VOLUME FOUR
FUNDING, AND ASSET AND LIABILITY MANAGEMENT

 

 

CHAPTER 6
THE FUNDING THE STATE BANK

 

 

TABLE OF CONTENTS

6.1 INTRODUCTION
6.1.1 THE STATUTORY STRUCTURE OF THE BANK

6.2 THE NEED FOR CAPITAL

6.3 THE CAPITAL STRUCTURE AND FUNDING OF THE STATE BANK
6.3.1 THE RAISING OF WHOLESALE FUNDS BY THE STATE BANK
6.3.2 THE RETAIL FUNDING OF THE BANK

6.4 THE CAPITAL AND RESERVES OF THE BANK

6.5 THE CHARACTERISTICS OF THE DIFFERENT TRANCHES OF CAPITAL
6.5.1 CAPITAL GRANTED BY STATE TREASURY FOR ESTABLISHMENT OF THE BANK - $165.0M
6.5.2 CONVERSION OF CONCESSIONAL HOUSING LOANS FUNDS TO SUBORDINATED LOAN CAPITAL AS AT 30 JUNE 1985 - $156.4M
6.5.3 CONVERSION OF SUBORDINATED LOAN CAPITAL TO SUBSCRIBED CAPITAL
6.5.4 CONCESSIONAL HOUSING LOAN FUNDS CONVERTED TO SUBSCRIBED CAPITAL IN 1987 -$150.0M
6.5.5 SUBSCRIPTION OF CAPITAL FROM SAFA 30 JUNE 1988 - $250.0M
6.5.6 THE CAPITAL RAISED IN US DOLLARS
6.5.7 CAPITAL ARRANGED BY J P MORGAN - PERPETUAL FLOATING RATE NOTES TO CAYMAN ISLANDS ENTITY $US 150.0M (NET $US 106.8M) 30 JUNE 1988
6.5.8 $US 150.0M SUBORDINATED NOTE ISSUE TO SAFA - DECEMBER 1988
6.5.9 $US 100.0M SUBORDINATED DEBT ISSUE ARRANGED BY BT AUSTRALIA 1989
6.5.10 CAPITAL RESTRUCTURE BY REMOVAL OF CONCESSIONAL HOUSING LOANS AS ASSETS FROM THE BANK'S BALANCE SHEET - 28 JUNE 1989

6.6 A CASE STUDY OF THE RAISING OF $US 150.0M (NET $US 106.8M) TIER 2 CAPITAL IN JUNE 1988
6.6.1 OVERVIEW OF TRANSACTION
6.6.2 CHRONOLOGY OF EVENTS
6.6.3 COST OF FUNDS
6.6.4 ALTERNATIVE SOURCES OF CAPITAL FUNDS
6.6.5 THE ROLE OF SAFA AS AN INVESTOR
6.6.6 ACCOUNTING ARRANGEMENTS
6.6.7 INFORMATION TO THE BOARD
6.6.8 FINDINGS AND CONCLUSIONS

6.7 SUBMISSIONS MADE TO THE INVESTIGATION
6.7.1 SUBMISSION OF CERTAIN PAST AND PRESENT DIRECTORS OF THE STATE BANK OF SOUTH AUSTRALIA AND BENEFICIAL FINANCE CORPORATION LIMITED
6.7.2 STATEMENT OF MR D W SIMMONS - CAPITAL STRUCTURE
6.7.3 SUPPLEMENTARY SUBMISSION TO THE AUDITOR-GENERAL ON MATTERS OF LAW
6.7.4 SUPPLEMENTARY STATEMENT OF MR D W SIMMONS - JULY 1992
6.7.5 FURTHER SUPPLEMENTARY SUBMISSION ON BEHALF OF THE FORMER CHAIRMAN, MR D W SIMMONS, 13 DECEMBER 1991
6.7.6 MR A R PROWSE
6.7.7 SUBMISSION OF THE STATE BANK OF SOUTH AUSTRALIA
6.7.8 SUBMISSION OF THE SOUTH AUSTRALIAN TREASURY

6.8 OTHER MATERIAL CONSIDERED BY THE INVESTIGATION

6.9 ISSUES WHICH HAVE ARISEN AS A CONSEQUENCE OF THE SUBMISSIONS AND EVIDENCE RECEIVED BY THE INVESTIGATION
6.9.1 THE PLANNING OF THE BANK'S CAPITAL STRUCTURE
6.9.2 THE RESPONSIBILITY FOR PLANNING THE BANK'S CAPITAL
6.9.3 THE NEED OF THE STATE BANK FOR CAPITAL

6.10 THE COST OF THE STATE BANK CAPITAL

6.11 COMPLIANCE WITH THE RESERVE BANK OF AUSTRALIA CAPITAL ADEQUACY REQUIREMENTS

6.12 REPORT IN ACCORDANCE WITH THE TERMS OF APPOINTMENT
6.12.1 TERMS OF APPOINTMENT A
6.12.2 TERM OF APPOINTMENT C
6.12.2.1 The Board of Directors
6.12.2.2 The Chief Executive Officer
6.12.2.3 Other Officers and Employees of the Bank
6.12.3 TERM OF APPOINTMENT D

 

 

 

6.1 INTRODUCTION

 

This Chapter considers the possibility of a connection between the way in which the Bank was funded and the matters which are raised by the Terms of Appointment. In particular, the Chapter considers whether the financial position of the Bank in February 1991 was a consequence of the way in which the Bank was funded.

While it would have been necessary for this Investigation to consider the matters which are the subject of this Chapter in their own right, those matters have assumed particular importance by reason of submissions made by certain past and present directors() of the Bank to the effect that the problems which the Bank has faced were caused by the way in which the Bank was capitalised. As appears from the more detailed discussion below, there are two parts to the submission. First, it has been submitted that the rate of return payable on the capital provided to the Bank was itself excessive. Secondly, it has been submitted that the requirement that the Bank pay a fixed annual dividend on certain tranches() of the Bank's capital was a factor that contributed to the Bank's losses. Those matters are said in the submission to have given rise to a pressure to grow and increase the profits of the Bank which, in turn, led to a deterioration in asset quality.

I am aware that the funding and capitalisation of the Bank is one of the matters examined before the State Bank Royal Commission. I do not intend to duplicate unnecessarily the work of the State Bank Royal Commission, but to the extent that the capitalisation of the Bank is relevant to the matters which are the subject of my Terms of Appointment, some degree of duplication has been unavoidable.

In the simplest of terms, a bank is a business that trades in the commodity of money. It borrows money from lenders at one rate of interest, and derives a profit by passing on that money to borrowers at a higher rate of interest. The difference is the margin to the bank. Out of the margin, the bank must pay its overhead costs, and any residue will represent the profit of the bank. In order to carry on such a business, a bank requires the funds with which to trade. Those funds must be derived from either the capital of the bank, or from borrowings. The need of a bank for funds was described in evidence in the following way:

"You have to understand also the way in which a bank operates. The bank operates a bit differently from a normal business, in that in a sense on a day by day basis - you know, a bank has only one product, however it packages it. It sells money, it buys money, and it plays games with money. That's all it does. Its finished goods, its works in progress, everything is money. So on a day by day basis the banks go through a clearing system, and there is a clearing account that is balanced on a day by day basis. Whatever is needed to keep the balance within the margins allowed for by board policy, you just borrow more to cover it, or you repay some borrowings. That's all you do. It is a very simplistic way the treasury works, but that's effectively what they do." ()

6.1.1 THE STATUTORY STRUCTURE OF THE BANK

The Bank is a creation of statute established by the State Bank of South Australia Act, 1983 ("the Act"). A number of the provisions of that Act are relevant for the purpose of this Chapter.

The Bank is established as a trading corporation by Section 6, which in sub-section (3) provides that the Bank holds its property for and on behalf of the Crown.

Sections 14 and 15 of the Act provide:

"14(1) The Board is the governing body of the Bank and has full power to transact any business of the Bank.

...

15(1) In its administration of the Bank's affairs, the Board shall 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.

(2) The Board shall administer the Bank's affairs in accordance with accepted principles of financial management and with a view to achieving a profit.

(3) The Board and the Treasurer shall, at the request of either, consult together, either personally or through appropriate representatives, in relation to any aspect of the policies or administration of the Bank.

(4) The Board shall consider any proposals made by the Treasurer in relation to the administration of the Bank's affairs and shall, if so requested, report to the Treasurer on any such proposals."

Those provisions are relevant to the matters which are considered by this Chapter because they provide an insight into the reason for the Bank's existence, and the way in which the affairs of the Bank were to be managed. The respective roles of the Bank Board and the Treasurer of the State of South Australia are defined.

Section 16 provides for the appointment of a Chief Executive Officer of the Bank who "subject to the control of the Board, (is) responsible for the management of the Bank".

Section 17 empowers the Board "to appoint such officers of the Bank as it thinks necessary for the effective operation of the Bank", a positive and important function.

The cumulative effect of these provisions is to make clear that it is the Board that has the ultimate responsibility to achieve the objects set out in sub-section 15(2), by administering "the Bank's affairs in accordance with accepted principles of financial management and with a view to achieving a profit", by appointing officers to ensure "the effective operations of the Bank", and by controlling the Chief Executive in "the management of the Bank".

The Act does not spell out the financial structure of the Bank, the size of the Bank, or how those matters should be determined. A consideration of the way in which the capital structure of the Bank was in fact determined is relevant to some of the issues discussed in this Chapter.

The Act makes it clear that the Bank's affairs are to be conducted for the ultimate benefit of the people of the State of South Australia, who, for the purposes of the administration of the Bank, are represented by the Treasurer. The scheme of the Act is that the Board should consult with the Treasurer() and that the Board should consider "any proposals made by the Treasurer in relation to the Bank's affairs" (); but the ultimate "governing body of the Bank" is the Board.

Section 19 of the Act lists a number of powers conferred on the Bank, including the power to:

"19(3)(h) ... - issue, buy, sell and otherwise deal with securities (including debentures and inscribed stock);" [Emphasis Added]

Section 20 is of relevance to the funding of the Bank, because it provides:

"20.(1) The Treasurer may, out of moneys provided by Parliament for the purpose, advance moneys to the Bank by way of a grant or loan.

(2) The terms of an advance under subsection (1) shall be as agreed between the Bank and the Treasurer.

(3) Where moneys are advanced to the Bank by way of a grant -

(a) those moneys shall, for the purposes of the accounts of the Bank, be treated as a subscription of capital;

and

(b) they shall not be repayable except upon resolution of both Houses of Parliament."

It is significant that money advanced by way of a grant shall "for the purpose of the accounts of the Bank be treated as a subscription of capital".

Section 21 is also of importance to the means by which the Bank can be funded. It provides in sub-section (1) that "the liabilities of the Bank are guaranteed by the Treasurer". The effect of the guarantee on the Bank's need for capital and its ability to borrow funds are matters discussed later in the Chapter.

The "operating surplus" of the Bank is to be dealt with in accordance with Section 22, which provides for the payment to the Treasurer of "a sum equal to the income tax for which the Bank would have been liable under the law of the Commonwealth assuming that it were a public company ..." () (which I refer to in this Chapter as "the Corporations Tax Equivalent") and "such further sum (if any) as the Treasurer having regard to the profitability of the Bank and the adequacy of its capital and reserves, determines to be an appropriate return on the capital of the Bank" () (which I refer to in this Chapter as "the Section 22 dividend").

That provision is relevant to the matters to be discussed in this Chapter, because it leaves it to the Treasurer to determine the adequacy of the Bank's capital and reserves, and what is an appropriate return on the capital of the Bank. In making such a determination, the Treasurer is required to have to regard to the recommendation of the directors.

