did not identify the persons to comprise the London branch Lending Committee by name nor did it indicate their qualifications and experience. The paper justified its recommendation on the basis that the delegated authority be approved "in order that lending propositions may be dealt with in an efficient and prompt manner".

In October 1988, the Bank Board approved a delegated lending authority of up to $US 2.0M for New York branch. The Bank Board approved the establishment of a New York office Credit Committee whose delegation permitted it to make secured or unsecured loans for a maximum term of five years on the basis of the following reasons put forward by Management:

"With the recent appointment of Vice President, Corporate, and Vice President, Administration and Operations, New York Office will have the capacity to pursue the wholesale lending market. Corporates targeted operate in a diverse range of industries with turnover in excess of USD 50.0M. It is considered that the level of experience and qualifications held by senior management justifies the level of delegated authority sought.

... Approval of the detailed delegated lending authority is recommended based on the quality and scope of business opportunities available, and the experience and qualification of New York Office staff within their geographic area."

Whilst the paper recommending the approval of the delegated lending authority for New York branch referred to the individuals to comprise the New York office Credit Committee by name, the paper did not set out any of their qualifications and experience.

In May 1989, the Bank Board approved a delegated lending authority of up to $NZ 3.0M for Auckland branch. The Bank Board approved the establishment of an Auckland branch Credit Committee, whose delegated lending authority permitted secured or unsecured lending for a maximum term of five years. Without advising the Bank Board as to the personalities involved nor their qualifications and experience, the proposal was supported on the basis that:

"Approval of the detailed delegated lending authority is recommended based on the experience and qualifications of Auckland Office staff within their geographic area."

19.4.4 PRUDENTIAL EXPOSURE LIMITS

From time to time, the Bank set maximum exposure limits (both actual and contingent) on any particular account. In July 1985, this limit was 20 per cent of the Bank's "capital base"(), limited to $33.0M, with exposure to a "group" of related accounts being required to be included within the maximum $33.0M exposure, unless specific Board approval was held. Under this policy, higher levels of exposure , could be submitted to the Bank Board for approval in particular cases. The policy also noted that the Bank Board would consider proposals to take on corporate risk outside approved guidelines on the basis that the risk could be sold down to place exposure within prudential guidelines within a period of six months.

The Bank also maintained prudential policies limiting off-shore exposure. In December 1985, the Bank's policy on off-shore exposure was as follows():

(a) off-shore assets limited to 20 per cent of the Bank's total assets;

(b) contingent off-shore exposure limited to 20 per cent of the Bank's "risk assets"(); and

(c) within these broad parameters, off-shore assets not to exceed $600.0M while contingent exposure not to exceed $500.0M.

In December 1985, the Bank Board approved New Zealand country exposures not being recorded in the total of the Bank's off-shore exposures. The Bank Board's approval limited New Zealand assets to 5 per cent of the Bank's total assets, and New Zealand contingent exposure to 5 per cent of the Bank's total risk assets. The Bank Board's approval was required for New Zealand assets to exceed $200.0M, and for contingent exposure to exceed $100.0M.()

In June 1986, the Executive Committee considered a recommendation for increases in the Bank's off-shore exposure limits. The Executive Committee paper noted that the "Bank has recently been able to take advantage of opportunities for rapid growth offshore." () The factors affecting this growth were stated to include the "increased use of swap-based transactions in international debt and capital markets.() The paper, therefore, for the first time, proposed a separate set of off-shore swap exposure limits. Swap transactions, under which the respective parties "swap" interest rate or exchange rate risk, was said to be entered into by the Bank:

"... almost exclusively as interbank transactions. Under the circumstances the counter party to the transaction is a bank subject to supervision and prudential control by the relevant bank regulating authorities." ()

It was also noted in the paper that:

"The Bank is involved in the swap market with a broad range of currencies, interest rate structures and counter parties. The Bank undertakes swap contracts in both directions, ie, from fixed rate to floating rate, floating rate to fixed rate, and both for the forward purchase and forward sale of a range of currencies." ()

Accordingly the following off-shore exposure limits were recommended to the Executive Committee:

(a) increase total off-shore direct exposure limits from $600.0M to 20 per cent of Bank total assets at any time (on the then current balance sheet size this limit was $1,000.0M);

(b) increase off-shore contingent exposure limits to 20 per cent of Bank total assets;

(c) create a separate set of off-shore Swap exposure limits, with assessed limits being restricted to 20 per cent of Bank total assets; and

(d) increase New Zealand country exposure limits to:

(i) direct - 5 per cent of total Bank assets;

(ii) contingent - 5 per cent of total Bank assets; and

(iii) swap - 5 per cent of total Bank assets.

These limits were approved by the Bank Board on 24 July 1986.()

From time to time over the period under review, the Executive Committee and the Bank Board considered and approved adjustments to these prudential exposure limits. In relation to Auckland branch, the Bank Board made substantial alterations to the New Zealand country exposure which is dealt with in Section 19.2.13(e) above.

In my opinion, the Bank Board should have ensured that at all times prudential limits for industry exposure within the London branch corporate loan portfolio were in place. These limits should have been approved by the Bank Board on the basis of a reasoned and substantiated recommendation from management, and such limits, once established, should have been regularly reviewed and reassessed for relevance and effectiveness. Management failed to submit recommendations for industry exposure limits for the London branch to the Bank Board. Notwithstanding this, however, I am of the opinion, that the Bank Board should have directed management to consider and recommend appropriate limits. In evidence to the Investigation, Mr Mallett said that the "emphasis in London was quite deliberately on property." () Mr Mallett explained that the "emphasis" of the London branch on property arose as "the first chief manager [of the London branch] went in and recognised what he believed was an opportunity for the Bank in the property market".() This cannot be described as an acceptable explanation.

In due course a 30 per cent maximum exposure to property in the London branch was established by management.() So far as concerned operations in New York, Hong Kong and Auckland, there is no evidence of the Bank Board approving limits for industry exposure within portfolios for these branches.

In my opinion, the Bank Board's failure to ensure that prudential limits for industry exposure were established, within the portfolios in respect of the overseas branches, is an example of the Bank Board's failure to deal appropriately with the management and prudential issues arising from maintaining remote branches. By 1988, these branches, theoretically, could represent an exposure of 35 per cent of the Bank's total assets. In my opinion, the Bank Board's inaction in this regard left it open to Management to act without Board direction in relation to prudential issues concerning industry exposure within portfolios. As is noted in Section 19.3.1.5 above, the Bank's exposure to property was the substantial factor in the recording of significant non-performing assets by London branch in the February 1991 Report to the Bank Board on non-productive assets.

19.4.5 TREASURY LIMITS

The Bank Board approved policies relating to Treasury dealing limits during the period under review as follows:

(a) October 1985 - limits approved for London branch for: open foreign exchange positions, mismatched forward foreign exchange positions, and money market mismatch positions;()

(b) January 1989 - limits approved for all overseas branches. The limits applied to open foreign exchange positions, money market mismatch positions, and open swap positions;() and

(c) August 1989 - increased limits approved for all overseas branches. The limits applied to open foreign exchange positions, money market mismatch positions, and open swap positions.()

The Investigation noted that the information provided to the Board for money market limits was brief. The paper presented in August 1989 illustrates the point, the following being submitted to the Bank Board:

"MONEY MARKET - Adelaide, London, New York, New Zealand.

Equivalent 91 day mismatch of AUD 750m (Adelaide), USD 300m (New York Office), USD 300m (London Office), and USD 300m (New Zealand office), restricting future losses on a 0.5% adverse rate movement to AUD 935,000/USD 375,000.

Long Futures - for London Office - 100 Long Futures contracts maximum position. Stop loss level GBP 25,000 or its equivalent when positions are to be immediately cut."

It is doubtful that a Board presented with this limited information could make a reliable and/or informed decision on this matter. Given that the London Treasury was operating in the areas of FRA arbitrage and spread trading futures positions, more detailed information regarding limits would, in my opinion, have been necessary for informed approval by the Bank Board.

19.4.6 BANK BOARD DISCUSSIONS CONCERNING OVERSEAS OPERATIONS

A review of the Board Minutes and supporting papers indicated that, in general, the level of information concerning the overseas branches provided to the Bank Board was unduly limited. This is surprising, given the extent of the rapid growth in the overseas operations over the period, and the development of Treasury operations in these locations.

In their evidence to the Investigation, the Non-Executive Directors said that the matter of overseas operations was a consistent and regular topic of discussion. The fact that some discussion in relation to overseas operations occurred at most, if not all, Board meetings is not contradicted by the evidence of Mr Clark. However, at least until the second half of 1990, with the exception of one occasion on 24 March 1988, the Bank Board's Minutes do not record details of discussions specifically on overseas branches. I accept the submission of the Non-Executive Directors that the Bank Board's Minutes did not, and were not intended to record all discussions taking place in the board room. I am therefore prepared to accept the evidence of the Non-Executive Directors notwithstanding the silence of the Minutes except as indicated below.

The following items are extracted from the Bank Board Minutes which record Bank Board discussions on overseas operations issues.

(a) Supervision of Overseas Operations

Expressions of concern by the Bank Board about control and supervision related exclusively to the London branch:

(i) Bank Board discussion 24 March 1988:

"Directors considered that part of the reason for the Bank failing to recognise and act on management problems in London Office earlier was the fact that there was limited contact with management of London Office. It was agreed that in future all managers of overseas operations would come to Adelaide for meetings with Bank management at least twice annually." ()

(ii) Group Managing Director's Overview - 27 September 1990:

"Management continues to be uneasy about London ... I have briefed our London auditors, Peat Marwick McLintock to do a full overview of our London Treasury operation and when this is completed I have asked Robin Sewell to use it as a guide to operate our London Treasury on a much lower risk basis.

Rob Wright has just returned from some weeks in London doing a hindsight review of all corporate loans. His full report is being compiled at present but verbally he has advised me that their loan portfolio is in good shape." ()

The assertion concerning the London branch loan portfolio is inconsistent with the reported non-productive loan risk exposure in February 1991 of $125.0M, by which date some $6.5M of income was uncollected or foregone.

(iii) Bank Board discussion 27 September 1990:

"Directors expressed their concern with London Office. Mr Prowse questioned whether the arrangement of Mr Lynn Todd reporting to Mr Robin Sewell would create any problems. The Group Managing Director advised that he had discussed in detail the situation with Mr Todd and, to date, he had accepted it.

The Chairman was also concerned as he noted in his recent visit to London that Treasury operations were exposing the London portfolio to foreign currency exchange risk."

Matters relating to Treasury operations in the London branch are dealt with in more detail in Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" of the Report.

(iv) Bank Board discussion 14 November 1990:

"The Chairman advised that he had recently met with the External Auditors of London and that they had expressed concern over operations. In addition, he advised that the Bank of England and the Reserve Bank of Australia had commented that the portfolio in London had a high level of exposure to the property market.

Mr Hartley stated that London's over-exposure to the property market suggested that supervision from Adelaide was inappropriate and this, in turn, reflected on International Division management. Mr Hartley questioned what effect the perceived errors in judgement by International management would have on other managers in the organisation.

Directors were assured that Mr Mallett was competent and his new reporting capacity to Director, Banking would ensure that he received adequate guidance and direction. Further, Mr Mallett's performance would be closely monitored."

(b) Management Reporting

Bank Board discussion 26 July 1990:

In this discussion, the Bank Board directed management to present the paper on the operations of the International Banking division, which is reported on in Sections 19.4.2 (b) above.

(c) Overseas Strategy

(i) The report requested by the Bank Board on 26 July 1990 was tabled on 23 August 1990. As noted in Section 19.4.2 (b) above, the Bank Board was concerned about the strategic justifications indicated in the Paper.

(ii) Bank Board discussion 27 September 1990:

"Mr Prowse questioned how much of New York's business operations were directly generated by South Australian entities. Mr Sewell advised that the operations in New York were not dependent upon business being referred from South Australia." ()

Mr Sewell's statement is reinforced by the tabled Board Paper which notes that the Bank at that time "banks 2 South Australian entities".