Section 23 requires the Board to cause accounting records to be kept, including an account of any surplus or deficit relating to a financial year and a balance sheet.

A Schedule to the Act contains transitional provisions that provide (inter alia) that the Bank succeeded to all the property of the amalgamating banks;() and that any moneys advanced to the old State Bank by the Treasurer pursuant to Section 9 of the State Bank Act, 1935, are to be regarded, subject to the provisions of Section 20(), as a grant to the Bank.

 

6.2 THE NEED FOR CAPITAL

 

Whether the State Bank, in fact, had a need for capital as opposed to borrowings, and the extent of the need for capital, are contentious issues.

I have received evidence and submissions that the Bank had a need for "free capital", or capital to which there is no fixed obligation to make interest or dividend payments, and that the relatively small amount of free capital of the State Bank contributed to its problems.()

On the other hand, it has been suggested that the State Bank did not need capital, or, if there was a need for capital, it was minimal. That suggestion is made because the Bank had inherited the established businesses of the two merging banks and it had the benefit of the government guarantee to attract the confidence of investors. Whether there is any force in that suggestion is considered more fully below. The fact is, however, that the Bank had decided that it would comply voluntarily with the requirements of the Reserve Bank of Australia with respect to capital adequacy, and the Bank did attempt to comply with those requirements. Accordingly, the Bank needed capital as defined by the Reserve Bank guidelines for that purpose, if for no other.

An issue arose before the Investigation as to whether funds obtained in some way other than by way of an advance pursuant to Section 20 of the Act could properly be treated as capital. None of the funds that the Bank treated as capital were, in fact, provided pursuant to Section 20. The Investigation was provided with the written submissions made to the State Bank Royal Commission by the Solicitor-General on the topic of capital. I accept the submission that Section 20 is facilitative only and cannot be read as providing the only means whereby the Bank could acquire capital. The dominant object of the Bank in increasing the amount of its capital from time to time was to comply with the Reserve Bank capital adequacy requirements. In my opinion, it is of no consequence if funds which were labelled as capital for Reserve Bank purposes were obtained other than by way of a grant pursuant to Section 20.

What is treated as capital for one purpose, may not necessarily amount to capital for all purposes. For example, subordinated debt may, for accounting purposes, form part of the Bank's wholesale funding and thus be treated as a liability, although, it will be treated as capital for the purpose of complying with the Reserve Bank guidelines.

It should be borne in mind that the capital adequacy requirements were designed to deal with a "private" bank (which will normally be a public company), rather than a State bank, which is fashioned by the particular provisions of the statute pursuant to which it is created. Accordingly, some modification may be required to apply the capital adequacy requirements to a State bank.

Prudential Statement No. A1 of the Reserve Bank outlines the Reserve Bank's approach to the prudential supervision of banks. Paragraphs 11-13 deal with the subject of Capital Adequacy. They provide:

"11. A bank requires capital:

. as a cushion to absorb losses;

. to evidence the willingness of shareholders to commit their own funds on a permanent basis;

. to provide resources free of fixed financing costs; and

. to finance investment in infrastructure and associates.

12. The Reserve Bank attaches great importance to ensuring that the capital resources of individual banks are adequate to the size, quality and spread of their business. It has counselled banks that they should avoid any weakening of their capital ratios. We have also asked banks to maintain an adequate cushion of free capital resources (i.e. shareholders' funds less investments in premises, subsidiaries and associated companies) to support bank deposits.

13. The Reserve Bank has developed, in consultation with banks, a framework for the supervision of the capital positions of banks. This framework is set out in a note published separately." ()

In 1988, the Reserve Bank issued Prudential Statement PS C1 which is concerned with the Capital Adequacy of Banks. The guidelines in that statement give effect to an international agreement which emanated from the Basle Supervisors Group. From 1988, the Reserve Bank required that each Australian bank should have a ratio of capital to risk weighted assets of not less than 8 per cent, with at least 4 per cent in core capital.() Previously, capital adequacy had been assessed by the ratio of capital to total assets. The guidelines emphasise that "the key element of capital is shareholders funds including disclosed reserves ..." ().

"Capital" is defined for the purpose of the Prudential Statement in the following way:

"Definition of Capital

Core Capital (Tier 1)*

. Paid-up ordinary shares.

. Non-repayable share premium account.

. General reserves.

. Retained earnings.

. Non-cumulative irredeemable preference shares.

. Minority interests in subsidiaries.

Supplementary Capital (Tier 2)**

. General provisions for doubtful debts.

. Asset revaluation reserves.

. Cumulative irredeemable preference shares.

. Mandatory convertible notes and similar capital instruments.

. Perpetual subordinated debt.

. Redeemable preference shares and term subordinated debt.††

* Goodwill will be deducted from "core" capital and total capital.

** Cannot exceed "core" capital.

† Consistent with the transitional arrangements in the Basle framework, there will be an initial limit of 1.5 per cent of total risk assets.

†† Cannot exceed 50 per cent of "core" capital. Minimum original maturity of at least seven years and an amortisation factor of 20 per cent of original amount to apply each year during the last five years to maturity." ()

An Explanatory Memorandum which accompanies the Prudential Statement explains the definition of capital in paragraphs 12-21. Because the State Bank had voluntarily agreed to comply with the Reserve Bank guidelines, the matters described in the Explanatory Memorandum go to the heart of the issues considered by this Chapter. An understanding of the philosophy reflected in the Prudential Statement helps to put the submissions which have been made to the Investigation into perspective, and so I set out the relevant paragraphs in full:

"Definition of Capital

12. Capital, for supervisory purposes, will be considered in two tiers. Tier 1 (or "core capital") comprises the highest quality capital elements. Tier 2 (or "supplementary capital") represents other elements which fall short of some of the characteristics of "core" capital but which contribute to the overall strength of a bank as a going concern. A brief summary of the main elements of capital is given in Attachment 1.

13. At least 50 per cent of a bank's capital base must be "core" (Tier 1) capital; the remainder (Tier 2) may consist of "supplementary" elements.

Core capital

14. The core of a bank's capital is shareholders' funds. They represent a permanent and unrestricted commitment of funds; they are available to meet losses enabling a bank to continue operating whilst any problems are redressed; and they do not impose unavoidable charges against earnings. Shareholders' funds therefore represent capital resources which can best contribute resilience and flexibility to a bank experiencing financial difficulties. For that reason, a strong tranche of shareholders' funds is required as the foundation of a bank's capital base.

15. Paid-up ordinary shares and non-cumulative irredeemable preference shares have the strongest claim for inclusion in "core capital" as does any non-repayable premium arising from the issue of such shares. General reserves and retained earnings (including measured current year earnings), although distributable in some circumstances, generally meet the attributes of "core capital". Minority interests in subsidiaries which are consistent with the other components named will continue to be counted in the calculation of shareholders' funds of the consolidated group. No limits will apply to the amounts of these components that can be included in a bank's capital base for purposes of measuring capital adequacy.

Supplementary capital

16. There are other capital elements that impart strength to a bank's position but to varying degrees fall short of "core capital". These elements will be included in the capital base as "supplementary" (Tier 2) capital but the amount may not exceed the amount of the bank's "core" (Tier 1) capital.

17. The components of "supplementary" capital are discussed in greater detail below; also set out are the particular conditions and individual limits which apply to specific elements.

Asset revaluation reserves

18. The Bank favours the common practice among Australian banks of revaluing assets regularly, for example by professional revaluation of premises and by marking securities to market value on a prudent basis. This approach obviates "hidden" or "latent" reserves reflecting the difference between historic cost and current value.

19. Under the Basle framework, reserves created by periodic revaluation of banks' premises can be included as a component of Tier 2 capital only if the revaluation is formally carried through to the balance sheet. Consistent with bank accounting and auditing practice in Australia, where a bank records revaluations of its premises, whether in the balance sheet or in the notes to the accounts, which are subject to audit review, they will qualify as part of Tier 2 capital.

20. For other assets there is a need to recognise the uncertainty and volatility associated with market revaluations. There is also a need to recognise that tax would apply if the assets were realised. For that reason, only 45 per cent of the effects of revaluing securities are to be included in Tier 2 capital. This applies whether the revaluation is recorded in the balance sheet or in the notes to the accounts.

General provisions for doubtful debts

21. Within limits, general provisions for doubtful debts will count as part of Tier 2 capital. Until the end of 1990 they may be included to a maximum of 1.5 per cent of risk-weighted assets. This will then be phased down to 1.25 per cent by the end of 1992. In the meantime, the Bank, like other banking supervisors, will seek to develop a more suitable definition of general provisions for doubtful debts free of amounts which should reflect diminution in value of assets or latent losses.

Mandatory convertible notes and perpetual floating rate notes and other similar capital instruments

22. Irredeemable preference shares carrying a cumulative dividend obligation are included in Tier 2 capital provided a bank has an option to defer or reduce dividends where profitability would not justify payment. In the absence of that option, these instruments will for the purposes of risk ratio calculations be treated in the same way as term subordinated debt (see below).

23. Perpetual subordinated debt and future issues of mandatory convertible notes (and similar capital instruments) are included in Tier 2 capital. However, mandatory convertible notes (MCNs) and similar capital instruments issued prior to the publication of this paper and which the Bank agreed could be counted to a limited extent as primary capital will be included in Tier 1 capital.

24. The Bank has reviewed the criteria set out in its Prudential Statement No. 13 in respect of perpetual subordinated debt and similar capital instruments. In the interest of international consistency, the Bank will now adopt the criteria set out in the Basle framework for "hybrid (debt/equity) capital instruments". These criteria, which are slightly less stringent than the Bank's existing guidelines, are set out in Attachment II.

25. There is no limit on the amount of cumulative irredeemable preference shares, perpetual subordinated debt. MCNs and other similar capital instruments that a bank may include in the permitted aggregate of Tier 2 capital.

Term subordinated debt

26. In the interest of greater international consistency and competitive equality for Australian banks, the Bank will permit the inclusion of term subordinated debt and similar instruments (including eligible redeemable preference shares) in Tier 2 capital but only to a maximum, in aggregate, of 50 per cent of Tier 1 capital.

27. To be eligible for inclusion in Tier 2 capital, term subordinated debt and similar instruments must meet the following conditions;

. the debt must have an original maturity of at least seven years and meet the Bank's requirements regarding subordination;

. during the last five years to maturity the amount counted as capital will be reduced each year by 20 per cent of the original amount.

Deductions from capital

Goodwill

28. The Bank will continue to exclude goodwill and similar intangible assets from capital in calculating capital ratios.

Inter-bank holdings of capital

29. For the time being, holdings of other banks' capital need not be deducted in calculating a bank's capital base. A bank's holdings of other banks' capital instruments will attract a 100 per cent weight in the calculation of the risk ratio. The Bank will continue to monitor developments. Should a bank's holdings of such claims become unacceptably large the Bank could require that they be deducted from its capital base." ()

Attachment 1 to the Explanatory Memorandum defines Tier 1 and Tier 2 capital in a way that is substantially, but not completely, the same as the definition of capital in Appendix 1. Attachment II discusses what are called "Hybrid capital instruments" in the following terms:

"This category includes a range of instruments which combine characteristics of equity capital and of debt. To qualify for inclusion in the capital base they must be:

. unsecured, subordinated and fully paid-up;

. not redeemable at the initiative of the holder or without the prior consent of the supervisory authority;

. available to participate in losses without the bank being obliged to cease trading (unlike conventional subordinated debt).

Although the instrument may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders' equity), it should allow servicing obligations to be deferred (as with cumulative preference shares) where profitability of the bank would not justify payment." ()

The Prudential Statement, PS C1 came into effect in August 1988.

In order to determine whether the State Bank had complied with the requirements of the Reserve Bank throughout the period under review, it will be necessary to have regard to the actual requirements of the Reserve Bank at the particular time under consideration.

These matters are also considered in Chapter 15 - "The Relationship with the Reserve Bank of Australia".

 

6.3 THE CAPITAL STRUCTURE AND FUNDING OF THE STATE BANK

 

The funds of the Bank fall into three broad categories: capital and reserves, retail funds and wholesale funds.

When the Bank commenced business in 1984, it inherited from its predecessors $43.6M which was treated as subscribed capital, reserves of $40.8M and capitalised profits of $31.3M. The total of the funds which were treated as capital was $165.6M. Various changes in the capital of the Bank have taken place during the period under review and, on 30 June 1990, the Bank's capital had grown to $1,340.6M. The movements in the Bank's capital are illustrated by the following table:

Table 6.1
The Bank’s Total Capital
As at 30 June
($M)

 

1984

1985

1986

1987

1988

1989

1990

Subscribed capital ($M)

43.6

44.0

94.0

350.0

600.0

663.9

663.9

% of Total Funds

26.3

12.4

24.0

61.4

61.7

50.6

49.5

Subscribed debt ($M)

-

156.0

106.0

-

134.5

472.0

450.6

% of Total Funds

-

43.9

27.0

-

13.8

36.0

33.6

Reserves ($M)

40.8

53.8

77.3

100.6

113.1

57.3

79.0

% of Total Funds

24.6

15.2

19.7

17.7

11.6

4.4

5.9

Retained profits ($M)

81.3

101.2

115.0

119.3

124.5

119.6

147.2

% of Total Funds

49.1

28.5

29.3

20.9

12.8

9.1

11.0

Total capital

165.6

355.0

392.3

569.9

972.1

1312.7

1340.6

% of Total Funds

6.2

10.3

7.4

8.3

10.2

10.3

7.8

Before the Bank commenced business it had total funds of $2,640.6M. That amount comprised the capital and reserves of $165.6M to which I have already referred, and both retail funds and wholesale funds.

The larger portion of the Bank's funds was initially provided by retail funds, but as the Bank grew, the growth in the Bank's assets was funded principally by wholesale borrowing. The movements in the different categories of funding, and the change in emphasis from retail deposits to wholesale borrowings, are demonstrated by the following table:

Table 6.2
The Bank’s Total Funding
As at 30 June
($M)

 

1984

1985

1986

1987

1988

1989

1990

Retail funds ($M)

N/A

4654.5

1662.6

1868.6

1970.2

2104.5

2362.2

% of Total Funds  

48.2

31.2

27.3

20.7

16.6

13.7

Wholesale funds ($M)

N/A

630.1

1947.3

2867.3

4233.9

7202.2

12079.9

% of Total Funds  

18.4

36.5

41.9

44.4

56.8

70.0

Other liabilities($M)

N/A

790.4

1329.9

1533.6

2356.0

2068.8

1465.3

% of Total Funds  

23.0

24.9

22.4

24.7

16.3

8.5

Capital and

reserves ($M)

165.6

199.0

286.3

569.9

837.6

840.7

890.0

% of Total Funds

6.2

5.8

5.4

8.3

8.8

6.6

5.2

Other capital
resources

-

156.0

106.0

-

134.5

472.0

450.6

% of Total Funds

-

4.5

2.0

-

1.4

3.7

2.6

Total capital              
% of Total Funds

2690.6

3430.0

5332.1

6839.4

9532.2

12688.2

17248.0

The table shows that during the period 30 June 1985 to 30 June 1990, the retail funds fell from 48.2 per cent to 13.7 per cent of the Bank's total funding, whereas in the same period wholesale funding increased from 18.4 per cent to 70 per cent.

The three categories of funds obviously have different characteristics. Capital and reserves are the funds of the shareholder. The actual cost of servicing the capital in the State Bank is discussed below.

Because the Bank needed capital in order to comply with the Reserve Bank guidelines, any comparison of the cost of capital with the cost of alternative sources of funding is immaterial. The issue is whether the capital needed, and in fact raised, was obtained on appropriate terms.

Retail funds are the deposits placed directly with the Bank by members of the public. These funds will generally be in the form of short or medium term deposit accounts. They are regarded by banks as a stable form of funding because they are collected in a large number of small accounts and retail customers rarely change their bank. Such funds are relatively inexpensive to service because the rate of interest which is payable is less than that which applies to other borrowings. In making any comparison with other forms of funding, however, the high fixed costs of running a retail bank must be taken into account.

Wholesale funds are borrowings from financial institutions, which will normally be for a medium or long term. The evidence before the Investigation is that, at least until the end of 1990, the Bank never experienced difficulty in borrowing wholesale funds at competitive rates because prospective lenders derived comfort from the guarantee provided by Section 21 of the Act. Problems that emerged during the latter part of 1990 are considered in Chapter 7 of this Report - "Treasury and the Management of Assets and Liabilities of the State Bank".

There is also evidence that the Bank had no difficulty in raising whatever capital was required, although there has, since 1989, been a view that the cost of a large proportion of the Bank's capital was excessively high.

There is conjecture as to whether funds that were treated by the Bank as Tier 1 capital and accepted by the Reserve Bank as such, were in fact, true Tier 1 capital.

Both matters are addressed by me later in this Chapter.

6.3.1 THE RAISING OF WHOLESALE FUNDS BY THE STATE BANK

As appears from Table 6.2, the Bank's wholesale borrowings increased from $630.1M at 30 June 1985 to $12,079.9M at 30 June 1990. They increased by $11,449.8M and rose from 18.4 per cent of total funds to 70 per cent. Without those wholesale borrowings it would have been impossible for the Bank to grow in the way in which it did. The uncontradicted evidence is that the raising of funds was entirely responsive to the growth in assets that was taking place. There was no formal determination of a capital structure for the Bank which was adhered to. The strategic plans of the Bank did make projections as to what would be required, but when the growth in assets outstripped the projection, as it inevitably did, further funds were raised in an ad hoc way in order to support the asset growth. This matter is discussed in Chapter 4 - "Direction-Setting and Planning".

Because of the government guarantee, the Bank never had difficulty in raising wholesale funds at advantageous rates. Ms A S Kimber, who was, from mid 1986 until October 1988 a capital markets officer and then the Manager, Capital Markets, gave evidence to the Investigation that the target was to borrow in foreign currencies, such as US dollars at around LIBOR() minus 0.25 per cent, and to borrow in Australian dollars at the Bank Bill rate minus 0.35 or 0.40 per cent, although there were times when the Bank was able to obtain cheaper funds.()

There is no evidence before the Investigation to suggest that the funds raised by the Bank in the wholesale market were raised at rates of interest that were not in the best interests of the Bank. The evidence is that the Bank had a significant market advantage, because of its good credit rating and the government guarantee, which it was able to exploit when borrowing funds. Whether the Bank put the benefit of its ability to raise cheap funds to full use on the lending side of its business falls outside the ambit of this Chapter. Also, as is discussed in detail in Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" of this Report, the evidence is clear that as the Bank grew and the emphasis changed from retail to wholesale funds, the Bank failed to put in place the systems and procedures that were required to manage those wholesale funds.

What is important for the purpose of this Chapter is that the Investigation has seen no evidence suggesting that there is any connection between the cost of the wholesale funds that the Bank borrowed, and the matters raised by the Terms of Appointment.

6.3.2 THE RETAIL FUNDING OF THE BANK

The retail activities of the Bank were carried out by the Retail Banking division.

At the time of merger, the new Bank, like its predecessors, was essentially a retail bank. It was because of a perception that it was in the commercial area that the potential for growth existed that the Corporate Banking division was promoted. The growth in the Bank's assets over the years was substantially in that area. So far as the Retail Banking division was concerned, the growth in funds was from $1,654.5M at 30 June 1985 to $2,362.2M, as at 30 June 1990, an increase of about 42.7 per cent. By comparison with the growth in the Bank's total funds during that period ($2,690.6M to $17,248.0M - 540 per cent), the growth in retail funds was quite modest.

The retail funds of the Bank expressed in both dollars terms and as a proportion of the Bank's total funds is shown in the following table.

Table 6.3
The Bank’s Retail funds
As at June

 


Retail
Funds
($M)

Proportion of the
Bank’s Total
Funds
Per Cent

1984

N/A

N/A

1985

1654.5

48.2

1986

1662.6

31.2

1987

1868.6

27.3

1988

1970.2

20.7

1989

2104.5

16.6

1990

2362.2

13.7

For most of the period under review, the Retail Banking division was operated as a separate entity. Retail deposits were used to fund retail assets (loans to customers). For a while there was a widespread belief within the Bank that there was an excess of retail deposits above retail assets which was applied towards the general funding of the Bank. That may, for a time, have been the case; but the evidence establishes that by, at least 1986, the Retail Banking division had become a net borrower of funds, and there was no excess of retail deposits to be utilised in other areas.

There was also a belief that retail funds were more beneficial than wholesale funds because they were cheaper. There is evidence, however, that one cannot calculate the cost of retail funds by reference only to the interest rate paid to depositors. If allowance is made for the overhead costs of the retail bank there may be no significant cost advantage over other types of funds. To the extent that retail deposits were either largely or fully utilised to fund retail assets, it is not open to suggest that the Bank should have utilised retail deposits in preference to wholesale funds. So far as the use of retail funds is concerned, the only matter for consideration is the profit that was being achieved on those funds by the Bank's Retail Banking division.

Between January 1986 and January 1987, retail lending had declined from approximately 52 per cent to 41 per cent of the Bank's income earning assets. That change was attributed to the growth in advances in the London office.() The relationship between retail assets and retail liabilities and the change which had occurred during 1986 was evidenced in the following terms:

"... Retail deposits have lost their position as the Bank's major liability. With retail lending virtually matching retail deposits, extra retail lending has been funded from wholesale deposits. The Bank needs to ensure that to maintain profitability levels, retail lending must be properly matched against funding. This may imply a greater emphasis upon higher-yielding retail business, such as commercial lending." ()

Initially the Retail Banking division was regarded as being highly profitable. For reasons which are discussed more fully in Chapter 7 - "Treasury and the Managemenet of Assets and Liabilities at the State Bank" of this Report, that belief may have been an illusion brought about by the fact that, for certain purposes, the divisional profits were calculated without proper allowance being made for overheads. There is evidence that the retail bank was costly to operate because it required premises for its branches, and was heavily dependant on expensive items of overhead, such as a computer facility and personnel. In order to obtain a true comparison of the cost of retail funds against the cost of wholesale funds, calculations would need to be carried out which make an accurate allowance for those overhead costs. I am not aware of any such costing having been carried out. To carry out a retrospective reconstruction of the profit and loss account now would be time consuming, and not serve any worthwhile purpose. Because the Retail Banking division was operated as a discrete entity, with all retail deposits being used to fund retail assets, a comparison of the respective costs of retail and wholesale funds would be inconsequential.

There was once a belief that the Retail Banking division provided cheap funds for use in the Bank's general activities, but that was shown to be incorrect when the Retail Banking division was demonstrated to have more assets than liabilities, so that it was in fact a net borrower of funds.()

I have reached the conclusion that the diminishing proportion of the Bank's retail deposits compared with total funds is not relevant to the matters raised by the Terms of Appointment, except in so far as that figure reflects the growth that was taking place in the Bank overall.