19.4.7 CONCLUSIONS

My general conclusions with respect to control and supervision of the Bank's Overseas Operations by the Bank Board are included in Section 19.9 below.

 

19.5 CONTROL AND SUPERVISION OF OVERSEAS OPERATIONS BY MANAGEMENT

 

19.5.1 GROUP MANAGING DIRECTOR

The day to day management of overseas operations was the responsibility of Mr Mallett from February 1986. However, Mr Clark played a critical role as the interface between Management and the Board. Mr Clark, together with Mr Mallett, shares responsibility for failing to present the required level of information to the Board in support of proposals for the establishment, and the operations, of the overseas branches.

Whilst the overseas branches reported directly to Mr Mallett and his department, rather than directly to Mr Clark, Mr Mallett regularly briefed Mr Clark on matters relating to the overseas branches. As noted below, Mr Clark was directly involved in negotiations with the Bank of England in relation to the London branch, and in discussions with the Reserve Bank of Australia concerning the Bank's overseas operations.

From his regular discussions with the regulatory authorities, Mr Clark was well aware of their concerns in relation to the London branch's Corporate Banking portfolio exposure to property.() Notwithstanding this, however, Mr Clark did not ensure that loan proposals going forward to the Bank Board (which by nature of the delegated lending authorities were the largest loans, for example, by September 1990, over $25.0M) contained a statement as to the London branch's then exposure to property, and the effect on that exposure of the loan proposal submitted for approval.() With his knowledge of the concerns of the regulatory authorities, Mr Clark should have ensured that the Board was fully informed of the London branch's exposure to property as a relevant factor in considering whether or not to approve the loan proposed.

19.5.2 CHIEF GENERAL MANAGER, INTERNATIONAL BANKING

(a) General

Up until December 1985, International Banking was under the management control and supervision of Mr Hosking and Mr P E Byrnes. In December 1985, after the death of Mr Hosking, Mr Mallett was appointed Acting Chief Manager, International, and was formally appointed Chief Manager, International Banking, in February 1986. In this position, he was responsible for the entire operations of the Bank outside of Australia and reported directly to Mr Byrnes.

In May 1987, Mr Mallett was appointed Chief Manager, Treasury and International, with his portfolio responsibilities being expanded to include the Australian Treasury Operations and the Overseas Treasury Operations. In this position, Mr Mallett reported directly to Mr G S Ottaway. In March 1988, Mr Mallett was appointed General Manager, Treasury and International, and reported directly to Mr Clark. In July 1989, Mr Mallett was appointed Chief General Manager, International Banking, and from January 1991 to the end of the period under review, was Chief General Manager, Corporate and International Banking.

At the time of his appointment as Chief General Manager, International Banking, in July 1989, Mr Mallett maintained responsibility for the overseas branch Treasury Operations; the Australian Treasury Operations became the responsibility of Mr Paddison, then Chief General Manager, Australian Banking.

Each branch was in daily communication with Head Office, and Mr Mallett visited each branch semi-annually, and also met on a regular basis with the Bank of England as the prudential regulator of London branch, and with the Reserve Bank of Australia in relation to the Bank's overseas operations. In addition to the operational aspects of supervision, Mr Mallett was responsible for the appointment of senior staff in the off-shore locations.

As noted above, the delegated lending authority for the Chief General Manager, International Banking, had, by September 1990, reached $16.0M. This delegation was by far the highest lending discretion vested in an individual - the next highest delegation to an individual was $5.0M.() This delegation placed Mr Mallett in a position to significantly affect the Bank's financial performance and asset quality. In addition, Mr Mallett received regular and detailed financial information on the overseas branches. The branches reported their financial positions on a weekly basis to Head Office and prepared a full financial analysis on a monthly basis, detailing profit and loss account and balance sheet.

In my opinion, in light of the above factors, Mr Mallett had a specific obligation to ensure the highest levels of control and supervision of these distant branches. He also had an obligation to keep the Bank Board informed of matters affecting the overseas branches which would enable the Bank Board to give prudential directions to Management in respect of the overseas branches, in particular, directions regarding their operations in particular markets or in particular types of lending.

(b) Mr Mallett's Approach to Control and Supervision of the Overseas Branches

In his evidence to the Investigation, Mr Mallett highlighted the difficulties in adequately supervising and controlling distant branch operations, in particular, the extreme difficulties in adequately monitoring a particular branch's (and therefore the Bank's) actual non-performing asset position, and whether or not that position was a result of a "one-off" event, or was part of, or indicative of, a trend.

Up until May 1990, Mr Mallett did not believe that the London branch's property exposure was going to be a "concern" nor did management of the London branch.() Information concerning the Bank's exposure to property and its non-performing asset situation, was flowing from London branch to head office but this process was susceptible to time lag, and, most importantly, to the level of the accuracy and reliability of the assessment made by the Account Manager as to whether the account was such as to lead to a potential loss by the Bank.

Management in Adelaide head office was in reality, totally dependent upon account managers in the London branch (and in other overseas branches), as indeed within their own head office, to take an independent view of the risk of the asset, and to objectively report on it to Management. Clearly inherent in this approach is the risk that an account manager will not fully and objectively report on an account which may have developed into one exposing the Bank to risk, as this may have been seen to adversely reflect upon the particular officer's own performance, including that officers' initial assessment of the credit risk applicable to a particular loan proposal.

The following extract from Mr Mallett's evidence() succinctly states the very real and substantial exposure taken by the Bank in adopting a "hands-off" approach to control and supervision in its overseas branches:

"The entire bank, whatever its business was, was totally dependent upon the account manager recognising the problem, communicating it then to his manager, his manager then taking the whole picture and communicating it up the line and in London the situation is worse of course because it's 10,000 miles away, and whereas in Adelaide you may have a feeling that something in Adelaide is going ... wrong, you don't rely even, you may not be totally dependent upon your account manager telling you that ...

In London you're totally dependent on the people over there and you're asking me why was the process in hindsight, and I have to agree, slow and it is simply because, I believe, human nature, reluctance to recognise that something you did has gone wrong and having recognised it's gone wrong, the problem compounds because you then rely on other people to tell you how much has gone wrong and you take the initial stab in the dark and there is so much uncertainty and ... other issues that may or may not come to play but the figures ... [are] only relevant at a moment in time."

With his understanding of this most fundamental issue arising in relation to control and supervision of the Bank's overseas branches, it was, in my opinion, incumbent on Mr Mallett to ensure that the highest level of relevant internal control systems were in place, at all times, in order to protect the Bank's interests.

As is noted in other Sections of this Chapter, there was no on-site audit conducted of the London branch for some three and a half years after its establishment. There was no credit inspection function independent of Management in the London branch for some four and a half years after the Branch's commencement of wholesale banking operations. In addition, delegated lending authorities did not restrict lending activities in relation to industry exposures within portfolios. Essential Management information stopped at Mr Mallett's desk that, in my opinion, should have been communicated to the Bank Board.

(c) Information Flow to the Bank Board

As noted earlier in this Chapter, there were substantial discrepancies in the level of information submitted to the Bank Board in support of the recommendations for establishing the various overseas branches when compared to the corresponding Executive Committee paper. This was particularly so in the case of the proposals put forward to the Bank Board recommending the establishment of the Auckland branch.

The Investigation also identified a number of reports on operational matters concerning the overseas branches where information presented to the Bank Board omitted matters that were material and that had been provided to the Executive Committee. The following is an illustration of such a matter. A number of papers submitted to the Bank Board concerning the New York branch omitted any reference to the type of corporate lending undertaken or proposed to be undertaken, by the New York branch. New York branch was, over the period from its establishment to the end of the period under review, actively involved in "Highly Leveraged Transactions" (as noted above, these are corporate loans to a borrower with a debt to equity ratio of 3:1 or higher) and, to a much lesser extent, Mezzanine Finance (subordinated lending).

In November 1987, the Executive Committee paper seeking that Committee's endorsement to the proposal to establish the New York branch(),in so far as this paper considers the proposed nature of corporate finance activities, made the following observation:

"To achieve the returns necessary to justify activity in this market, the Bank must be prepared to consider innovative and complex transactions. Participation in complex structured transactions is central to the profitability of most successful small foreign banks in the U.S."

In evidence to the Investigation, Mr Mallett as the presenter of this paper, confirmed that this paragraph was referring to Highly Leveraged Transactions.() This reference was omitted from the corresponding Bank Board Paper. I regard this as a material omission, in that the Bank Board was not advised of matters that were significant in relation to prudential management of the Bank's risks in the New York branch.

The June 1988 paper to Executive Committee on the establishment of the New York branch() made it clear that the complexity of the financing arrangements proposed for New York branch had significant implications for the required level of staffing skills to adequately protect the Bank's position in these transactions:

"To enter this market successfully, the Bank must develop or acquire the skills to assess complex corporate transactions. Head office must also develop the skills and experience to support this business."

This reference was omitted from the corresponding Bank Board Paper.() I regard this omission, also, as material, as it deprived the Bank Board of the opportunity to assess the risk profile of the New York branch to give appropriate directions to Management for prudential management of those risks.

In December 1989, Mr Mallett presented a paper to the Executive Committee() concerning the formation of a United States subsidiary to assist the New York branch with respect to corporate finance activities. This paper referred to the proposed areas of activity, and included a specific reference to the proposed involvement of the New York branch in "Mezzanine Finance".

All reference to the proposed areas of activity for New York branch were omitted from the corresponding Bank Board Paper.() I regard this, also, as a material omission, which deprived the Board of the opportunity to discharge its obligations as to prudential management of the Bank's risk profile in the New York branch. The Investigation put these discrepancies to Mr Mallett, who in evidence, expressed the view that such matters were not "relevant" () as the Bank was involved in similar transactions (albeit, not known by these particular labels) in Australia.

The following extract of Mr Mallett's evidence clearly indicates his view that matters that fell within Management's delegated authority were matters for Management, and not the Bank Board.

Mr Mallett: "... we were doing mezzanine debt in Australia. Debt is debt and has a higher risk profile. ... but I don't remember going to the Board at any stage and saying, "hey, in Australia," or "hey, in New York, we are doing second tier financing".

Question: You didn't see a need to draw it to their attention?

Mr Mallett: That was Management's responsibility. I don't see that was a Board responsibility at all. Just for the record, if the Board delegated me a discretion, it was a total discretion. That's been my banking experience. If the Board said: you can approve $5m, $10m, that's it.

...

Mr Mallett: I certainly didn't ever go the Board and say: Do you realise, as Board of Directors - or Credit Committee or whatever it was, and say, you know, that in New York we'd done a mezzanine debt, a debt that has a greater risk than senior debt for that particular company ... Maybe I'm not the most experienced person dealing with a Board, but there were some things that I didn't think were the Board's - interest to the Board. I mean, the Board was running a bank, and running a bank we lend money.

...

Mr Mallett: ... so far as I'm concerned the activities of management within discretions were Management's responsibility, not the Board. I wouldn't have gone to the Board and - equity, yes, but not mezzanine.

...

Question: So the type of lending, if it was within discretion, was a matter for Management?

Mr Mallett: Absolutely. Management ought to be accountable for some things."()

Yet, notwithstanding Mr Mallett's views, Management was not unanimous in its appreciation of high risk lending being carried on in New York office, particularly mezzanine finance arrangements which carried spreads of some 8 per cent.

On 14 May 1990, the Executive Vice President, United States of America, in a memorandum to Mr Mallett, raised as a "strategic initiative" a mezzanine financing arrangement with a United States company which was active in this area.

On 24 May 1990, Mr Mallett replied as follows:

"Thank you for this background. My response is a bit late seen (sic) as though I have already approved two transactions ... I would have to make comment that there will be a lot of heartache from various parts of the organisation in regard to the risk profile of some of these transactions. Obviously it is my belief that the risk profile is understood and boxed but other peoples' opinions tend to be influenced by more traditional lending structures ... It is not an area that we should look to grow too quickly. I would really like to see some track records established in some of our existing transactions and the profits banked. It has, however, as you have mentioned, if well managed and properly evaluated, very attractive revenue streams to the Bank."