There is no evidence that the Bank has been disadvantaged by the increase in the proportion of wholesale funds. While retail deposits may have certain advantages over wholesale funds in that they are more stable and cheaper, a complete analysis of those suggested advantages would be time consuming and ultimately of no relevance to this Investigation, because there is no evidence to suggest that further retail funds were available to the Bank. The 1987-1992 Group Strategic Plan suggests that, by January 1987, the growth in retail assets was itself being funded by wholesale borrowings.() Accordingly, if the Bank wished to allow the growth in assets to continue, that could only be achieved by a corresponding growth in wholesale borrowings. The initial proportion of retail funds to wholesale funds could only have been maintained by curtailing growth.

While the Retail Banking division may not have been as profitable as it was once believed to be, there is no evidence before the Investigation to suggest that the losses and non-performing loans which are the subject of this Investigation are in any way connected with the cost of the Bank's retail funds.

 

6.4 THE CAPITAL AND RESERVES OF THE BANK

 

The nature and cost of the capital of the Bank has developed into the most important issue for the purposes of this Chapter, particularly in the light of submissions made by certain directors of the Bank.

The statutory framework within which the Bank is to be capitalised has already been discussed, as have the requirements of the Reserve Bank. The capital of the Bank falls into four categories, namely subscribed capital, subordinated debt, reserves and retained profits.

An overview of the Bank's capital can be obtained from an examination of matters in Table 6.1 above. This table has been restated here for ease of reference.

Table 6.4
The Bank’s Total Capital
As at 30 June

 

1984

1985

1986

1987

1988

1989

1990

Subscribed capital ($M)

43.6

44.0

94.0

350.0

600.0

663.9

663.9

% of Total Funds

26.3

12.4

24.0

61.4

61.7

50.6

49.5

Subordinated debt ($M)

-

156.0

106.0

-

134.5

472.0

450.6

% of Total Funds

-

43.9

27.0

-

13.8

36.0

33.6

Reserves ($M)

40.8

53.8

77.3

100.6

113.1

57.3

79.0

% of Total Funds

24.6

15.2

19.7

17.7

11.6

4.4

5.9

Retained profits ($M)

81.3

101.2

115.0

119.3

124.5

119.6

147.2

% of Total Funds

49.1

28.5

29.3

20.9

12.8

9.1

11.0

Total capital

165.6

355.0

392.3

569.9

972.1

1312.7

1340.6

% of Total Funds

6.2

10.3

7.4

8.3

10.2

10.3

7.8

The table shows that, as a percentage of the total capital, subscribed capital increased from 26.3 per cent to 49.5 per cent, while reserves diminished from 24.6 per cent to 5.9 per cent and retained profits diminished from 49.1 per cent to 11.0 per cent; although there was an increase over the period in reserves and retained profits in dollar value terms.

The way in which the capital of the Bank increased over the years is shown in the following table:

Table 6.5

Year Ended
30 June
Details of Capital Raisings Amount
1994 (1) Capital of predecessor banks assumed by the Bank. $A 43.6M
1985-1986 (2) Concessional housing loans advanced from State Treasury and gradually converted to capital; dividend of 7.4 per cent per annum. $A 156.4M
1987 (3) Concessional housing loans advanced from SAFA converted to capital; dividend of 5.2 per cent annum on a face value of $A 150.0M $A 150.0M
1988 (4) Subscription of capital from SAFA; dividend of Bank Bill plus 0.65 per cent per annum. $A 250.0M
  (5) Issued discounted perpetual floating rate notes ("FRNs") to a Cayman Islands entity; interest of LIBOR plus 0.65 per cent annum on the face value of notes ($US 150.0M). $US 106.8M
1989 (6) Transferred from interest equalisation reserves to SAFA capital contribution; dividend of bank bill plus 0.65 per cent annum. $A 63.9M
  (7) Issued 10 year FRNs to SAFA; interest of LIBOR per annum $US 150.0M
  (8) Issued 7 year subordinated debt to ANZ Executors and Trustees; interest of LIBOR minus 0.15 per cent annum. $US 100.0M

On 23 June 1989 a restructure of the Bank's capital took place. The restructure resulted in the following:

Table 6.6

  Category Amount Composition
Tier 1: State Treasury subscribed capital (free capital). $A 125.0M (1) $A 43.6M

(2) $A 81.4M (of $A 156.4M)

  SAFA contributed capital at Bank Bill plus 0.65 per cent

per annum.

$A 538.9M (2) $A 750M (of $A 156.4M)

(3) $A 150.0M

(4) $A 250.0M

(6) $A 63.9M

Tier 2: Perpetual FRNs   (5) $US 106.8M
  SAFA FRNs   (7) $US 150.0M
  ANZ subordinated debt   (8) $US 100.0M

 

 

6.5 THE CHARACTERISTICS OF THE DIFFERENT TRANCHES OF CAPITAL

 

As can be seen from Table 6.6, the capital of the Bank at the end of the period under review was made up of a number of tranches. The sources differed, and the terms as to interest and repayment were also different. The matters which arise for consideration in this Chapter require an understanding of the different terms and conditions, and of the way in which those terms and conditions were negotiated and agreed to by the Bank. A summary of the position is set out hereunder.

6.5.1 CAPITAL GRANTED BY STATE TREASURY FOR ESTABLISHMENT OF THE BANK - $165.0M

At the date of its formation the new State Bank had capital and reserves of $165.6M. Of this amount, $43.6M was the capital of the old State Bank which had previously been subscribed by the Government. The remaining $122.0M was retained earnings and reserves from the antecedent banks. None of this capital attracted any fixed dividend payment.

6.5.2 CONVERSION OF CONCESSIONAL HOUSING LOANS FUNDS TO SUBORDINATED LOAN CAPITAL AS AT 30 JUNE 1985 - $156.4M

As a means of increasing the Bank's capital, the Bank and State Treasury agreed to convert certain funds which had previously been provided for the purpose of concessional housing loans into capital. The Bank's capital was increased in that way in the financial years ending 30 June 1985 and 30 June 1987. This was done because the forecast increases in the Bank's assets necessitated additional capital to satisfy capital adequacy requirements. In the first instance, the capital of the Bank was increased by converting funds that had been provided by the State Treasury concessional housing loans to subordinated loan capital.

During the year ended 30 June 1985, loans totalling $156.4M were converted into subordinated loan capital. This was viewed as an interim step towards conversion of those funds into subscribed capital when required by the Bank.() This tranche was subject to an agreed dividend of 7.4 per cent per annum, which had been the rate applicable to the advances under the agreement relating to concessional housing loans.

The conversion of the funds to subordinated loan capital was first discussed and approved at a meeting of the Board of Directors of the Bank in March 1985. It was finalised in June 1985. The

March Board Minutes record the following:

"A proposal was submitted to secure a firm long term arrangement with the Treasurer and State Government for the continuing provision of new capital sufficient to sustain the ongoing growth of the Bank and satisfy Reserve Bank of Australia guidelines in regard to capital adequacy.

The object of the arrangement is to establish a reliable, medium term assurance of capital adequacy through the conversion and refinancing the loans to the Bank for Concessional Housing on lending. By that means the Government would avoid budget outlays for Bank capital and be released from a proportion of annual funding requirements for housing, whilst the Bank would achieve an immediate injection of $157.0M to its capital base." ()

The terms of the arrangement are set out in a letter from the Premier and Treasurer, Mr J C Bannon, to Mr L Barrett, Chairman of the State Bank of South Australia, dated 4 April 1985. In that letter, the arrangements are summarised as follows:

"1. The Bank's capital will be increased from $43M to $200M through the `conversion' of $157M of the Bank's existing debt obligations to the Government into capital.

2. It will be a matter for the Bank to decide what precise form the capital takes and what terminology is used to describe it.

3. It will be a matter for my decision as to whether any remaining indebtedness is held in the name of the Government itself or the South Australian Government Financing Authority (SAFA).

4. The loan of $200M at present outstanding to the Bank by the Government, evidenced by an exchange of letters, will remain at that level and in that form, with interest rates reviewed on the basis of an agreed schedule as recently discussed between Messrs Emery and Ottaway. The Bank will, if requested, increase this form of lending to the Government up to 12½% of its total advances (including concessional housing loans), subject to the Bank's lending for other purposes not being prejudiced and any new loans being at an interest rate mutually agreed. This would imply additional loan availability at the present time in the order of $35M.

5. The Government will promptly and sympathetically consider any request by the Bank to "convert" further amounts of debt to capital.

6. State Bank inscribed stock at present owned by SAFA will be the subject of the rearrangement under Section 18 of the Government Financing Authority Act 1982 with the Bank repaying this debt according to the present maturity schedules and present interest rates.

7. If so requested by the Government, the Bank and the Treasury will make arrangements such that the net flow of funds from the Government to the Bank in respect of concessional housing ie. new lending less capital repayments) will each year be $20M less than under current arrangements (ie. the Bank will in effect fund $20M of this activity annually from its own funding resources at market rates if so requested up to a total of the conversion of $157M into capital.

8. It is recognised that the above rearrangements will have various effects on interest payments between the Bank and the Government; these effects will be "offset" through adjustment in interest rates on remaining debt relationships so that, having regard also to taxation and dividend flows, the net flow of these "charges" as between the Government and the Bank is not significantly altered (it being understood that absolute precision in these calculations will not be possible).

9. The Bank will ensure that, if any of the above arrangements have the effect of increasing its recorded profit, such arrangements as are necessary will be made to ensure that payments to staff are not thereby increased under the special remuneration bonus scheme.

10. The Bank accepts, in principle, the Government's view that its operational decisions should be principally based on the maximisation of returns to the State as a whole and not on net returns to the Bank - ie. its decision should be based on pre-tax and not post-tax profit considerations. However, it is recognised that on some occasions for sound commercial reasons and in order to meet competitive market situations, it may be appropriate to base decisions on post-tax profit considerations. The implementation of these principles should be in accordance with guidelines to be developed between Treasury and the Bank.

11. The Government will undertake to "rediscount" up to $35M of the Bank's lending to it or SAFA in the event of the Bank having liquidity problems (details to be discussed with Treasury)."

On 10 April 1985, Mr Barrett wrote to Mr Bannon advising him that the Bank accepted, in principle, the broadly expressed proposals set out in Mr Bannon's letter of 4 April 1985. The letter stated that:

"Arrangements to allow implementation of the restructure of capital and other matters should now be negotiated in finer detail between Treasury and Bank personnel."

No formal documentation of the arrangement was prepared during the period under investigation. This was a matter that was the subject of comment by me in my annual Audit Report to Parliament for 1989-1990.

6.5.3 CONVERSION OF SUBORDINATED LOAN CAPITAL TO SUBSCRIBED CAPITAL

By 30 June 1985, concessional housing loan funds amounting to $156.4M had been reclassified as subordinated loan capital. The subordinated loan capital was then converted into subscribed capital. All subordinated loan capital had been converted to subscribed capital by December 1986. The matter was considered by the State Bank Board on 27 June 1985. The Minutes of that meeting record:

"Under the terms of the agreement the Bank will have a fixed quarterly liability of 7.4% per annum on the full amount of converted loans, whether held as subscribed or as subordinated loan capital. Debt conversion will be confined to the extent necessary to ensure that gearing does not fall below 20:1." ()

The progressive conversion of subordinated loan capital to subscribed capital is shown in Table 6.7.

Table 6.7

Subscribed Capital

Date


Amount
($000)

Cumulative
Total
($000)

30.05.85

391

391

01.01.86

10,000

10,391

01.04.86

10,000

20,391

01.06.86

30,000

50,391

01.08.86

30,000

80,391

01.12.86

76,000

156,391

30.06.87

-

156,391

30.06.88

-

156,391

30.06.89

-

156,391

6.5.4 CONCESSIONAL HOUSING LOAN FUNDS CONVERTED TO SUBSCRIBED CAPITAL IN 1987 -$150.0M

In June 1987, Mr K S Matthews recommended to the Executive Committee that $153.0M of concessional housing loan funds be converted into subscribed capital, as from 1 July 1987. The recommendation was that the conversion should be on similar terms to those which applied to the earlier conversion of concessional housing loan funds which is referred to above.()

Ultimately, an arrangement was reached between the Bank and SAFA for the conversion of an amount of $150.0M of concessional housing loan funds directly to subscribed capital. The arrangement was made with SAFA because the concessional housing loan funds had by that time become an asset of SAFA.()

The terms of the conversion are set out in a document headed "Heads of Agreement Between State Bank and SAFA". A copy of that document was presented to the SAFA Board at its Board meeting on 30 June 1987. The terms of the conversion were that $150.0M of concessional housing loan funds were to be converted into non-repayable capital. The terms in the Heads of Agreement as to interest contain the following provisions:

"Until 15 December 1997, 5.2% payable quarterly (this is the present interest rate of 5.1% plus another 10 gained to SAFA, which is equivalent to an improved return of $150,000.00 per year).

To apply after that - as agreed between SAFA and the Bank by not later than the end of 1987 or, if not agreed, as determined by the Treasurer after consultation with the two parties.

Interest obligations:

To be subordinate to all the Bank's other obligations (except payments in lieu of income tax and dividends to the Government).

Arrangement fee:

$100,000.00 payable on 30 June 1987.

Further discussions:

If requested by either party, discussions to take place in good faith to restructure these arrangements if they can be improved to the advantage of either party without disadvantage to the other.

Description/Treatment in Accounts:

SAFA will describe in its accounts as "non-repayable capital provided to State Bank" and, of course, treat the annual payments as income;

A matter for the Bank as to how it treats, except that it is understood that the profit of the Bank as determined for the purposes of the calculations under Section 22 of the State Bank of South Australia Act will be after making the annual payment to SAFA." ()

The arrangement described in the Heads of Agreement was approved by the Treasurer on 30 June 1987.

On 30 June 1987, Mr Prowse wrote to Mr Clark advising him that the Heads of Agreement had been approved by the SAFA Board and the Treasurer, and requesting confirmation of the Bank's acceptance of the agreement. On 6 July 1987, Mr Clark wrote to Mr Prowse and stated:

"I confirm the Bank's acceptance of the agreement as outlined in the Heads of Agreement attached to your letter. I look forward to receiving your formal documentation of the agreement." ()

Although the respective letters of Mr Clark and Mr Prowse refer to formal documentation of the Agreement, there is no evidence before this Investigation that any further documentation was brought into existence.

The Heads of Agreement provided that the rate of return on the capital after 1997 was to be agreed between SAFA and the Bank by no later than the end of 1987, or, if not agreed, to be determined by the State Treasurer after consultation with the two parties. At a Board meeting on 17 December 1987, the Bank Board gave its approval for management of the Bank to negotiate with SAFA "based on the dividend relating to a mutually acceptable indicator such as a Bank Bill rate plus margin".()

A letter dated 20 January 1988 from Mr P Emery, Chief Executive, South Australian Government Financing Authority, to Mr Matthews, Chief General Manager, State Bank, sets out the understanding reached in discussions between SAFA management and Bank management:

"1. From and including 16 December 1987 the return payable to SAFA by SBSA would be one related to a floating debt rate, and in particular the six month Bank Bill offered rate plus a margin of .65% per annum on the principal amount of $150M;

2. From that date the funds will be available for the State bank to use as it sees fit for normal banking purposes and will not be subject, in particular, to any requirement that they be used for home lending;

3. The return payable to SAFA would be payable out of the profits of SBSA, calculated before any dividend payable to the State on its capital contribution and before the calculation of taxation payable to the State in lieu of Commonwealth taxes (ie. the measure of SBSA's "taxable" profit would be calculated after deducting the payments for the return on SAFA's capital contribution).

4. The return would not be payable in full in any one year only to the extent SBSA makes insufficient profit in that year (before taxes and distributions to the Government) to make such a payment. In that event, the amount remaining unpaid would accumulate to SAFA's account and earn interest for SAFA at the rate agreed in 1 and be paid in subsequent years ahead of distributions to the Government (similar concept to dividend on preference shares).

5. The amount of return unpaid and outstanding at the end of any year shall not exceed the average annual profits in real terms at current prices (before the payment of the return payable under these arrangements) over the previous five years - to the extent such excess results, that excess will be regarded as no longer due.

6. Capital contribution is assumed by both parties to form part of the capital base of SBSA for Reserve Bank purposes and to the extent the above arrangements are not consistent with the latter's requirements, SBSA undertakes to enter into whatever reasonable arrangements are necessary in order that the State Bank can fulfil such requirements subject, of course, to feasibility and the approval of the Treasurer." ()

On 2 March 1988, Mr Emery wrote to Mr Matthews confirming that the approval of the SAFA Board and Treasurer had been given to the above arrangement.()

Mr Emery's letter of 20 January 1988 is also of importance because the terms and conditions set out were adopted in the case of later tranches of capital provided by SAFA.

6.5.5 SUBSCRIPTION OF CAPITAL FROM SAFA 30 JUNE 1988 - $250.0M

The raising of these funds is referred to in the Board Minute dated 25 February 1988, which records:

"The Reserve Bank had circulated to Australian banks proposals for a Risk Based Measurement of bank capital adequacy. Proposals required capital to be linked to both on and off-balance sheet business of the Bank and its subsidiaries.

The Bank would require a capital of 8% by 30th June 1988, comprising of two tiers of capital, Tier 1 being Core Capital of at least 4% and Tier 2, or Supplementary Capital, which cannot exceed 100% of Tier 1 capital. This requirement, together with extra capital to provide for growth anticipated in the Strategic Plan, indicated that total capital resources of $1.6 billion would be required by 1993.

IT WAS RESOLVED to approve that the Bank commence negotiations with the State Treasury with a view to raising sufficient funds by way of both capital and subordinated debt, so as to provide the Bank with capital resources of $1 billion as at 30th June 1988, with up to $250m being in foreign currency, as a proportion of the Bank's assets are held in foreign currency." ()

The negotiation of additional Tier 1 capital was delegated by Mr Clark to Mr K L Copley. Mr Copley's evidence about the raising of this tranche of capital is as follows:

"The feeling of executive committee, directed very strongly by Mr Clark, was that at that time, the July 1988 period, the ability to raise capital by banks would be more difficult because there was such a need worldwide, and that as a result of that wouldn't it be a good idea if we recapitalised our bank right now and got in before it, particularly as the Reserve Bank were giving some preliminary indications at around about the same time that they may implement these new guidelines earlier." ()

"So I was charged with the responsibility of raising $250 million worth of tier one capital from the government. I negotiated that with Mr Emery, who was then the deputy Under Treasurer, once again not knowing which hat he was wearing. He was very keen to provide it. There was no difficulty as far as the government was concerned in providing that capital.

...

So I negotiated it with Emery. The basis of the negotiations were that it would be provided on the same basis as had already been established within the bank for the conversion of the subordinated debts to capital." ()

With respect to the dividend rate which was to apply to the additional tranche of $250.0M Tier One capital, Mr Copley said:

"Now, prior to the 250 million there was a meeting which took place in about November of 1988, ... at which was present Emery and one of his offsiders. I think it was Robert Ruse, Gobbitt, Matthews and Copley - and Copley, bear in mind, has been in the organisation for about four months at that stage and is still feeling his way a bit. And it was decided at that meeting, with Matthews running it from the bank's point of view, that at the time that arrangement changed that the dividend rate on that subordinated debt converted to capital would be Bank Bill rate plus a margin of 65 cents.

That's important to bear in mind, because it was around about after that time I started then to negotiate to get this 250 million, and of course that having just been established, that was the basis upon which Emery wanted the next 250 million to be treated as well. I took that back to executive committee to get their approval, to take the capital on that basis. So the board were at all times aware of what was being done, and the executive committee was at all times aware of what was being done." ()

This evidence indicates that the members of both the Executive Committee and the Bank Board were aware of and approved the dividend obligation which attached to this tranche. Certain directors have submitted that the fixed commitment to pay interest on the funds provided by SAFA at the Bank Bill rate plus 0.65 per cent was oppressive. I address this matter in Section 6.10 of this Chapter.

On 3 May 1988, Mr Matthews wrote to Mr Prowse advising him that the State Bank would require an additional $400.0M of capital by 30 June 1988. The letter proposed that $150.0M be provided by SAFA in a form which qualified as Tier 1 capital. The letter also proposed that $250.0M be raised by way of Tier 2 capital, part of which would be raised in US dollars as perpetual debt. The letter indicated that the Bank was negotiating to raise $US 100.0M and sought to raise a further $120.0M in Tier 2 capital from SAFA.

In a way which has not been made clear to the Investigation, the tranches of additional capital actually taken on by the Bank changed to the sum of $250.0M Tier 1 capital provided by SAFA, and a sum of $US 150.0M Tier 2 capital raised with the help of J P Morgan, rather than the tranches of $150.0M Tier One capital and $250.0M Tier Two capital which are referred to in Mr Matthews' letter and the Board resolution of 26 May 1988.

On 27 May 1988, Mr Emery sent a message by facsimile to Mr T L Mallett requesting his confirmation of the terms and conditions relating to the tranche of $250.0M of Tier 1 capital provided by SAFA. The conditions were stated to be those set out in the letter of 20 January 1988 from Mr Emery to Mr Matthews regarding the conditions which would apply after 1997 to the concessional housing loan funds which had been converted to capital. The specific terms were as follows:

"Pricing

- Bank Bill offered rate plus 65;

- Arrangement fee of $4M payable by 30 June 1988;

Description Reserve Bank Aspects

A matter for the Bank, but note its intention to describe the total amount of $250M as Tier 1."

On 27 May 1988, Mr Copley sent a facsimile message to Mr Emery confirming that the terms contained in the facsimile message from Mr Emery to Mr Mallett were as "agreed in telephone conversation today". The terms were approved by the SAFA Board at a meeting of 14 June 1988, and by the Treasurer on 27 June 1988.

The evidence before the Investigation suggests that while the Board had, at a meeting on 25 February 1988,() authorised an increase in the capital of the Bank up to $1.0B with up to $250.0M being in a foreign currency, and, at a meeting on 26 May 1988, had noted that the Bank had "mandated" J P Morgan to arrange an issue of $US 150.0M undated or perpetual note subordinated debt,() the Board was never told in understandable terms what rate of interest or other conditions were to apply to the funds added to the capital of the Bank in June 1988. More importantly, the Board did not participate in the decision to divide the additional capital totalling $400.0M, between Tier 1 and Tier 2 capital in the proportions that eventuated.

The actual raising of the capital had been delegated by Mr Clark to other members of staff, in particular Mr Copley and Mr Mallett. Mr Mallett assumed responsibility for making very important decisions on behalf of the Bank without any specific direction or authority from the Board. Ms Kimber said that Mr Mallett had acted in accordance with a power of attorney.() If that is correct, it demonstrates a misunderstanding of the nature of the power of attorney, together with a conscious decision not to inform the Board of the detail of the transaction. When the terms of the transaction with J P Morgan changed at the last moment, J P Morgan enquired whether Board approval was required for the revision. Ms Kimber spoke to a Bank solicitor and a decision was made that there was no reason to advise the Board.()

In so far as members of the Board now complain that the terms on which the capital provided by SAFA were onerous,() those terms were matters which the directors should have, but did not sufficiently, concern themselves with at the time the transactions were negotiated and approved. Additionally, the staff members who were involved in the transactions should have kept the Board better informed, and obtained Board approval before entering into the transactions.