In evidence to the Investigation, Mr Mallett said that his reference to "heartache" was to certain members of the Executive and Lending Credit Committee.()

Whilst Mr Mallett may be technically correct in his view of delegated authorities so far as the performance of those delegated authorities is concerned, his failure to draw the Board's attention to the nature of the corporate finance activities of the New York office, in view of the fact that the Executive was not unanimous as to the desirability of engaging in this particular form of lending, deprived the Bank Board of the opportunity of deciding for itself whether such lending activity was in the interests of the Bank, and if so, what prudential controls and limitations ought to be imposed in relation to these activities. Morover, Mr Mallett's withholding of the information sits uneasily with his description of the difficulties of exercising effective control over the off-shore branches.

The above is but one of a number of situations noted in this Chapter where the Bank Board was not informed of information from which it could, in discharging its functions, have set in place prudential controls and limitations.

(d) The Lack of Significance to Mr Mallett of the Bank as a "Government Bank"

One matter of particular significance in respect of which Mr Mallett gave evidence was his views as to whether or not the Bank's position as a bank carrying a Government Guarantee required him, as the Chief General Manager in charge of the Bank's overseas operations,to adopt a higher level of attention to internal control systems in order to protect the interests of the people of South Australia as the ultimate "underwriters" of the Bank's liabilities. So far as he was concerned, Mr Mallett did not see anything "special" because of the Bank's status as a Government guaranteed State Bank:

"... Would I have treated [control and supervision of the overseas branches] any differently because it was the State Bank of South Australia? My answer is no. I mean, consistently, it's only in recent times that I'm fully coming to grips with the fact that this is a government bank. I really came into this organisation with no experience of anything other than private banking and for many years it was as though we were a private bank, a board and a Managing Director, or General Manager, whoever, so, no, I didn't treat, I didn't run, did not assume that we had to do anything more special because we were a state bank." ()

(e) Loan Proposals Submitted to the Bank Board

As is noted in Section 19.7 below, Mr Mallett was in regular contact with the Bank of England and attended prudential consultations with the Bank of England and the Reserve Bank of Australia.() In his evidence to the Investigation, Mr Mallett stated that:

"Every time London [branch] did a credit paper, they would always put down their industry exposure." ()

A review by the Investigation of a selection of property secured loan proposals presented to the Bank Board identified only one occasion on which London branch's exposure to property was shown.() This proposal was presented to the Bank Board in March 1990, and indicated London branch's then exposure to property as 27.5 per cent of total London branch risk assets, with a forecast increase to 29.2 per cent having regard to "recent approvals" and on the basis that the proposal then before the Bank Board was approved.

In my view, having regard to Mr Mallett's knowledge as to the concerns of the regulatory authorities concerning London branch's exposure to property, it was incumbent upon him to ensure that, in all cases, this information was drawn to the attention of the Bank Board. This would have enabled the Bank Board to fully assess the risks involved in the loan proposal. These risks would include not only the risks inherent in the particular loan proposed, but also the risk arising from "portfolio exposure" to one particular "industry". I am of the view, that Mr Mallett failed in his duty to the Bank Board, and to the Bank, in not presenting information relating to London branch property exposure.

At the same time, however, in my opinion, the Bank Board should have required Management to present information to the Bank Board on risk concentration and the implications for the Bank's risk profiles in the London branch in relation to its property exposure.

19.5.3 CHIEF MANAGER OF EACH BRANCH/OFFICE

The Chief Manager in each overseas office had responsibility for the daily operations of that office. The extent of responsibilities varied from office to office, depending on the level and range of activities within the office concerned. These matters are discussed above in Section 19.3 of this Chapter.

19.5.4 CONCLUSIONS

My general conclusion with respect to control and supervision of the Bank's overseas operations by Management are included in Section 19.9 below.

 

19.6 INTERNAL CONTROLS AND THEIR REVIEW

 

19.6.1 INTERNAL POLICIES AND PROCEDURES

In my opinion, the nature of the operations of the overseas branches would, as a matter of prudential financial management, require the following policies and procedures manuals:

(a) Corporate Banking - covering the preparation of loan proposals, the loan approval process (including approval limits), security exposure monitoring (counter-party, industry, country), loan management, and loan administration();

(b) Treasury - covering dealing procedures, exposure monitoring, and operations procedures;

(c) Accounting;

(d) Reporting; and

(e) General - covering budgets, business plans, strategic plans etc.

The manuals that have been made available to the Investigation dealt with some, but not all, of these areas.

(a) London

(i) Office Policy (1985);

(ii) Procedures Manual (1988); and

(iii) Asset Based Financing Operations Manual (1990).

(b) New York

(i) Reporting and Procedures (1988);

(ii) Operating Procedures/Accounting (undated);

(iii) Loan Administration - Operational Procedures (undated); and

(iv) Treasury Operations (1991)

(c) Auckland

(i) Procedures Policy (1989);

(ii) Banking Division Manual (1990); and

(ii) Treasury Manual (Security Pacific NZ, 1987).

(d) General

(i) International Finance Policy (1990);

(ii) International Finance Procedures (undated);

(iii) International Banking (1987);

(iv) Policy/Procedures - Treasury (1989);

(v) Corporate Banking: Accounting, Policies and Procedures (1989);

(vi) Group Credit Manual (1991);

(vii) Commercial Lending (1985); and

(viii) Global Treasury (1991).

The off-shore branches/offices had individual policies and procedures manuals as well as those applied to the Bank as a whole. As will be noted later in this Chapter of the Report, in some cases, individual offices either did not maintain specific procedures manuals (eg Hong Kong - Lending) or did not keep the manuals up-to-date (eg London).

19.6.2 GROUP INTERNAL AUDIT

On-site Internal audits of the overseas branches were first performed in May 1989, when London branch was audited, after having operated in wholesale banking since October 1985. The audits of overseas branches that were performed, and which had relevance to matters occurring during the period under review were as follows:


Branch/Office

Rating
(by Internal
Audit Department)

London (commenced wholesale banking
operations October 1985):

May 1989

Limited compliance audit

None Applied

July 1990

Corporate Banking

Unsatisfactory

August 1990

Treasury Operations

Satisfactory Minus

May 1991

Corporate Banking;

Accounts Payable;

Staff Related Issues

Satisfactory Minus

June 1991

Treasury

Satisfactory

Hong Kong (established April 1987):

August 1990

Preliminary audit review

None Applied.

New York (established November 1988):

May 1989

Audit of New York office

None Applied

July 1990

Treasury Operations

Excellent

August 1990

Corporate Banking

Unsatisfactory

June 1991

Corporate Banking

Satisfactory Plus

June 1991

Treasury Operations

Satisfactory Plus

Ackland (established December 1988):

June 1990

Corporate Banking

Satisfactory

June 1990

Information systems

Unsatisfactory

March 1991

Treasury

Satisfactory

The Bank's failure to secure early on-site internal audit review of internal control systems in the overseas branches is reported in detail in Chapter 23 - "Internal Audit of the State Bank". So far as concerns this Section of this Chapter, I am of the view that the significant delay in securing adequate and effective on-site inspection by Internal Audit department of the overseas branches' internal control systems is a serious failure on the part of the Bank Board, Mr Clark, and Mr Mallett, to discharge their obligation for the prudential management of the Bank's assets.

So far as concerns New York branch, the very nature of the lending activity conducted by that branch, and the growth in assets reported in respect of that branch imposed a particular obligation on the Bank Board, Mr Clark and Mr Mallett. The Board and the two executives concerned had a responsibility to ensure that there was a regular review, independent of Management, of the internal control systems in place to manage the Bank's risks. Any such review would assess the effectiveness and relevance of the internal control systems, and recommend new or improved systems.

I regard the delays in securing on-site internal audit reviews of the London branch and the Auckland branch as a significant failure by the Bank Board and management to adequately discharge their respective responsibilities.

As appears above, Auckland branch inherited its most substantial non-productive assets from either Security Pacific or Corporate Banking, Head Office. Notwithstanding this, ongoing management of the Bank's exposure required maintenance of effective and relevant internal control systems, and these should have been reviewed earlier than 19 months after establishment of the branch.

So far as London branch is concerned, the absence of effective internal audit review is a most significant failure of the Bank on the part of the Bank Board, Mr Clark, and Mr Mallett, to protect the interests of the Bank. For the reasons indicated in Chapter 23 - "Internal Audit of the State Bank", I do not regard it as appropriate or justifiable that the Bank Board, Mr Clark, and Mr Mallett seek to rely upon the activities of the external auditors. The failure to secure even the most rudimentary on-site internal audit review of internal control systems for three and a half years after the establishment of the London branch is, in my opinion, a failure on the part of the Bank Board, Mr Clark and Mr Mallett of their respective duties to protect the interests of the Bank.

19.6.3 WHOLESALE CREDIT INSPECTION

A memo dated 16 February 1990 from Mr Mallett to the Director, Australian Banking, proposed the establishment of a Wholesale Banking Credit Inspection Team with responsibility for reviewing the loan activities of International Banking, Corporate Banking and Business Banking. The Wholesale Credit Inspection Section was then established in 1990 and consisted of one person, Mr Wright, who performed the inspections. Reports were produced for London branch (August 1990) and for Hong Kong office (January 1991):

(a) London

The report on the London branch was based on a review of all accounts on the lending portfolio and concluded that:

"... to the best of my assessment, there are no problem or potential problem loans on London's books which London Office has not already identified and is reporting upon together with appropriate action plans in place".

This report noted that, in 18 cases, annual reviews of loans had not been carried out in a timely manner, but that accounts due for review were being closely monitored by London management on a formal basis.

The executive summary noted that:

"The present state of the UK property market causes some concern and has resulted in a small number of property loan borrowers defaulting. However, all are subject to strong management control and various strategies are in the course of negotiation which are expected to enable London Office to manage these accounts out of trouble over a period without (on present indications) possibility of loss".

As noted earlier, this conclusion is contradicted by the February 1991 Non-Productive Assets Report() to the Bank Board only some 6 months later, as well as the findings of an Internal Audit report of May 1991() which expressed serious concerns about the quality of the London branch loan portfolio. Mr Wright has given evidence on this matter, that satisfies me that the change in circumstances in the London portfolio is not attributable to a lack of care on his part in carrying out this inspection.

(b) Hong Kong

The report on the Hong Kong office portfolio concluded that there were "no problem loans" but "two exposures do require close attention".

Given that London branch had been engaged in wholesale banking activities since September 1985, and that New York office in particular had been involved in high risk corporate lending from November 1988, the question naturally arises as to why it was not until February 1990 that the proposal for the establishment of a Wholesale Credit Inspection Unit was put forward. This question is partially answered in the paper itself:

"We have to date, deliberately chosen not to introduce a credit inspection procedure for the wholesale side of the Bank. This has centred around several issues, one being the dynamic growth of the business and our concentration on this area rather than a review of the credit implications and, that with little delegation of authority, arguably credit review could only question senior management's decision ... It is a common practice in all major banks globally, to have a delegated lending inspection team who, operating under appropriate policy guidelines, review on an annual basis, all lending activity." [Emphasis Added]

In evidence to the Investigation, Mr Mallett explained that the principal reason for the delay in the establishment of a wholesale credit inspection unit was that most of the lending was "new lending" and wholesale credit inspection review was not therefore required:

"Mr Mallett: ... As far as I was concerned with international the majority of my lending was new lending but it had only been done in the past 18 months, ... the dramatic growth in New York, that was my [catalyst] for credit inspection."

Even though London branch's lending activities had been in place for some four and a half years by that time, Mr Mallett did not see that as a compelling factor:

"Mr Mallett: [London book] didn't worry me ...

Question: It was New York that concerned you?

Mr Mallett: Yes.

Question: And why was it New York that concerned you and not London?

Mr Mallett: Because New York had a different style of book. It had grown quickly ... It was predominantly lending of a more complex analytical type.

...

Mr Mallett: ... The catalyst in my mind was New York growing book, a growing balance sheet, a more complex lending. London, as we said earlier, was bread and butter lending. It was very simple banking ... So I wasn't that concerned about having it reviewed. I mean, there wasn't any urgency to get a review, bearing in mind that it was looked at every six months by the external auditors and the reporting accountants. They reviewed our loan portfolio ..."

In his evidence to the Royal Commission, Mr Clark made the following observations in relation to the failure to introduce a credit inspection procedure for the wholesale side of the Bank.

"Question: ... Were you aware of that type of comment being uttered by middle management.

Mr Marcus Clark: That paper is addressed to me.

Question: And is it correct that there had been a deliberate decision not to introduce a credit inspection procedure of the wholesale side of the Bank.

Mr Marcus Clark: Yes, that was true at that stage.

Question: Whose decision was that.

Mr Marcus Clark: Mr Mallett's, because we did have a different method of credit processing and approval in New York and London to that in Australia."

The external auditors of London branch did carry out an audit of that branch for the purposes of its reports to the Bank of England, and also reported on internal systems and controls. The Investigation did not sight any evidence that the external auditors of London branch were charged with the responsibility of assessing, from a credit perspective, the London corporate book, and reporting on that book to Management and the Bank Board in a way designed to assist the Bank Board to set prudential limits and controls in respect of that branch's activities. Any purported reliance on the external auditor to discharge this role was, in my opinion, misplaced.

19.6.4 EXTERNAL AUDIT

As all overseas operations were consolidated into the Bank's financial statements, all were, to this extent, subject to external audit.

The Auckland branch operations were conducted as part of SBSA (NZ) and so were the subject of a specific statutory external audit. The other overseas operations, however, were conducted through branches, so "branch-specific" statutory audits were not required.

In 1990, KPMG Peat Marwick McLintock, the London branch external auditors, reported to management on certain matters arising from limited audit procedures of London branch as part of the Bank's statutory audit. In October 1990, that firm reviewed Treasury Operations in the London branch to determine the cause of a GBP 0.5M loss, and, in March 1991, KPMG Peat Marwick McLintock investigated the events surrounding the identification of an unexpected deferred charge of GBP 0.4M in the balance sheet of the London branch, which had occurred during the period under review.

In addition to this work, the external auditors in London prepared regular reports to the Bank of England on the branch's prudential returns, and on its reporting and internal control systems. The role of the external auditors in relation to London branch is dealt with in detail in Chapter 23 - "Internal Audit of the State Bank".

In January 1991, KPMG Peat Marwick performed limited audit procedures in the New York office as part of the Bank's statutory audit.

Matters relating to the performance by the external auditors of their responsibilities as such in relation to the Bank, will be dealt with in detail in a subsequent report.

 

19.7 REGULATORY AUTHORITIES

 

This Section of the Report deals with communications between the Bank and the regulatory authorities, the Reserve Bank of Australia and the Bank of England. As discussed in Chapter 15 - "The Relationship with the Reserve Bank of Australia" of this Report, the Bank was not legally subject to the Reserve Bank's supervisory jurisdiction. It was, however, subject to the jurisdiction of the Bank of England with respect to the activities in the United Kingdom. The focus of this Section is on those communications that relate to the Bank's overseas operations. Initially, a chronological analysis of the consultations is presented, at the end of which I present my conclusions on this particular topic. In some instances, to assist the reader, I present observations in the course of presenting the chronology.

Regular meetings were held by management with both the Reserve Bank of Australia and the Bank of England. Annual "Prudential Consultations" were held between the Bank and the Reserve Bank of Australia. As appears below, not all matters raised by the regulatory authorities in these Prudential Consultations were reported to the Bank Board, and, in most instances, there are substantial contradictions between the Reserve Bank of Australia's record of a particular meeting, and the Bank's record of the same meeting.

(a) 1985 Consultations

On 23 October 1985, Mr Clark, Mr K S Matthews, Mr Byrnes, Mr Ottaway, and Mr C W Guille, on behalf of the Bank, attended a Prudential Consultation with the Reserve Bank of Australia. The Reserve Bank's record of this meeting noted that the Reserve Bank observed that, during the course of this consultation, the Bank's "aims for its London operations seemed quite ambitious"  and that, in response, the Bank said that it felt "comfortable with their plans for London and did not believe that they were ambitious or unwise."

At its meeting on 24 October 1985, the Bank Board was advised that the Prudential Consultation had taken place. In relation to the matters raised by the Reserve Bank of Australia concerning the London branch, the minutes simply note:

"Discussions centred on prudential arrangements in place by the Bank to prevent business risk." ()

(b) 1986 Consultations

The Prudential Consultation with the Reserve Bank of Australia held on 12 September 1986 was attended by Mr Clark, Mr Matthews, Mr G T Hazel (General Manager, Treasury and Capital Markets division), and Mr D C Masters (Chief Manager, Corporate Banking).

In this meeting, Mr Clark commented on the Bank Group's significant expansion over the previous year and the Reserve Bank of Australia's minutes record the following:

"Mr Marcus Clark responded that the group had expanded by 56 per cent in the past year and that this rate of growth was too fast; he suggested that growth exceeding 30 per cent could lead to indigestion." ()

Mr Clark was recorded as identifying London branch as a significant contributor to the Group's growth.

The Investigation was unable to locate any written report on this Prudential Consultation to the Bank Board or notes of an oral presentation of the matters raised.

(c) 1987 Consultations

The operations of the London branch, in particular its internal control systems and head office's supervision, direction and control, over London branch, was raised again by the Reserve Bank of Australia at a Prudential Consultation held on 15 October 1987.() This consultation was attended by Mr Clark, Mr Ottaway (at that time General Manager, Corporate and International Banking), and other executives of the Bank. Mr Mallett was not in attendance. At this meeting, Mr Clark referred to recent "problems" in London "due mainly to losses on forex operations" and "loss of some key staff".()

The Investigation was unable to locate any report on the proceedings of this Prudential Consultation to the Bank Board either written or oral.

(d) 1988 Consultations

On 12 May 1988, Mr Matthews and Mr Copley attended an ad hoc meeting with the Reserve Bank of Australia. During the course of this meeting, the Reserve Bank of Australia again expressed its concern as to supervision, direction, and control, of the Bank's overseas operations.()

The Prudential Consultation between the Reserve Bank of Australia and the Bank on 15 November 1988, which was attended by Mr Matthews, Mr Ottaway, Mr Copley and Mr Mallett, on behalf of the Bank, addressed a number of significant issues in relation to the Bank's overseas operations.()

The Reserve Bank of Australia's minutes of this Prudential Consultation record the following matters relevant to the Bank's overseas operations:

"Mr Kelleher [Reserve Bank] drew Mr Matthews' [the Bank] attention to a number of aspects of the bank's operations that were causing us some concern. These included ... offshore expansion of activities (including the Bank's recent establishment of operations in New York and now its proposed New Zealand branch). Mr Kelleher noted that the underlying rate of growth of the Bank may be too fast and we were concerned to ensure that the bank's management systems could properly monitor and control risks associated with this level of business.

Mr Kelleher drew attention to the Bank of England's concerns about the level of the UK branch's investment in property. Mr Mallett was [surprised] by this statement as the bank had heard no unfavourable comment from the B of E and as far as he was aware that institution was quite happy with SBSA's level of property lending." [Emphasis Added]

This account of the proceedings is totally at odds with the report of the meeting to the Bank Board, prepared by Mr Matthews, which states:

"Reserve Bank commented that they were satisfied with our offshore arrangements and advised that they had not had any adverse comments from regulatory authorities in the various areas." ()

Mr Matthews' report was tabled at the meeting of the Bank Board on 24 November 1988 and the Bank Board Minutes record the following in relation to that report:

"The Reserve Bank were satisfied with the Bank's offshore arrangements and advised that they had not had any adverse comments from regulatory authorities in the various areas." ()

(e) 1989 Consultations

On 16 November 1989, the Prudential Consultation with the Reserve Bank of Australia was attended by Mr Matthews, Mr Copley, Mr Guille, and, for part of the meeting, by Mr Mallett, Mr Paddison and Mr Gobbett (Chief Economist) on behalf of the Bank.()

The Reserve Bank's minutes of this Prudential Consultation record that during the course of this meeting, the Reserve Bank of Australia observed that the Bank's New Zealand activities had expanded rapidly and that it "would have to doubt the wisdom of that expansion ..." and that in reply, Mr Matthews said that:

"... SBSA was not unique in seeking to build up its assets in NZ, with all of the majors currently building assets there ... Assets had, of course, been built recently through the Security Pacific acquisition, which SBSA saw as simply too good a deal to let pass." ()

The Reserve Bank of Australia also expressed its concern to the Bank as to the growth in the Bank's overseas operations generally:

"Mr Kelleher [Reserve Bank] said that it was difficult to ignore the significant growth in the bank's overseas operations during the past year. He added that, from our perspective, we had some difficulty in understanding the Bank's strategy for being offshore, given the extra risks involved and finer returns relative to business in Australia." () [Emphasis Added]

As is noted below, this issue was reported to the Bank Board.

The Reserve Bank minutes record the following response by Mr Mallett on behalf of the Bank:

"In response to Mr Kelleher's noting of high level of property exposure [Mr Mallett] agreed that this is the case but pointed out that in five years' presence in market, no losses/defaults encountered. Have had long discussions with B of E in relation to the branch's property exposures and believe B of E are comfortable with position." ()

I do not regard the statement attributed to Mr Mallett concerning "defaults" in relation to property lending activities in the London branches as correct. Mr Mallett was aware from the Lending Credit Committee review of potential bad debts as at 28 June 1989 of a default in respect of a property secured loan in London branch. Furthermore, I do not accept the statement attributed to Mr Mallett as regards the Bank of England. In evidence to the Investigation, Mr Mallett conceded that he was aware, at least by 1988, that the Bank of England was concerned with the Bank's exposure to the United Kingdom property market.()

The proceedings of the Prudential Consultation held on 16 November 1989, were reported to the Bank Board in a paper presented by Mr Matthews dated 17 November 1989. This Board Paper stated:

"As far as State Bank Group operations were concerned, the Reserve Bank did not raise any matters of serious concern. However, it was apparent that the Reserve Bank is expecting some slowing in the growth of the group consisted (sic) with minimising risk in difficult times."

Attached to this Board Paper was a file note of the proceedings of the Prudential Consultation which contained no reference to the Reserve Bank's expression of concern as to the high level of property exposure in the London branch. This file note did, however, refer to the Reserve Bank's views concerning the importance of supervision, direction, and control, of the Bank's overseas operations, in the following terms:

"... At all times (and for all banks) it was important to closely monitor and understand the risks in the businesses of offshore offices ..."

The Bank Board Minutes() do not indicate that the Bank Board directed management to present a report on the "risks" inherent in the business of the off-shore branches.

On 29 November 1989, the Reserve Bank of Australia's New York representative attended a Prudential Consultation with Mr Sewell, the head of the Bank's New York operations. The Reserve Bank's minutes of this meeting record that during the course of this consultation, the Reserve Bank sounded a warning concerning the New York branch's spectacular growth in assets:

"We drew out the great risks that exist in rapid development of lending business, and the need to be sure that the pace of growth does not exceed the capacity of systems, management resources, and experience in the markets and lending business being developed ... The striking growth in lending which has been achieved in the initial year must be a cause for some reservations." () [Emphasis Added]

The Investigation could find no evidence of any record of this meeting being presented to the Bank Board.

(f) 1990 Consultations

The 1990 Prudential Consultation was held on 29 August 1990 with Mr Clark, Mr Mallett, and other senior officers in attendance.

The Reserve Bank of Australia's record of this meeting in relation to the Bank's overseas operations concentrates principally on concerns with respect to supervision, direction, and control, in relation to the United Banking Group. The London branch's exposure to property was, however, again discussed. The minutes of the Reserve Bank of Australia record the following responses by Mr Mallett on behalf of the Bank:

"The London property portfolio, which has rated a special mention at recent meetings with SBSA both here and in London, has been built up over 5 years and is well secured. The Bank is involved in no development projects. Mr Mallett said that the Bank could not foresee any problems unless property values fell by 30/40 per cent. Mr Austin [Reserve Bank] remarked that such falls might not be uncommon in a shakeout."