In July 1988, the Quarterly Operating Review for the quarter ended June 1988 advised the directors that the Bank had raised additional capital amounting to $250.0M from SAFA. The Board Minutes do not indicate any enquiry as to the terms on which the additional capital had been raised.

6.5.6 THE CAPITAL RAISED IN US DOLLARS

The Bank raised additional capital funds off-shore in 1988 and 1989. The funds were in the form of subordinated loans to meet Reserve Bank of Australia capital adequacy requirements for Tier 2 capital. The tranches were as follows:

. The sum of $US 150.0M (net $US 106.8M), raised by the issue of perpetual floating rate notes (FRNs) through J P Morgan.()

. The sum of $US 150.0M, raised by the issue of ten year Floating Rate Notes to SAFA.

. The sum of $US 100.0M, raised as a seven year debt through BT Australia.

. The sum of $US 150.0M, raised by a note issue arranged by J P Morgan.

6.5.7 CAPITAL ARRANGED BY J P MORGAN - PERPETUAL FLOATING RATE NOTES TO CAYMAN ISLANDS ENTITY $US 150.0M (NET $US 106.8M) 30 JUNE 1988

These funds comprised the balance of the additional capital referred to in the Board Minutes of 25 February 1988 and 26 May 1988.

This transaction provided a tranche of $US 106.8M Tier 2 capital. During the course of the Investigation, it became apparent that a number of features of the transaction are relevant to questions raised by this Chapter. A detailed analysis of the transaction, and the conclusions which I have come to as a consequence of the analysis, are set out separately in Section 6.6 of this Chapter. The analysis includes a consideration of the terms that applied to that tranche.

6.5.8 $US 150.0M SUBORDINATED NOTE ISSUE TO SAFA - DECEMBER 1988

The minutes of a State Bank Board meeting on 24 November 1988 record that the Board considered the Bank's capital requirements, and gave approval to management to "acquire additional capital of $200 million by way of sub-ordinated debt by 30 June 1989".

On 5 December 1988, Mr Ruse, General Manager, SAFA, wrote to Mr I Wheaton, Manager, Capital Markets, State Bank of South Australia, confirming details of the arrangement. The letter indicates that one amount of $US 95.0M was to be made effective from 14 December 1988, which would mature on 21 November 1998. The interest rate was stated to be the six month LIBOR. A second advance of $US 55.0M was to be made on 23 December 1988, and was to mature on 26 December 1998. The interest rate was to be the three month LIBOR.

The Treasurer gave his approval to the transaction on 13 December 1988. The minutes of a meeting of the Bank Board held on 22 December 1988 record that the sum $US 150.0M of Tier 2 capital "had been obtained from SAFA at LIBOR, which would be settled prior to 31 December 1988".

The interest cost of this tranche of Tier 2 capital, which was term subordinated debt, is to be contrasted with the cost of the capital which had been raised through J P Morgan six months earlier by means of the perpetual floating rate notes.

6.5.9 $US 100.0M SUBORDINATED DEBT ISSUE ARRANGED BY BT AUSTRALIA 1989

A third borrowing in US Dollars, which raised the sum of $US 100.0M as seven year subordinated debt, was arranged by BT Australia in early 1989.

Papers dated 14 March 1989, and submitted to the Bank's Board, recommended that the issue be included as part of the Bank's Tier 2 capital base. The papers set out the background to the issue as follows:()

"In January 1989 Treasury and International Division was approached by Bankers Trust Australia, with an invitation to bid for a $US100 million deposit maturing October 31 1996, which would be provided by an Australian resident (ANZ Executors and Trustees) and would consequently be free from withholding tax implications.

A bid was subsequently made for the deposit on a senior debt basis, and during the course of negotiations we were invited to enter a new bid for the deposit on a sub-ordinated basis. A new bid was made, at a level of $US libor less 15 basis points - only marginally above that for senior debt - such that the proceeds could be considered as either debt or capital. The bid was successful, and the deal was arranged using documentation which the Reserve Bank subsequently approved as meeting the requirements of its tier 2 capital definition.

It is recommended that the Board approves that the proceeds of this transaction be included in the Bank's tier 2 capital base."

The approval of the Bank's Board was given at a meeting on 23 March 1989.()

An interest rate swap was arranged with BT Australia, which fixed the interest rate to the Bank at LIBOR minus 0.15 per cent per annum, rather than a fixed rate of 8.375 per cent per annum which originally attached to the issue.

The borrowing was issued in two tranches of $US 50.0M each. Semi-annual payments were to be made in arrears, on face value, with the borrowing maturing on 31 October 1996.

6.5.10 CAPITAL RESTRUCTURE BY REMOVAL OF CONCESSIONAL HOUSING LOANS AS ASSETS FROM THE BANK'S BALANCE SHEET - 28 JUNE 1989

From at least March 1988 onwards, management of both SAFA and of the Bank had discussed ways of improving the capital adequacy of the Bank. These discussions resulted in a restructure of the Bank's balance sheet by the removal of concessional housing loans as assets. The restructure was approved by the Board. In doing so, the Board relied upon a paper from

Mr Copley which discussed the merits and disadvantages of the restructure in the terms set out hereunder:

"FINANCE DIVISION

TO: BOARD OF DIRECTORS

TOPIC: CONCESSIONAL HOUSING

RECOMMENDATION

It is recommended that Board of Directors approve that concessional housing be removed off-balance sheet in the manner outlined.

BACKGROUND

Both the Department of Housing and Construction and SAFA support the concept of State Bank removing concessional housing from its balance sheet whilst continuing to operate the activity in South Australia as Agent for SAFA or its nominee.

Following the discussion with the Department of Housing, work was undertaken to establish as to whether the commission rate of 0.875% currently being received for the administration of the concessional housing portfolio is adequate. This has indicated that after allowing for direct costs and an estimate of costs incurred by branches we are achieving a net profit of around $3m p.a. This seems to be reasonable but attempts will be made to increase the percentage when the changes are made.

My discussions with SAFA centered around the way in which the assets will be removed from the balance sheet. Assuming we agree to the proposal the following procedure will be adopted:-

1. The total value of concessional housing of some $730m would be paid to State Bank by SAFA.

2. State Bank would in turn repay to SAFA the amount of loans of some $327m, leaving the amount of around $400m which represents the capital converted from concessional housing subordinated loans of $306m, Reserves of $58m and other borrowings of $39m.

3. Following this, SAFA would be looking for a review of the dividend rate being paid on that capital. It is currently around 7%, which I am informed, was designed to cover the margin on the concessional housing loans. However, you will recall that some few months ago, negotiations were undertaken for a conversion of that rate to Bank Bill rate plus 0.65 at the completion of a 10 year period. The request of SAFA is that that rate should immediately be lifted to that rate, but with the 0.65 margin being phased in over the remainder of the 10 year period. It would start at a very low rate of say 0.05%.

Such action would, of course, result in us paying a larger dividend but it is my opinion that what is being suggested, which it should be remembered is comparable to the dividend on the $250m taken on balance sheet as subscribed capital at June 30, is a good arrangement from State Bank's point of view. It improves the Capital ratios by removing $730m (risk weighted at 50%) and provides up to $400m to eliminate some liabilities from the balance sheet.

The use of the $400m to reduce existing liabilities would, at a rate of 13%, immediately reduce costs by around $52m. However, an offsetting effect of the transaction would be that $19.3m currently received from concessional housing as interest on the $306m of capital would no longer be received. Also, approximately $7m of interest paid by concessional housing for dedicated loans would revert to the Bank.

Thus, the net improvement to profit would be around $26m.

It should be noted, however, that such action will result in little retention of profit because the increased dividend on the capital will approximately equate to that amount.

It should also be noted that by reducing assets by approximately $730m, the cost of PAR will fall around $730,000 per year, adding that amount to profit.

A further benefit is that in a full year the return on shareholders funds would increase by around $3% p.a. [sic] making the return, based on the 1988/89 Budget of $97.0M, approximately 14% and based on the Managing Director's target of $110m, approximately 15%.

Presented by: Approved:
K. L. COPLEY,  
Chief Manager ,

Group Finance.

[Signed L Barrett]
  CHAIRMAN.

23rd November 1988" ()

It is readily apparent that while the restructure did improve the Bank's capital adequacy, there was a substantial increase in the dividend rate payable on the funds which were the subject of the restructure. The rate increased from 7 per cent to the Bank Bill rate plus 0.65 per cent, or, at that time, about 13 per cent.()

The paper presented to the Board by Mr Copley has assumed significance before this Investigation for a number of reasons. Mr D W Simmons says that the paper is misleading, because the transaction did not result in a saving to the Bank as the paper represented, but in fact, resulted in increased expenditure.() In my opinion, the paper and consequent Board resolution are examples of the Board's willingness to give approval to a transaction in a situation where the supporting Board Paper could not have been fully understood and/or the nature of the transaction was not fully understood.

The mechanics of the restructure are set out in a minute from Mr Prowse to the Treasurer dated 13 June 1989. According to the minute, the impact on the Bank's balance sheet at 31 December 1988, when only the capital provided to the Bank by way of concessional housing loan conversions and the Bank's corresponding assets were brought into account, was as follows:

Subscribed Capital

$M

Converted Loans for Government

156.4

Converted Loans from SAFA

150.0

Surplus retained in the Scheme

61.6

   
Total

368.0

   
Liabilities  
SAFA

335.3

Other

43.4

   
Total

746.7

   
Assets  
Loans to Home Buyers

731.2

Cash Balances

15.5

   
Total

746.7

The minute records that concessional housing loan assets of $746.7M would be removed from the Bank's balance sheet "while leaving the Bank with the same amount of subscribed capital and reserves as currently exists". The minute also records that, in order to achieve this, SAFA would forgive the Bank's indebtedness to it of $335.3M, and it would advance to the Bank $43.4M and provide additional capital of $368.0M. ($368.0M was the total of the concessional housing loans converted into capital and the concessional housing loan reserve).

The minute records that the additional capital would be treated by the Bank in its accounts as $81.4M capital provided by Treasury, and capital of $286.6M provided by SAFA.()

The restructure of capital and the transfer of assets took place on 23 June 1989. The arrangements were not formalised, however, until Mr Copley wrote to SAFA on 24 July 1990 saying:

"The purpose of this letter is to formalise certain agreements made as at 22nd June 1989 and which operated from 23rd June 1989 in connection with the removal of the assets and liabilities relevant to the Concessional Housing Scheme from the Bank's balance sheet.

These agreements include the restructure of capital provided to the Bank by the South Australian Treasurer and South Australian Government Finance Authority (hereinafter referred to as SAFA) which is detailed in Part A below and the takeover of a portfolio of Inscribed Stock borrowings by SAFA from the Bank as described in Part B."

The letter noted that as from and including 23 June 1989, funds totalling $663.9M had been provided by the Treasurer and SAFA to the Bank by way of capital. The letter noted that, of this total, an amount of $125.0M represented a contribution by the Treasurer on which dividends were payable in terms of Section 22 of the Act. The sum of $125.0M consisted of the initial advance of $43.6M, and a further advance of $81.4M on 23 June 1989.