On 27 September 1990, the proceedings of the Prudential Consultation were reported to the Bank Board in a paper prepared by Mr Guille.() Neither the Bank Board Paper, nor its attached diary note, make any reference to the Reserve Bank of Australia's, now many times repeated, reference to concerns about the London branch's property exposure.

The Bank's growth in its overseas operations was the subject of particular attention during the course of the 29 August 1990 Prudential Consultation. This matter was reported to the Bank Board in the following extract from the diary note attached to the Board Paper:

"Mr Austin [Reserve Bank] recalled that at the last consultation, the RBA had expressed concern at the rapid growth of the State Bank Group and queried asset quality, management resources, overseas operations and controls over subsidiaries. In the intervening period, assets had grown over 40 per cent, asset quality had deteriorated and Beneficial had emerged as a problem. In addition, Mr Austin said the RBA had considerable difficulty understanding why the latest profit plan anticipated further strong growth, particularly overseas ...".

The Bank Board Minutes record that the paper was "noted" and that:

"Mr Guille advised that feedback from the Reserve Bank was generally positive and that the Reserve Bank's understanding of our business was most helpful. There was some areas of concern, particularly in relation to Beneficial Finance, which would continue on the agenda for regular discussions."

Having regard to all the evidence stated in this Chapter, I am of the opinion that this record in the Bank Board Minutes was misleading as to the nature of the matters dealt with during the Prudential Consultation.

On 6 November 1990, the Bank met with representatives of the Bank of England and the Reserve Bank of Australia in Adelaide. This meeting was attended by Mr Clark and other executives on behalf of the Bank. At this meeting, the matter of the London branch's exposure to the United Kingdom property market was yet again a topic of discussion. The Reserve Bank of Australia's minutes of this meeting record that:

"[Mr Clark] noted that Mr Anderson [Bank of England] had cautioned him every year about property." ()

The Bank's own record of the meeting with the Bank of England on 6 November 1990 notes:

"We were aware the London book was unbalanced in terms of its property exposures, and the situation would be corrected." ()

The Investigation sighted no evidence of any report of this meeting being presented to the Bank Board.

On 21 November 1990, Mr Clark and other senior executives of the Bank again met with the Reserve Bank of Australia, and yet again the London branch's exposure to property was a topic of discussion.() The diary note made by the Bank observed:

"The RBA was told that we were restructuring our loan books in New York and London. In London our exposure to property was being reduced along with a general scaling down of operations." ()

This diary note was presented to the Bank Board at its meeting on 22 November 1990. The minutes of this meeting contain no reference to the Board being advised that the matter of London branch's exposure to property had been the subject of repeated expressions of concern by the Reserve Bank of Australia and the Bank of England.

(g) 1991 Consultations

On 9 January 1991, Mr Mallett met with the Bank of England with the matter of the London branch's property exposure again being discussed. Mr Mallett's diary note of this meeting contains the following record:

"[Mr J Anderson (Deputy Head of Banking Supervision division), Bank of England] emphasised that their concern in regard to the Banking systems exposure to property in the UK was now being fully justified. In regard to our own activity, they would like to see the exposure reduced to within 30% of our balance sheet. [Mr Mallett] responded that the 30% level was a bank policy and its current breach related to [a property] transaction which had been transacted outside of Board approvals ... It was agreed that [the Bank] would move to sell down the [property transaction] exposure and other property exposure that was necessary to achieve these levels." ()

On Mr Mallett's return to Adelaide, he wrote to the Bank of England advising that, following a review of the London branch:

"... we will endeavour to bring back the level of property commitments in relationship to total income earning assets to 30% or less by 30th June 1991. This reduction includes a sell-down of the [property transaction facility referred to above]." ()

(h) Other Significant Issues Raised

Apart from the recurring expressions of concern by the regulatory authorities as to the growth of the Bank's balance sheet, and London branch's exposure to the United Kingdom property market, there were other significant issues which were raised by the Reserve Bank and the Bank of England from time to time as follows:

(i) Control and Supervision of the London Branch

This issue was raised at the Bank's meeting with the Bank of England and the Reserve Bank, on 6 November 1990, in Adelaide. Mr Guille's file note reads:

"Mr Clark said that as far as London operations were concerned, steps were being taken which would see some major changes in focus and organisational reporting." ()

This issue was raised again at a meeting with the Reserve Bank of Australia held on 14 January 1991; Mr Paddison and Mr S C Targett attended on behalf of the Bank. The Bank's record of this meeting reads:

"Les Austin [Chief Officer, Bank Supervision, Reserve Bank of Australia] also stressed that the RBA [Reserve Bank] were keen for Head Office to take an active role in the supervision of London Treasury." ()

At a meeting between the Bank of England and Bank Director, Mr Bakewell, held on 11 April 1991, the Bank of England expressed its concerns about the administration and control of the London branch during the period under review in the following terms, noted in Mr Bakewell's Trip Notes:

"[The Bank of England was] of the view that the administration and control of the London activities of the SBSA had been at the best lax ... we [SBSA] seemed to have taken positions which other more mature overseas banks had declined and [the Bank of England] put this down to our [the Bank] desire to make the "entity a profit centre"."

(ii) The Performance of the London Branch

At the Bank's meeting with the Bank of England and the Reserve Bank of Australia on 6 November 1990, in Adelaide, the Bank of England presented statistics comparing the Bank's London branch's performance with that of 66 other overseas banks under its supervision. The London branch's return on assets, operating expenses as a proportion of total assets, and bad debt expense as a proportion of average receivables, were all considerably worse than the average for the 66 other overseas banks.()

As I observed earlier in my commentary on the 1990 consultations with the regulatory authorities, the Investigation sighted no evidence of a report on proceedings of this meeting being presented to the Bank Board. This clearly was information which should have been presented to the Bank Board by Mr Clark in order to enable the Bank Board to consider the continuation of the Bank's London branch operations.

(iii) The Size of the London Branch Loan Portfolio

At a meeting with the Reserve Bank of Australia in London on 22 November 1989, the Reserve Bank of Australia commented on the London branch's balance sheet "footings" (ie total assets). The Reserve Bank's minutes of this meeting record that they were advised by the Chief Manager, London branch, Mr Wilcox, that:

"... future growth will be dependent on the opportunities available but that the [1990] budget permitted footings to increase to GBP 600 million if the opportunity arose." ()

The Bank of England's concern about the size of the London branch's loan portfolio was again covered at a meeting attended by the then Chief Manager, London branch, Mr Lynn Todd on 19 May 1990. The Bank's record of this meeting reads:

"[Mr C Mann queried] the increased corporate loan book compared to a year ago and we were able to confirm that we were within our budget ..." ()

(i) Observations on Consultations Between the Bank and Regulatory Authorities

Having regard to the matters detailed above, I am satisfied that there was a substantial flow of information to Mr Clark, Mr Mallett, and other Bank executives in Adelaide, regarding the concerns of both the Bank of England and the Reserve Bank in relation to the Bank's overseas operations generally. This was particularly so in relation to the growth in the Bank's overseas assets, and the level of property exposure in the London branch.

The expressions of concern by the regulatory authorities in relation to the level of exposure in the London branch to property was first recorded as being raised in the Reserve Bank of Australia's Prudential Consultations in November 1988, and repeated regularly thereafter.

On the evidence described in this Chapter, I am of the opinion, that neither Mr Clark, Mr Mallett, Mr Matthews nor Mr Guille fully and adequately related to the Bank Board the expressions of concern by the regulatory authorities as to the growth in the Bank's overseas assets, and as to the London branch's level of property exposure. Accordingly, the Bank Board was denied the opportunity of assessing the Bank's overseas risk profile and of setting appropriate prudential controls in place in order to protect the interests of the Bank.

Of significant concern is the fact that Management adopted a deliberate bias in the portfolio of the London branch in favour of property exposure, and that this continued without amendment until very late in 1990, notwithstanding the clearly expressed concerns of the Reserve Bank of Australia and the Bank of England. In my view, it is a serious omission, on the part of both Mr Clark and Mr Mallett, to have failed to specifically bring to the Bank Board's attention the fact that the London branch's portfolio was deliberately biased in favour of property in spite of the expressed concerns of the prudential regulators.

In so far as Mr Matthews and Mr Guille recorded meetings with the regulatory authorities, and reported upon these to the Bank Board, on the basis of the evidence, I am satisfied that the records so made and the reports so presented, failed to fully and accurately report the nature of the discussions held with the prudential regulators.

The reports which were presented to the Bank Board, however, in my opinion, contained sufficient warning signals to the Bank Board to put it on notice that it was required to obtain further information from Management concerning the Bank's overseas operations, in particular, the London branch. In addition, the Bank Board should have been on notice as to the prudential supervision and control issues arising in respect of the Bank's operations, having regard to what was reported to the Bank Board in relation to the prudential consultation held on 16 November 1989. The Bank Board should have demanded from Management a greater level of detail in order for it to properly discharge its responsibilities to the Bank.

So far as concerns other matters raised by the prudential regulators, as noted above, I regard the fact that the prudential regulators found it necessary to draw the Managing Director's attention to concerns about the control and supervision of the London branch as indicative of a serious deterioration in such control and supervision which put at risk the Bank's assets. Both Mr Clark and Mr Mallett must bear responsibility for this situation.

I also regard the information relayed by the Bank of England to Bank Management on 6 November 1990 as consistent with its statement to Mr Bakewell that the Bank took positions in the United Kingdom which "other more mature overseas banks had declined". There is no evidence of the Bank of England's statistical information provided at the meeting on 6 November 1990 being presented to the Bank Board. In my view, it was incumbent on Mr Clark to present this information to the Bank Board in order for it to determine for itself whether, on profitability grounds, the continuation of the London branch operations was justified.()

 

19.8 SOME ISSUES RAISED BY REVIEWS OF OVERSEAS OPERATIONS

 

19.8.1 LONDON BRANCH

Various reviews of London branch by both internal and external parties gave rise to a number of consistently recurring issues. The following Section of this Chapter reviews the particular areas of concern regarding the Bank's overseas operations, and the occasions on which these matters were raised at various levels within the Bank management.

(a) Internal Control Systems - Treasury and Operations

The internal control systems within the London branch were reviewed during the period by a number of parties independent of management:

(i) Bank Group Internal Audit;

(ii) KPMG Peat Marwick McLintock; and

(iii) Bank Wholesale Credit Inspection.

The most significant of the concerns raised by these reviews were:

(i) Internal Audit Report - May 1989

This report noted that in the New Products area there was a lack of segregation of duties. There were also no written procedures in this area. In addition, there were no back-up computer facilities available. Management controls within Treasury were reported as of a "good standard" and within Corporate Section as of a "high standard" with management controls within Accounting Section being described as "adequate".

The Internal Audit department report for the year ended 30 June 1989, which was "noted" by the Bank Board at its meeting on 24 August 1989, recorded that:

"An audit was conducted on London Office for the first time, in April/May 1989. Recommendations were made for improving internal controls within the new products area and accounting standards. Overall, the London Office controls were adequate and performing satisfactorily."

I regard the report to Board as accurately reflecting the findings of the report on the audit of London branch.

(ii) External Audit (KPMG Peat Marwick McLintock) Management Letter - Audit 30 June 1990

This management letter noted that the following matters, inter alia, "required a high level of attention":

. Limits on off-balance sheet activity were monitored by the dealers themselves;

. The branch's risk management systems were not able to produce reports of interest rate gap exposures;

. There was a need for closer supervision of the prudential reporting process; and

. Accounting entries relating to accruals for FRA deals not adequately controlled.

There is no evidence that either this Letter to Management or a summary of its findings was presented to the Bank Board.

(iii) Internal Audit report: Treasury Operations - August 1990

Internal Audit stated in this report that it had "formed the opinion that the level of internal controls are less than satisfactory" for the following reasons:

. Inadequate segregation of duties between Treasury Operations and the Accounting Function;

. No formal written policy outlining procedures for the management of gap exposures nor an adequate computer system in place to report gap exposures;

. Limits monitoring by Credit Control does not include all Treasury products, and limits monitoring of off-balance sheet products was performed by Treasury dealing personnel;

. No system was in place to manage adequately swap commitments. The monitoring of positions and the recording of deals were not segregated from dealing activities; and

. The policy and procedures manual (produced June 1988) did not reflect current London branch business.

The main effect of the above weaknesses in the internal control environment was to undermine the level of control that London branch management could achieve. The segregation of duties within the Treasury area is of great importance to ensure that accounting and management reporting systems function correctly. Without this control, there is the possibility that the Bank could be exposed to market risks because of the inaccuracy or inadequacy of management information.

There was the major risk of dealers incurring an exposure that could result in an unacceptable level of risk and possibly loss.

A summary of the findings of the Internal Audit Report on London Treasury Operations was presented in the Internal Audit department Quarterly Report to September 1990. The audit of London branch Treasury Operations was graded Satisfactory Minus, and the following was indicated to the Bank Board:

"Major concerns identified include no formal written policy outlining procedures for the Management of Gap exposures or an adequate system in place to report Gap exposures, inadequate limits monitoring, no system in place to adequately manage London's AUD $9B worth of Swap commitments and a General Ledger accounting system which does not meet London's accounting requirements. London Management are taking steps to address these deficiencies."

This report was presented to the Audit Committee on 20 November 1990, which directed that future Quarterly Internal Audit Reports include Management's response to problems highlighted, and steps being taken to resolve these issues. The minutes do not record any substantive comment by the Audit Committee on the above findings.

(b) Internal Control Systems - Credit

The points raised by the various reviews related to the delays in the annual review of loan accounts and the insufficient detail provided in credit documentation:

(i) External Audit Management letter - Audit 30 June 1990

This Management letter noted that there was a need to produce "more orderly credit files [to] reduce the risk of unexpected credit problems ... Reporting of credit excesses to Head Officer intra-month in addition to month end would improve the "early warning system"."

There is no evidence that either this Letter to Management or a summary of its findings, was presented to the Bank Board.

(ii) Internal Audit report: Corporate Banking - July 1990

In this report, Internal Audit concluded as a result of their work, that the effectiveness of internal controls in a number of the areas examined was found to be unsatisfactory. The main findings of the report were:

. The Branch was entering into transactions for financing leases which had not been accounted for in the Bank's records and monthly financial reports to Head Office. The leases identified amounted to GBP 1.0M; and

. In a number of cases, annual reviews of loan accounts were overdue. "Overall, a pattern of delaying annual reviews was observed."

The findings of this audit review were reported to the Bank Board in the Internal Audit department's Quarterly Report to the Bank Board for the quarter ended September 1990. The audit of London branch Corporate Banking Section Internal Controls was graded Unsatisfactory with the following observations being made:

"London office has committed facilities approximately totalling AUD $1B. Audit examined the portfolio controls, accounting controls and administrative procedures. We are of the opinion that the effectiveness of these controls in the areas examined were not of a satisfactory level.

Audit concerns included controls in internal accounting and reporting, segregation of duties, administration controls and lack of Group policies and procedures.

There were particular concerns with a number of overdue reviews, incorrect accounting for lease financing involving approximately AUD 4M and collection of overdue receivables with outstandings over AUD $1M, which were distorting profit and loss figures. London office have addressed the issues raised by Audit and are taking corrective action."

As noted above, this Quarterly Report was presented to the Audit Committee, but the relevant minutes record no comments on these substantive findings. I would expect that concerns of the Committee would be recorded for the purpose of making clear to the Bank Management matters that should be the subject of attention.

(iii) Internal Audit report: Corporate Banking - May 1991

In this report, Internal Audit expressed its "concern that credit papers examined did not always address satisfactorily all issues such as security position, projected cash flow analysis, and construction of transactions".

The main effect of the above control weaknesses is to reduce the effectiveness of the credit approval process. In particular, inadequate evaluation of credit issues and delays in reviewing credit files could give rise to loan losses. Without the proper functioning of these procedures, the assets of the Bank could not be properly controlled.

(c) Asset Quality

(i) Credit Inspection report by Mr Wright (Chief Manager, Credit Inspection) - August 1990

As noted above, Mr Wright, Chief Manager, Credit Inspection, presented his report on his credit inspection of the London branch in August 1990 at which time he formed the opinion that the London branch Corporate Banking portfolio did not raise issues for concern. As indicated in 19.6.3 (a) above I am satisfied, having heard his evidence that he discharged his responsibilities properly in carrying out this review.

(ii) Internal Audit report: Corporate Banking - May 1991

In this report, Internal Audit expressed its:

"... opinion that the quality of assets examined is unsatisfactory and reflects both the financial performance of accounts sampled and the amounts of specific provisions required. It is a further reflection of the poor economic climate in the United Kingdom and the depressed real estate market, given that over 40% of assets are directly associated with the property market."

This analysis by Internal Audit department more closely reflects the London branch non-productive loans position as reported in the February 1991 report on non-productive loans to the Bank Board.

(d) Procedures Documentation

The main point raised in the various reviews was that procedures manuals were not kept up-to-date:

(i) External audit management letter - Audit 30 June 1990

This Management letter noted that procedures, controls, and accounting policies, for off-balance sheet instruments were not formally documented.

(ii) Internal Audit report: Corporate Banking - July 1990

In this report, Internal Audit observed:

"The current manual on Corporate Banking operations needed to be updated."

(iii) Internal Audit report: Treasury Operations - August 1990

Internal Audit reported:

"Existing Policies and Procedures Manual must be updated and maintained to reflect the business perf [sic] by [London branch]."

Staff in overseas locations must be able to refer to procedures manuals that provide guidance in all aspects of the Bank's operations. Without procedures manuals that are kept up-to-date, management in Head Office cannot ensure that authorised procedures are being followed. As a result, control over the operations of the London branch could not be properly exercised.

(e) Position Limits and Monitoring

A review was performed in October 1990 by London branch's external auditors, KPMG Peat Marwick McLintock, at the request of Mr Clark to determine the cause of a GBP 0.5M loss that arose in London Treasury in the first week of August 1990. It was discovered that the losses arose from spread trading futures positions. The external auditors concluded that:

"None of these spread positions have breached limits because there are no specific limits for spread trading ... It would appear that the management of SBSA in Adelaide are insufficiently aware of the potential of the London Treasury to make losses as well as profits."

The external auditors recommended that:

"London and Adelaide immediately discuss and agree upon a clearly defined limit for interest rate risk, and that daily reporting of exposures against this limit arising from off-balance sheet positions is instituted."

The report indicates that no specific limits were in place for this complex part of the Treasury operations. It is of paramount importance that limits for such transactions be in place and that they are approved by the Bank Board. The Bank Board should have been aware of these unusual types of transactions so that it could exercise proper control over the activities of the off-shore Treasury departments.

(f) Prudential Reporting

Annual audits were performed by KPMG Peat Marwick McLintock of the statistical returns to the Bank of England. In 1988, 1989, and 1990, the auditors concluded that the returns were correct in all material aspects, except for some errors which were not noted as material.

The auditors also produced reports in September 1989 and September 1990, of reviews of London branch's accounting and other records, and of the internal control systems. The reports concluded that the records and control systems were established and maintained in accordance with the Bank of England guidelines, with the following exceptions:

(i) Credit risk: The 1989 report stated: "the branch currently informs Head Office only of excesses over credit limits existing at the month-end, rather than of excesses (if any) which existed during the month." The 1990 report noted that this was corrected.

(ii) Interest rate risk: The 1989 report stated: "the branch relies on certain information supplied by the dealers to monitor its daily interest rate position without any current independent check ... The branch has entered into transactions (for example [Forward Rate Agreement] arbitrage) which are considered to be broadly hedged ... but currently there are no independent checks to ensure that the transactions are in fact hedged and are not exposed to interest and foreign exchange risk." The 1990 report noted that "the branch remains unable to report interest rate gap exposures. Limits on off-balance sheet products are monitored only by the treasury dealers but should also be checked independently."

In the absence of properly functioning control systems, the Bank Board and senior Management at Head Office could not properly control the operations of London branch. In particular, without satisfactory management information systems for reporting Treasury exposures, the Bank could incur risks that it is not aware of, and so, would not be able to manage those exposures properly. As a result, the Bank could incur losses which could have been prevented by adequate control systems.

In addition to the above concerns raised over the period, in a report prepared by KPMG Peat Marwick McLintock, in March 1991, at the request of Mr Russo (acting manager of the London branch), the external auditors were asked to carry out a brief investigation into the events surrounding the identification of an unexpected deferred charge in the balance sheet of the branch, for the financial year 1990-1991, of some GBP 0.4M. The deferred charge arose in relation to Forward Rate Agreement arbitrage, and the identification of the reasons for this item was made difficult by the complicated nature of the arbitrage.

In June 1990, a shortfall of GBP 0.4M was identified on the deferred balance of the arbitrage transactions. Rather than recognise this charge in 1989-90, London branch (in consultation with Head Office) decided to defer the charge to 1990-91:

"The situation was brought to the attention of the newly appointed Head of Finance and Operations, Neil Kelly, who consulted with the Head of Credit and Development, Abe Rawat. They concluded that to report an unexpected reduction in profits of this order would be disastrous ... The branch had committed to Head Office its profit for the year and branch staff had the impression that the bank's results worldwide were under pressure."

The report goes on to note that the failure to record the amount was queried by Mr Copley's office but that:

" ... the Chief Manager at the time (Murray Wilcox) eventually agreed the branch's desired approach with Head Office."

The external auditor's report concludes that:

"At a minimum, the events surrounding the £400,000 `problem' could be characterised as aggressive accounting practice, together with lax bookkeeping and financial management. At worst, they could be viewed as a deliberate attempt to shift unexpected losses from one year to the next in a manner which would not be detected and which, through incompetence, came to light in any event".

The main effect of this item was to increase the Bank's reported profit for the year ended June 1990.

19.8.2 HONG KONG OFFICE

(a) Internal Control Systems

A preliminary audit review performed by Internal Audit in August 1990 raised a number of matters, notably:

(i) payments made on behalf of individuals were not adequately documented;

(ii) there was inadequate information on a loss from an early drawdown;

(iii) in certain instances, verification of customer information appeared inadequate;

(iv) there was no cost recovery in respect of legal work performed on syndicated loans; and

(v) there was no Policies and Procedures Manual for lending.

The use of a formal Manual for lending policies and procedures is considered essential to ensure that the systems authorised by the Bank Board and senior management are followed. Without such a manual, the credit approval process may not be complied with, or loans may not be properly maintained, and, as a result, the Bank may incur losses.

In December 1990, a credit inspection of the Hong Kong office was carried out by Mr Wright, Chief Manager, Credit Inspection. The inspection revealed the following weaknesses in corporate lending procedures:

(i) credit reviews of loan facilities were not always conducted in a timely manner; and

(ii) financial analysis and comment in review submissions was not undertaken in sufficient depth to ensure that borrowers' performance and position had been fully and critically reviewed.

One additional point that was noted was there was little depth of experience in the corporate lending area.

(b) Asset Quality

The December 1990 credit inspection made the following points about asset quality:

(i) Corporate loans

A complete inspection of the loan portfolio (17 accounts) was performed. The conclusion reached as a result of this work was that although there were no problem loans found in the portfolio, two loans required close attention.

(ii) Property Loans

It was noted that no loans in this category were in default at inspection date, nor was there any need for provisioning.

19.8.3 NEW YORK BRANCH

(a) Internal Control Systems - Commitments Register

Internal Audit report: Corporate Banking - August 1990

(i) The audit identified mezzanine debt (ie subordinated debt) and other facilities to the value of $34.0M approved as at March 1990 which were not reflected in the Bank's commitment records before the examination of the records on 6 June 1990; and

(ii) Inadequate information on the commitments register.