The letter noted that the balance of $538.9M had been provided by SAFA and "includes capital provided in June 1988 and the effect of the restructuring process necessary to remove the Concessional Housing Scheme from the balance sheet of the State Bank of South Australia as from 23rd June 1989." The letter also noted that the capital amount of $538.9M provided by SAFA was subject to payment of dividends by the State Bank to SAFA under the following conditions:

"2.1 $338.868M

Dividends will be based on the 3 month Bank Bill rate ... plus a margin of 0.65 percent per annum.

2.2 $100.0M

Dividends will be based on the three month Bank Bill rate ... plus a margin of 0.65 per cent per annum until 15 July 1992 at which time SAFA may seek future Bank Bill rate re set dates and future dividend payments on either a three monthly or six monthly basis.

2.3 $50.0M

Dividends will be based on the three month Bank Bill rate ... plus a margin of 0.65 per cent per annum until 15 September 1993 at which time SAFA may seek future Bank Bill rate re set dates and future dividend payments on either a three or six monthly basis.

2.4 $50.0M

Dividends will be based on the six month Bank Bill rate ... plus a margin of 0.65 per cent per annum until 15 September 1993 at which time SAFA may seek future Bank Bill rate re set dates and future dividend payments on either a three or six monthly basis."

The letter confirmed that the return payable to SAFA was to be payable out of the profits of the Bank, calculated before any dividend payable to the Treasurer on his capital contribution, and before the calculation of the Corporation's Tax Equivalent pursuant to Section 22 of the Act. The letter provided that the return would not be payable in full in any year that the Bank made insufficient profit before taxes and distributions to the Government to make such a payment. In that event, the amount remaining unpaid was to accumulate to SAFA's account and earn interest at the rate relevant to that particular component of capital, and be paid in subsequent years ahead of distributions to the South Australian Treasurer.

The letter confirmed that the amount unpaid and outstanding at the end of any year should not exceed the average annual profits, in real terms, at current prices (before the payment of the return payable under the arrangements) over the previous 5 years. The letter stated that, if such an excess resulted, it would be regarded as no longer due.

The letter also declared that "the capital contribution by SAFA is assumed by both parties to form part of the capital base of the Bank for Reserve Bank of Australia purposes and, to the extent the above arrangements are not consistent with the latter's requirements, SAFA undertakes to enter into whatever reasonable arrangements are necessary in order that the Bank can fulfil such requirements, subject to feasibility and the approval of the Treasurer".()

 

6.6 A CASE STUDY OF THE RAISING OF $US 150.0M (NET $US 106.8M) TIER 2 CAPITAL IN JUNE 1988

 

An investigation of the circumstances in which this tranche was raised has identified a number of features of the Bank's operations which are of relevance to this Chapter.

Like the tranche of $250.0M Tier 1 capital which was raised concurrently, the origins of this tranche can be found in Board Minute 36/88 of 25 February 1988, which discussed the need to obtain capital denominated in $US.

The transaction is described in a paper dated 24 May 1988 which was prepared by Ms Kimber and presented by Mr Mallett, then General Manager Treasury and International, to the Bank's Board at a meeting on 26 May 1988.() Because of the questions that arise from both the transaction generally and the paper in particular I have set out the paper in its entirety.

"TREASURY AND INTERNATIONAL DIVISION

TO: BOARD OF DIRECTORS

TOPIC: USD CAPITAL RAISINGS

PAPER SUBMITTED FOR NOTING

State Bank of South Australia has mandated J.P. Morgan to arrange an issue of USD150M undated or perpetual subordinated debt on the condition that it is accepted by the Reserve Bank of Australia as qualifying as tier two capital.

The paper is to be issued at a discount. Current indications are that it is likely to have an issue price of approximately 72% of the face value of USD150M. This issue will be purchased by a Cayman Islands Vehicle owned by a Jersey Charitable Trust. (See diagram).

The Cayman Islands Vehicle will in turn issue USD150M of 15 year dated Floating Rate Notes at par. The investors in this dated FRN will be the South Australian Government Financing Authority for USD 75M the rest will be syndicated by J.P. Morgan.

The Cayman Islands Vehicle will use the USD28M difference between the proceeds of the dated FRN and the cost of the perpetual FRN, as a defeasance deposit which will yield USD150M in 15 years. This will then be used to repay the dated FRN's leaving SBSA with free capital. It is intended that the vehicle for the defeasance will be either US Treasury Bonds which have been stripped of their coupons or some other AAA deposit.

SUMMARY TERMS AND COSTS

Perpetual Note (issued by SBSA)

The principal amount (face amount): USD150M. Issue price approximately 72% i.e. USD108M. Drawdown date: as soon as possible prior to 30th June 1988. Maturity: none. Coupons: 6 month Libor + 0.65% on the face amount payable semi-annually in arrears up to and including the end of year 15. Thereafter 100th of 1 basis point on the face point payable semi-annually in arrears i.e. USD150 p.a.

Coupon Obligations

In order to comply with the Reserve Bank's guidelines on tier two capital, SBSA's coupon obligations would be subject to the following provisions.

1. SBSA will be obliged to pay coupons on any due coupon date where a) the Bank would having made such a payment remains solvent immediately thereafter and b) the coupon date occurs at the end of a period of 12 months in which SBSA has either i) paid or declared a dividend or ii) recorded an operating profit before extraordinary items, tax or dividends.

2. SBSA will have the option to pay the coupons on due coupon dates other than those referred to above.

3. Any interest not paid on a compulsory interest payment date will accrue. Any interest not paid on an optional interest payment date will not accrue.

Dated Floating Rate Notes (issued by Cayman Island Vehicle)

Principal amount: USD150M. Issue price: par. Drawdown date: the same as the perpetual FRN's. Maturity: 15 years. Coupons: 6 months Libor + 0.65% payable semi-annually in arrears. This coupon will be secured by SBSA's perpetual FRN.

Repayment of principal would be secured by the proceeds of the defeasance.

Costs

SBSA will enter into a swap for 15 years to fix the cost of paying coupons on USD150M whilst we have only received cash of USD108M. This will cover the open interest rate position on USD42M which would not be covered by income from matching assets. Assume that this swap could be done at a cost of 10% p.a. and that the Bank invests the proceeds of the issue at Libor. The cost of the capital per annum for the first 15 years is then:

Swap: 10% x 28M =

2,800,000

Coupon: .65% x 150M =

975,000

Total:  

USD3,775,000

This is approximately A$4.8M at the current exchange rate.

Chief Manager, Group Finance advises, that this cost can be amortised over a longer period since after 15 years the capital is virtually free requiring only a servicing payment of USD150 p.a. If a period of 40 years was chosen for amortisation the cost would be approximately A$1.8M p.a.

In practice we would expect to achieve rates better than Libor on the assets purchased with the proceeds of the issue. Gearing on the capital will generate additional profit which will at least partly offset the cost of the capital.

Prepared by:  
A. S. Kimber  
Manager, Capital Markets  
   
Presented By NOTED:
T. L. Mallett, [Signed L Barrett]
General Manager  
Treasury and International CHAIRMAN

24th May 1988"

The minute relating to the Boards consideration of this matter on 26 May 1988 records:

"Directors noted that with the support and approval of Treasury, State Bank of South Australia had mandated J. P. Morgan to arrange an issue of $US150m undated or perpetual subordinated debt, on the condition that it would be accepted by the Reserve Bank of Australia as qualifying as tier two capital." ()

6.6.1 OVERVIEW OF TRANSACTION

The Bank entered the transaction in May 1988 to obtain additional capital funding as part of the plan to increase the capital of the Bank to $1.0B, as at 30 June 1988. The transaction was a structured financing arrangement. It was proposed to State Bank, and subsequently organised, by J P Morgan. The transaction required the Bank to issue floating rate notes with a face value of $US 150.0M. The notes were issued at a discount and the net proceeds to the Bank from the issue were $US 106.8M. Pursuant to the terms of the notes, the Bank was required to pay interest for a period of fifteen years from the date of issue at LIBOR + 0.65 per cent on the face value of the notes ($US 150.0M). After fifteen years, interest was to be payable at a nominal rate only, namely 1/100th of one basis point on the face value of the notes, representing an annual interest cost of only $US 150 per annum.

The original proposal was that the notes issued by the Bank would be purchased by certain Cayman Island based companies. They would package the State Bank notes with other high credit rated, zero coupon assets to provide security for the issue by the Cayman Island companies of fifteen year floating rate notes. The income received by the Cayman Island companies from the State Bank notes would meet the Cayman Island companies' interest obligations on the fifteen year notes. The proceeds from the zero coupon assets would provide funds to meet the principal repayment obligations pursuant to the notes issued by the Cayman Island companies. The original proposal was that the notes issued by the Cayman Island companies would be syndicated to Japanese investors.

J P Morgan promoted the transaction on the basis that, after fifteen years, it would provide the Bank with a tranche of $US $150.0M perpetual capital which would be subject to a servicing cost of only $US 150.0 per annum. In the meantime, the Bank would enjoy the benefit of a sum that qualified as Tier Two capital for the purpose of the Reserve Bank capital adequacy guidelines. The Bank had confirmation from the Reserve Bank that the funds could be included in the Bank's Tier 2 capital for capital adequacy purposes.

6.6.2 CHRONOLOGY OF EVENTS

On 1 February 1988, Mr G Johnston, the Senior Manager of the Corporate Finance division of J P Morgan, wrote a letter to Mr Mallett in which he referred to discussions, and indicated that J P Morgan was preparing a "presentation on capital funding for SBSA" which J P Morgan proposed to deliver that week. The letter indicated that J P Morgan had recently arranged funding for a major non-Australian financial institution which J P Morgan believed could assist the State Bank in raising funds that would be accepted by the Reserve Bank as capital. It was pointed out that a number of elements of the structure would require careful consideration with respect to the Reserve Bank's capital guidelines and Australian income tax legislation. ()

On 4 February 1988, Mr Johnston sent to Mr Mallett a facsimile message which included spreadsheets Mr Johnston had prepared calculating the cost of the funds raised by way of collapsing perpetual floating rate notes for a range of average LIBOR values. The message indicated that Mr Johnston would explain the spreadsheets in more detail in a presentation that he proposed to send the following day. The Investigation has inspected all the material produced by the Bank, but has not seen the "presentation".

On 12 February 1988, Ms Kimber and Mr I N Wheaton of the Bank met Mr R Ruse of SAFA. The proceedings of this meeting were recorded in the following Call Report prepared by Ms Kimber:

"

"CALL REPORT

STATE BANK OF SOUTH AUSTRALIA  

12/2/88 11.30 a.m.

Distributed to: T.L. Mallett
I.N. Wheaton
From: A. S. Kimber
Company: SOUTH AUSTRALIAN GOVERNMENT FINANCING AUTHORITY
Address: 108 King William Street,
ADELAIDE. 5000
Representative: Robert Ruse, General Manager
SBSA Representative: A.S. Kimber
I.N. Wheaton

Details of Discussion:

We called on Mr. Ruse to discuss SAFA's attitude to possible capital funding options and the extent to which they will be prepared to provide guarantees etc. According to Mr. Ruse SAFA are of the view that they would prefer to provide State Bank with the capital we require rather than having us go to the market and pay substantially above Libor. SAFA could raise any USD we required by raising them on behalf of SAFTL and then having SAFTL invest in the Bank's capital. This would be far cheaper than any other options we have seen, ignoring tax implications. Given State Bank's unique position as a tax payer such considerations are not important although they would be for a private company. A similar arrangement to that which applies to the most recently converted subordinated debt for the period after 1997, could probably be devised for any new capital which was raised.