The purpose of recording these amounts at the proper time is to enable the Bank to readily ascertain its financial exposure generally, or to individual borrowers or groups of borrowers.

It is also important from a Treasury Management point of view, as the funding requirements of these commitments should be made known at the earliest possible time.

The findings of the Internal Audit department's review of New York office's Corporate Banking Section were reported in the Internal Audit department's Quarterly Report for the quarter ended September 1990, which was presented to the Audit Committee. The audit was reported with an Unsatisfactory grading.

(b) Internal Control Systems - Annual Reviews of Loan Accounts

Internal Audit report: Corporate Banking - August 1990

Reviews of certain accounts overdue and facilities extended without authority. Total facilities identified with overdue reviews were $US 80.2M comprising mainly Highly Leveraged Transactions each of $US 10.0M or more.

By not performing credit reviews on time, the Bank may be exposed to loan losses arising from loan problems that could have been identified earlier, when more appropriate corrective action could have been instigated.

(c) Internal Control Systems - Limits for Loan Exposures

Internal Audit report: Corporate Banking - August 1990

The report contained the following observations on guidelines and limits for highly leveraged transactions or mezzanine debt finance:

"No guidelines or limitations are in place defining how far the Bank will pursue with this type of financing [highly leveraged transactions]. In view of the high level of risk associated with HLT's, Audit identified the need to set limitations on the level and distribution of these transactions i.e. limiting them across industries and limiting them as a % of the total loan portfolio."

(d) Segregation of Duties

Internal Audit report: Corporate Banking - August 1990

(i) The Credit approval Section was not independent of the Lending Section; and

(ii) Loans Administration was performing its own accounting functions.

Segregation of duties within the Lending Section is of paramount importance to ensure that credit approval procedures are strictly adhered to, and that loan maintenance and accounting systems function correctly. Without such procedures, the assets of the Bank were not properly safeguarded.

The Internal Audit report described the potential risk in these circumstances in the following way:

"This is a major breakdown in internal control and gives powers to change records and still balance the books."

(e) Credit Gradings

Internal Audit report: Corporate Banking - August 1990

No grading system for credit quality and "no set criteria for deciding on irregular accounts".

A grading system for loans enables management to accurately assess the asset quality of the loan portfolio, and to identify problem loans promptly so corrective action can be taken. At the same time, on the basis of the gradings, management can evaluate whether provisions are required and, if so, at what level provisions should be set.

(f) Asset Quality

Internal Audit report: Corporate Banking - June 1991

The quality of assets from the files examined was considered to be unsatisfactory. In particular, Internal Audit were concerned with a number of accounts that had little or no equity, and that had a negative cash flow position. Recommendations were made for some accounts to be downgraded.

(g) Budget Process

Internal Audit report: Corporate Banking - August 1990

Unrealistic budgets were considerably lower than actual results.

It was important that realistic budgets are set so that senior management and the Bank Board could properly evaluate the performance of the New York office, and then properly assess the management of the operation and determine the most appropriate level and content of future business in that office.

(h) Provisions

KPMG Peat Marwick New York office performed limited audit procedures in January 1991, and a report was issued to their Adelaide office, a copy of this being received in Mr Mallett's office on 11 February 1991. The auditors expressed concern in relation to four non-accrual loans:

"SBSA has not recognised losses on these loans. Based on our analysis, we believe that it is probable that losses will be incurred on all of the above loans. SBSA has taken the position that losses will not be recognised until such losses can be quantified due to the uncertainty of the workout terms. We believe that it would be prudent for reserves to be established specifically for these loans at the branch level or allocated at the Head Office".

The establishment of prudent reserves would enable senior management and the Bank Board to assess fully the financial position of the New York office, and to make decisions regarding that office on the basis of appropriate information. It would also ensure that the Bank did not misstate its financial position.

This report makes the following observation in relation to the general level of loan loss provisions maintained by the Bank in relation to its New York operations:

"... Peat Marwick noted that SBSA plans to achieve a reserve for loan losses equal to 1% of outstanding loans over the next two years. Since we have not performed an evaluation of the adequacy of the loan loss reserve, we cannot determine whether 1% of this portfolio is adequate. However, we note that all of the top 100 US banks had reserves in excess of 1% at December 31, 1989, and that the economic and business environment has substantially worsened since that date in the US. In addition, we note that SBSA has had significant loan growth since June 30, 1990 [approximately $200.0M]. Such growth is unusual, as many US banks have downsized during this period."

19.8.4 AUCKLAND BRANCH

(a) Internal Control Systems

The only reviews by parties independent of management of the operations of the Auckland branch were those performed by Group Internal Audit. The main concerns raised by these reviews were:

(i) Internal Audit Report: Information Systems - June 1990

. SBSA (NZ) was deficient in its systems documentation, and was too heavily dependent on one Information Systems member of staff;

. The branch was not receiving details of published Head Office Information System policies and procedures; and

. The Information Systems Strategic plan prepared in March 1989, had not been approved or accepted by management at the time of the report.

(ii) Internal Audit Report: Treasury - March 1991

The branch's policies and procedures were established in 1989 and did not fully reflect the current business undertaken by New Zealand Treasury.

Without up-to-date policies and procedures manuals, the Bank Board and senior management could not ensure that the internal control systems addressed all risks and exposures incurred. In particular, if the policies and procedures in place were not wholly appropriate for the Auckland branch's current business, some new areas of business may not have been adequately covered by guidelines and limits.

19.8.5 AUGUST 1990 REVIEW OF INTERNATIONAL BANKING OPERATIONS

Mr Hartley gave evidence to the Investigation that around the end of 1989 he expressed concerns about the Bank's involvement in overseas operations, and called for a full review to be presented to the Bank Board. This was probably at the November 1989 Board Meeting. However, in his evidence to the Investigation, Mr Clark denied that any such direction was given until at least mid-1990.

Mr Hartley in his evidence which has some support from other Non-Executive directors, said:

"... We were not getting a proper return on the funds tied up. Just simple arithmetic showed me that, so I demanded - I raised this, didn't get anywhere, so I demanded a formal written paper from management to justify in a formal way for discussion at a future meeting and given proper space on the agenda, to justify what we were doing with this increasing exposure in London. ... I waited for this paper and it didn't materialise. I asked maybe three months later, 'Where's my paper on international?'. 'It's coming, it's coming'. I waited another 3 months - 'It's coming - it's coming'. Then I rang Trevor Mallett directly myself, having got nowhere with Marcus Clark, and he didn't know anything about it, so I wrote to him to put it on record and I have a - I think that might be in - yes, it is. It's in the papers you've got. I then got to giving him the history of why I was concerned and when I first expressed my concerns. He then produced a paper which I thought was a very shallow document which didn't address the issues at all."()

This is yet another instance which I have had occasion to consider in the course of this Investigation, when there has been a difference of opinion or recollection between the Board and management as to whether directions were given or requirements were implemented. It highlights the absence of proper procedures for communication between the Board and management or alternatively the resistance of management to keep the Board informed adequately and properly on important areas of the Bank's operations.

 

19.9 CONCLUSIONS ON CONTROL AND SUPERVISION OF THE OVERSEAS BRANCHES

 

Given the growth in assets and lack of profitability of the overseas branches, in my opinion, the Bank Board received relatively little information in its regular reports about the performance of the overseas branches, especially on an individual location basis. The Chief General Manager, International Banking, however, maintained regular correspondence and communication with each of the branches and received detailed financial and other returns from the overseas branches. Management (including the Managing Director) had, or had the ability to access, a substantial volume of information concerning the overseas branches, but the level of information provided to the Bank Board was, in my opinion, influenced by Mr T L Mallett's attitude towards informing the Board on matters that fell within his discretion.

In view of the rapid growth in the Bank's international operations over the period, and the level of risk involved for the Bank in operating overseas, Mr T M Clark and Mr T L Mallett should have provided regular detailed reports on an individual branch basis, to the Bank Board. This is emphasised by the fact that London Treasury was using advanced Treasury techniques, such as FRA arbitrage, and New York office was involved in Highly Leveraged Transactions and Mezzanine Financing.

Effective control and supervision by the Bank Board of the Bank's overseas operations was made more difficult by the "quality" of the information that was provided by management to the Directors. In the report on the New York branch, presented, to the Bank Board in September 1990, no mention was made of Highly Leveraged Transactions or Mezzanine Finance, and the report stated that no loss of principle or interest was expected on non-accrual loans. There was no mention of the substantial provisions that were to be required within six months of the report.

Similarly, the Credit Inspection report of London branch, in August 1990, concluded that all problem and potential problem loans had been identified.

In addition to the above mentioned matters, in my opinion, the Bank Board was not adequately informed, for most of the period under review, of concerns raised by the regulatory authorities. Indeed, the information provided to the Bank Board in November 1988 substantially conflicts with the record made by the Reserve Bank of Australia of that meeting.

In their submission to the Investigation, the Non-Executive Directors had this to say about the provision of information to the Bank Board:

"In regard to the volume of information received by the Bank Board, it should always be borne in mind that by virtue of the Group Operating Reviews, the Group and Managing Director's monthly overview (from April 1990) and individual Board papers in respect of specific loan proposals, the Board believed that it was being kept abreast of developments. In addition - and perhaps more importantly -the Board received reports each month from Mr Mallett, during which time Board members would pose questions to Mr Mallett about overseas operations generally. In the absence of any indication of major problems with either the international loan portfolio, the Bank's international banking strategy or expressions of concern on the part of any of the regulatory authorities, the Board was entitled to assume that the Bank's overseas operations were being managed properly."()

Evidence was given by a number of the Non-Executive Directors in support of the above submission.

In relation to the inherent problems in supervision and control of "distant branch operations", the Non-Executive Directors made the following submission to the Investigation:

"The problems which Mr Mallett has since identified to the Auditor-General's Inquiry() in respect of the supervision and control of "distant branch operations" were never communicated to the Board, be it by Mr Mallett, Mr Marcus Clark or any other member of management. To the contrary, in response to frequent questions as to the capacity of management to cope with growth in the overseas operations, the Board was constantly assured ... that the Bank had the capacity and the resources to cope with that growth, even in "distant branch operations"."

There is nothing in the evidence given by Mr T M Clark and Mr T L Mallett to suggest that either of them at any stage advised the Board that management was otherwise than in control of the situation in relation to the overseas branches. Nevertheless the question squarely arises whether the Bank Board should have adopted a proactive approach to the matter of control and supervision of the overseas branches, and should have probed management more actively in relation to reports on those operations given the level of information provided to the Bank Board on those operations.

Notwithstanding the submission and the evidence of the Non-Executive Directors, I am of the opinion that the Bank Board, in light of the overseas branches' asset growth accompanied with profitability at a level substantially below that of the rest of the Bank Group, should not have simply been content to rely on management's "assurances," but should have called for written detailed reports on the operations of the overseas branches and the relevance and effectiveness of internal control systems. I refer to Section 19.3.8 above, and to my answer to the Non-Executive Directors' "rhetorical question" there noted.

The fact is that over the period under review the Bank Board did receive some written reports which, in my opinion, should have elicited from the Bank Board a response far more searching and definite than simply seeking and being content to rely on "assurances" from management.

The Bank Board submitted that it had "regard, at all times, to its responsibilities under Section 15."() If that is so, then the Bank Board could not have failed to appreciate that rapidly increasing assets with poor profitability raised such serious doubts about the maintenance of the Bank's overseas operations that more positive action than simply asking management and being given "assurances" was called for. I am satisfied that it was only towards the end of 1989 that the Bank Board took action to require management to produce a written comprehensive review of the performance of and justification for overseas operations. In my opinion, such a written comprehensive review was called for, given the circumstances of the Bank's overseas operations, at least on an annual basis from the end 1986 onwards, and most certainly from 1988 onwards in light of the significant profitability problems revealed in the 1988 Profit Plan in relation to the Bank's overseas operations. In my opinion, it was not good enough for the Board to rely upon a "question and answer" process with management. The Bank Board should have conducted any question and answer process at least against the background of a detailed review of the Bank's overseas operations at the level of some detailed information as that contained in the August 1990 paper presented to the Bank Board, or better.

 

19.10 GENERAL SUBMISSIONS OF THE NON-EXECUTIVE DIRECTORS

 

The Non-Executive Directors made detailed and lengthy submissions to the Investigation in relation to the Bank's overseas operations. In this Chapter, where appropriate, I have drawn attention to specific matters submitted on behalf of the Non-Executive Directors. However, I believe it is now appropriate to present those submissions of the Non-Executive Directors which seek to draw together the various contentions and explanations which they saw as relevant to the subject matter of this Chapter.

The Non-Executive Directors submitted that it was necessary to:

"... have regard to the limited opportunities which a Board of Non-Executive Directors has to go beyond what management tells them, both in terms of recommendations in respect of which Board approval is sought or the information made available to the Board from time to time about the performance of the Bank's operation.

... A Board of Non-Executive Directors cannot involve itself in the day to day operations of the Company and ... is reliant upon management to keep it abreast of matters about which it should be aware. In this, the Board must proceed on the assumption that management is acting honestly, with integrity and highlighting all matters about which a Board is entitled to know. These are very fundamental assumptions.

It is submitted that a Board of Non-Executive Directors, meeting once or twice a month and with no independent resources - and no reasons to go behind management's assurances - cannot possibly be expected to do what management itself is retained to do.

... There were never any matters about which the Board could be said to have been put on notice of the need to test the quality or reliability of management's representations to the Board."()

I do not accept that there was "never any matters" about which the Board could be said to have been put on notice. In this Chapter there is reference to matters on which the Board was on notice that were deficiencies concerning the management of the overseas operations of the Bank. In my opinion, the Board failed to respond to these deficiencies, and in this respect, did not adequately or properly supervise, direct and control the affairs and transactions of the Bank.

I will further deal with these broad submissions in the next Section of this Chapter in which I express my conclusions on the Bank's overseas operations.

 

19.11 CONCLUSIONS ON THE BANK'S OVERSEAS OPERATIONS

 

The State Bank of South Australia is a bank which enjoys a privilege not available to proprietary based banks, namely, the privilege of a sovereign credit risk rating. This arises because of the specific Government Guarantee contained in the Act.

The marketing and financial advantages to the Bank of its sovereign credit risk rating was certainly not lost on the Bank Board and Management in their endeavours to expand the Bank's operations overseas on a major scale.()

I am satisfied that the Bank Board accepted Management's assessment that the South Australian market was saturated and that there were significant opportunities for growth, and therefore profit, overseas. In this regard, the sovereign credit risk rating of the Bank gave the Bank a significant pricing advantage, both in respect of its liabilities (funds raised) and in respect of its assets (pricing advantages in respect of offering credit enhancements which were themselves able to carry the sovereign credit risk rating).

In my view, with the benefit of the sovereign credit risk rating and the Government Guarantee, came an obligation for a level of attention and performance by the Bank Board consistent with its obligations under the State Bank of South Australia Act, 1983 and in particular, Section 15.

At a practical level, the Board of a proprietary based bank answer to the bank's shareholders - investors who have a financial interest in the profitability and general financial well-being of the entity, and who can act via their votes to remove a board that fails to perform or to protect their interests as shareholders.

The Bank regarded the State Government as its shareholder. The State Government did, of course, guarantee the Bank's liabilities. The Bank's own Internal Audit department succinctly stated the effect of the guarantee in its report on a particular corporate banking account as follows:

"A Government Guarantee is merely an assurance that in the event of financial crisis, the buck does not stop until it reaches the taxpayer who will be forced to come to the rescue." ()

The Bank Board had a duty under Section 15(2) of the Act to "administer the affairs of the Bank in accordance with accepted principles of financial management ...". In addition, the Bank Board's actions in respect of the overseas operations of the Bank were required to be considered in the context of the requirement that the Bank Board act with a view to securing a benefit to South Australians and the South Australian economy and with a view to achieving a profit.

Not only was the Bank Board required to act within the constraints imposed by virtue of the Government Guarantee, and the specific requirements of Section 15 of the Act, but, in this matter of international banking, the Bank had minimal experience prior to its establishment in July 1984. The predecessor merging banks were banks whose operations were predominantly based in South Australia, and the Savings Bank of South Australia's London retail branch was of marginal consequence.

The legal and fiduciary obligations placed on the Bank Board, together with the recognition of the Bank's lack of experience on the international scene, imposed on the Bank Board an onus to carefully consider the reasons for, and the control of, the Bank's overseas expansion. Particular emphasis should have been placed upon the control and supervision of the off-shore branches, the quality of assets, the profitability of the off-shore branches, and their ongoing strategic relevance to the Bank.

In my opinion, the Bank Board was motivated to establish the Bank as a participant in the international banking arena. The 1988 Strategic Plan referred to the Bank positioning itself as:

"... the dominant bank in SA, a regional bank in Australia and a niche player in the global market." ()

Notwithstanding whatever "prestige" there may have been in the State Bank of South Australia being seen as a "niche player in the global market", I am satisfied that the apparent and overriding consideration was the perceived profitable growth opportunities in overseas markets. By June 1988, however, in my opinion, the Bank Board should have called for a thorough review of the Bank's overseas operations, and if appropriate on the basis of marginal strategic relevance and substandard profitability, should have seriously considered the withdrawal of the Bank from those operations.

But the Bank Board did not do this. The Bank's operations continued to grow, and grow rapidly, and to diversify into new areas.

I do acknowledge, however, that, expressed in simple percentage terms (that is, overseas assets to total bank assets, and overseas total risk exposure to bank total risk exposure), the non performing asset situation of overseas operations was not disproportionate to the figures produced by the Bank overall in its non-performing asset review as at the end of February 1991. At this time, overseas assets represented 27.4 per cent of the Bank's total income earning assets and the overseas branches' total risk exposure to non-performing assets represented 23.2 per cent of the Bank's total risk exposure to non-performing assets. Be that as it may, such considerations cannot be regarded as resolving the problems presented by the off-shore branches.

There was no shortage of information produced out of the overseas branches and forwarded to head office. Nonetheless, the level of information provided by Management to the Board in the Monthly Operating Reviews and in other ad-hoc reviews was unjustifiably limited. I am satisfied that, particularly so far as Mr T L Mallett is concerned, during his time as the head of the Bank's international operations, the level of information submitted to the Board was constrained by his view that matters that fell within Management's delegated authority were matters for Management and required only sketchy reporting to the Bank Board. Whilst Mr T L Mallett is no doubt correct in his view that he was at liberty to act as was appropriate within the ambit of his delegated authorities, that ambit did not represent the limits of his responsibility to the Board. The driver of a motor vehicle may stay within the speed limit, but still drive with culpable negligence. The broader situation is that it was his responsibility to deal with the fact that the Bank's overseas operations were exposing the Bank to new and greater risk profiles. The failure to adequately inform the Board of these matters deprived the Bank Board of the opportunity of setting appropriate prudential standards for these particular developments.

An issue of significance noted in the course of this Investigation was the contrast between the information flow to the Bank Board, and the information flow to Management and the Executive Committee, with respect to the Bank's overseas operations during the period under review.

It is to be expected that the Executive Committee would receive the benefit of a far greater level of information than the Bank Board. Nonetheless, the Board must be advised of all material issues, and, on the evidence available to me, and for the reasons stated in this Chapter, I am of the opinion, that the Board was not kept aware of material issues. By way of example, the Executive Committee paper proposing the establishment of New York branch contained the proposed New York branch's business strategy, the corresponding Bank Board Paper was simply limited to financial projections and a relatively superficial rationale in support of the proposal. As is stated in this Chapter, the New York office was required to consider complex and innovative transactions as a basis for its profitability.

I am also of the opinion that, for the reasons indicated above in this Chapter, Mr T M Clark and Mr T L Mallett presented papers to the Bank Board which did not fully and accurately convey information concerning the Bank's overseas operations, and which omitted information that was material for the Bank Board's deliberations. In addition, I am of the opinion that in relation to reporting on the matters of consultations with the Reserve Bank of Australia, Mr K S Matthews and Mr C W Guille prepared and/or presented papers to the Bank Board which did not fully and accurately convey information concerning those consultations.

I conclude from all the information available that the editing from Board Papers of information contained in the corresponding Executive Committee papers was not carried out by Management for any improper purpose, but reflected Management's view as to what was appropriate information for the Bank Board to have regard to in performing its, ie the Bank Board's, duties. The Bank's Management had a strong sense of management's prerogative in those areas where it had delegated authority. In the day to day operations of the Bank this was a defensible position for management to take. It was not, in my opinion, defensible when wider issues of policy were involved and the nature and extent of risks were not adequately made known to the Board. Here the Executive Committee made serious errors of judgement.

The Investigation does note with concern, however, the significant discrepancies in the Bank's management reporting of discussions with the regulatory authorities in relation to the Bank's overseas operations when compared to the records maintained by the regulatory authorities themselves. The matter of Management's reporting to the Bank Board of discussions with the Reserve Bank of Australia is dealt with in more detail in Chapter 15 - "The Relationship with the Reserve Bank of Australia" of this Report.

The weakness of the Bank's control and supervision of its overseas branches was, in my opinion, exacerbated by the late introduction of Internal Audit department reviews and credit inspections. Clearly, so far as management of overseas operations was concerned, "control" was not a priority. As Mr T L Mallett's February 1990 memorandum notes, attention had been concentrated on the dynamic growth of the business rather than the credit implications of this growth.

In my opinion, Management's pre-occupation with growth of the overseas operations at the expense of attention to prudential controls and ongoing credit assessment was a predominant cause of in the profit and asset quality outcomes reported in February 1991.

 

19.12 REPORT IN ACCORDANCE WITH MY TERMS OF APPOINTMENT

 

19.12.1 TERMS OF APPOINTMENT A

I have investigated and inquired into matters relating to the overseas operations of the Bank as directed in my Terms of Appointment A. For the reasons indicated in this Chapter, I hereby report that, in my opinion:

(a) The matters and events reported on in this Chapter in relation to the conduct of operations in and by the overseas branches of the Bank which gave rise to non-productive assets as at February 1991, together with other matters examined in this Report caused the financial position of the Bank as reported on the nominated dates.

(b) The processes reported on in this Chapter in relation to the overseas branches of the Bank led the Bank to engage in operations which have resulted in material losses or in the Bank holding significant assets which are non-performing and were not appropriate.

(c) The procedures, policies and practices adopted by the Bank in the management of significant assets which are non-performing, as reported on in this Chapter, were not adequate.

(d) In relation to the overseas operations of the Bank, adequate or proper procedures did not exist for the identification of non-performing assets or assets in respect of which a provision for loss should be made.

19.12.2 TERM OF APPOINTMENT C

I have also, as directed by my Term of Appointment C, investigated and inquired into matters relating to the supervision, direction, and control, of the overseas operations of the Bank.

For the reasons indicated in this Chapter, I hereby report that, in my opinion the operations, affairs, and transactions, of the Bank with reference to its overseas operations were not adequately or properly supervised, directed and controlled by the Board of Directors of the Bank, the Chief Executive Officer (Mr T M Clark) and Mr T L Mallett.

19.12.3 TERM OF APPOINTMENT D

I have further, as directed by my Term of Appointment D, investigated and inquired into whether the information and reports given by the Chief Executive Officer (Mr T M Clark) and other officers of the Bank to the Bank Board were, in all the circumstances, timely, reliable and adequate and sufficient to enable the Board to discharge adequately its functions under the Act. For the reasons indicated in this Chapter, I am of the opinion that:

(a) the information and reports given by the Chief Executive Officer (Mr T M Clark) and Mr T L Mallett, to the Bank Board were not, under all the circumstances, timely, reliable and adequate, and were not sufficient to enable the Board to discharge adequately its functions under the Act; and

(b) the reports noted in this Chapter in relation to consultations with the Reserve Bank of Australia given by Mr K S Matthews and Mr C W Guille were not, under all the circumstances, reliable and accurate, and were not sufficient to enable the Board to discharge adequately its functions under the Act.