SAFA would be willing to co-operate with the Bank in any way on alternative sources of capital if these prove cheaper than the cost to the State of funding the Bank through offshore markets. The capital stock issued by the R. & I. Bank was discussed. In principle SAFA would not be opposed to such an issue by SBSA, however the cost in the scheme for the R. & I. Bank was fairly high.

In summary SAFA is prepared to provide guarantees or other support for a capital fund raising issue by SBSA if that means that the Bank can raise capital at a lower overall cost than that which could be provided by SAFA (or SAFTL)." () (Emphasis added)

The Call Report demonstrates Ms Kimber's understanding that SAFA:

(a) was prepared to provide capital to State Bank;

(b) believed it was able to provide capital more cheaply than the Bank could obtain funds through its own endeavours; and

(c) was in fact willing to provide funds at a cost less than the Bank would obtain them elsewhere.

The Call Report was marked for distribution to Mr T L Mallett and Mr Wheaton.

A paper titled "Capital Raising Opportunities", dated 17 February 1988, was presented to the Bank's Executive Committee following the release, by the Reserve Bank in January 1988, of proposals for capital adequacy supervision of banks. The paper recommended that the Bank approach SAFA regarding the raising of $US 200.0M - $US 250.0M in subordinated debt. The paper acknowledged the need for a proportion of the additional capital that was required to enable the expected growth in group assets to be subscribed in a foreign currency to provide protection against a devaluation of the Australian dollar. The paper discussed a number of "vehicles" for raising additional capital in the short term. With respect to the possibility of raising capital by the use of collapsing perpetual floating rate notes, the paper observed:

"2. "Collapsing" FRN

The nature of a "collapsing" FRN is such that SBSA obtains perpetual capital funding on which interest payments are payable only for the first 15 years, there being no ongoing cost after the 15th year. J.P. Morgan report significant investor demand for this product.

The disadvantages of the collapsing FRN are its high issue fees (1.9%), relatively high costs for years 1 to 15 (around Libor plus 21 - 189 for Libor range of 8 -10%), and the fact that it has not yet been tested with the Reserve bank (although it appears to conform to their specifications of capital)." ()

The paper observed that preliminary discussions had taken place regarding the possibility of further capital injections by SAFA and that "SAFA's attitude appears quite favourable, their belief being that they can provide funding on cheaper terms than the ... options (which were analysed in the paper)". The paper concluded with the recommendation:

"It is recommended that formal discussions be opened with S.A.F.A. regarding the raising of USD 200-250 million in capital. The alternatives discussed above should be revisited in the light of firm quotations made by S.A.F.A. prior to a final decision being made." ()

Also, in February 1988, a paper was provided to the Board titled "Capital Requirements". The paper sought the Board's approval for the Bank to negotiate with State Treasury for the raising of additional capital. The paper did not refer to the possibility that the Bank might raise capital from parties other than State Treasury.() It was after consideration of the paper on 25 February 1988, that the Board passed the resolution, recorded in minute 36 of 1988, authorising negotiations with State Treasury to raise the necessary funds to provide the Bank with capital resources of $1.0B as at 30 June 1988 with up to $250.0M being in foreign currency.()

On 31 March 1988 Mr Johnston of J P Morgan wrote to Mr Mallett referring to recent discussions. The letter referred to other transactions that J P Morgan had been involved in, and under the heading "Market Appetite," stated the author's belief that a transaction of $US 100.0M - $US 150.0M could be readily syndicated. The letter concluded with a statement that:

"We believe that a significant investor interest exists for such an issue by SBSA and stand ready to action this opportunity just as soon as you are in a position to move."

The letter also appended a calculation showing the all-in costs at different future average LIBOR rates, and commented that the transaction was "extremely attractive" on a pre tax equivalent basis if all coupon payments are fully deductible.()

On 8 April 1988, Mr Mallett met with members of the Bank Board, including Mr Barrett and Mr Simmons, to discuss the proposed J P Morgan transaction. It was an informal meeting. There is no record of the meeting in the Board Minutes, nor is there any evidence that those in attendance were provided with any briefing material. Mr Simmons made the following diary note:

"On the 8th April I attended the State Bank for a Board meeting to vet a scheme whereby a second teir [sic] capital would be introduced offshore. This was a deal with Morgan Guarantee and there was a debt of defeasance. [sic] The basic deal I said was OK subject to approval from tax lawyers and accountants."()

On 14 April 1988, J P Morgan provided a draft mandate letter to the Bank which outlined the terms of the transaction. A facsimile message which accompanied the draft noted a number of points concerning the transaction, including the need for approval from the Reserve Bank of Australia.()

On 19 April 1988, Mr Mallett and other Bank officers met with officers of the Reserve Bank to obtain confirmation that capital raised by the proposed notes would qualify as Tier 2 capital. The meeting was followed by a letter from Mr Mallett to the Reserve Bank dated 27 April. The letter stated an argument in favour of treating funds raised by the proposed issue as Tier 2 capital, and requested an indication that the Reserve Bank would be prepared to treat the funds in that way.()

Mr Matthews wrote to the Under-Treasurer on 29 April 1988 on the topic of Bank capitalisation. The letter described the changes to the Reserve Bank Capital Adequacy requirements, and the State Bank's projected need for capital over the ensuing five years, having regard to the Reserve Bank guidelines and the Bank's planned growth. Mr Matthews said with respect to the proposed additional Tier 2 capital:

"In relation to the $US denominated Tier Two perpetual debt, the Bank is currently negotiating to raise $US 100 million. Our understanding is that there is a current market opportunity to raise these funds ...".()

On 6 May 1988, the Bank's joint external auditors, Touche Ross & Co and Peat Marwick Hungerfords, wrote to Mr Matthews setting out the way in which the proposed notes issue should be treated in the Bank's accounts.

On 10 May 1988, the Under-Treasurer, Mr Prowse, wrote to Mr K S Matthews, Chief General Manager at State Bank, about a number of matters concerning Bank capitalisation. The letter referred specifically to the proposed raising of $US denominated capital through J P Morgan. Mr Prowse restated SAFA's willingness and ability to provide the Bank with $US dominated capital.

He also said:

"In light of the above, your advice that the Bank is "currently negotiating to raise US$100 million" by way of perpetual debt to count as Tier Two capital, raises important issues for consideration. We have stressed in previous discussions that we see little point in a member of the South Australian Government family of organizations borrowing, for capital adequacy purposes, from the rest of the world at rates well above LIBOR on a perpetual basis when the Bank's capital requirements can be met from the State's own sources and funded from term debt costing LIBOR or less. We would therefore ask you to defer the issue of any US$ perpetual debt until you have had an opportunity to discuss this matter further with us.

Another major issue on which we have sought (but not yet obtained), your advice is the possibility of improving the Bank's gearing by somehow taking concessional housing lending out of its balance sheet." () (Emphasis added)

The attitude of SAFA could not have been made clearer.

On 12 May 1988, Mr Matthews sent, by facsimile, to Mr Mallett in Tokyo, a copy of Mr Prowse's letter of 10 May 1988, in which Mr Prowse asked the Bank to defer the issue of any $US perpetual debt.

On 26 May 1988, the Board noted that the Bank had mandated J P Morgan to arrange the issue in the terms set out in the paper prepared by Ms Kimber and presented by Mr Mallett.() The paper includes a broad summary of the transaction proposed to be undertaken by the Bank. It specifically notes the involvement of SAFA as an investor in the notes to be issued by the Cayman Island companies to the extent of $US 75.0M, and states that J P Morgan would syndicate the remaining $US 75.0M. The terms and cost of the transaction are summarised in the paper. In summarising the cost of the capital to the Bank, an attempt was made to calculate the net cost of the proposed transaction in United States of America and Australian dollars. The paper also discussed the proposed accounting treatment of the transaction, and the annual net impact of the transaction on the Bank's profit and loss.()

The extent to which the paper accurately informed the Board about the transaction is considered later. It is, however, appropriate to mention in passing that the paper included arithmetical errors which made the of the cost of capital analysis defective.

The paper was noted and the transaction impliedly approved by the Board without demur. There is no record of any concern being expressed by a Board member. Furthermore, there is nothing to suggest that any member of the Board queried either the stated fixed rate of interest of LIBOR plus 0.65 per cent on the principal amount, or the other stated costs of the transaction.()

Between 27 April and 2 June 1988, Mr Mallett held further discussions with officers of the Reserve Bank. The Reserve Bank was concerned by the wording of a default clause in the draft documentation which addressed the obligation to repay principal in certain circumstances. In a letter to Morgan Grenfell, Mr Mallett stated that he had been told by the Reserve Bank on 2 June that the documentation met their requirements, save for two matters which the State Bank was able to accommodate.() The letter indicates that on 3 June Mr Mallett advised the Reserve Bank of the State Bank's ability to accommodate the two outstanding matters. The two matters are set out in a facsimile message from the Reserve Bank dated 3 June 1988.()

On 6 June, following a representation from Mr Matthews, the Reserve Bank indicated it was prepared to waive one of the requirements which related to a side agreement between the State Bank and the South Australian Treasury. On the following day, however, the Reserve Bank verbally advised both Mr Mallett and Mr Matthews that its legal advisers were unable to accept the default clause. Mr Mallett's letter indicates that the Reserve Bank's legal advisers were concerned with the possibility that the notes could be repayable, and therefore fall outside the 1986 guidelines for perpetual capital.()

On 8 June, Mr Mallett forwarded to the Reserve Bank an amended default clause in the hope that it would enable the Reserve Bank to treat the funds to be raised by the proposed issue as capital.()

On the same day Mr Mallett received a facsimile message from Mr Matsui, Associate Director of J P Morgan Securities Asia Ltd. Mr Matsui referred to his concern that the Reserve Bank decision would cause the lead investor, which had underwritten the transaction to the extent of $US 75.0M, to withdraw. Mr Matsui requested a letter setting out the circumstances surrounding the Reserve Bank's position so that position might be explained to possible investors. Importantly, the message indicated that the lead investor might not be prepared to accept the revised terms.()

Mr Mallett wrote to Mr Matsui on the same day. He outlined the history of the discussions with the Reserve Bank. He also referred to the Bank's embarrassment at having to change a fundamental term in the documentation at such a relatively late stage.()

By a letter dated 8 June 1988, Mr Pearson, Chief Officer, Supervision Unit of the Reserve Bank, confirmed that, subject to certain conditions, the notes would be accepted by the Reserve Bank as part of the Bank's capital base.()

Japanese investors did in fact abandon the transaction during early June. J P Morgan has told the Investigation that that was because the investors were not prepared to accept the "lower standard of documentation" which was a consequence of the amendments required by the Reserve Bank.() The Bank then took steps to have SAFA take the place of the Japanese investors.

In June 1988, Mr Emery for the Under-Treasurer, prepared a minute to the Treasurer seeking his approval for the investment by SAFA and/or its affiliated companies in the proposed issue of notes by the Bank. The minute was signed by the Under-Treasurer on 17 June. It includes the following paragraph:

"USD Tier 2 Capital

SAFA and/or its affiliated companies could provide all of the USD Tier 2 requirements of the State Bank. However, commitments have been (made) by the State Bank to certain arrangers and investors in relation to a structured perpetual debt arrangement (refer attached SAFA Board Paper No. 274 for outline of arrangement) through a Cayman Island shell company from which it would be difficult for the State to withdraw."

Further, it remarked that "the maximum amount available for the SAFA Group is currently $US125M out of the total $US150M subscription amount, of which $US94M would flow as proceeds to the State Bank". The Treasurer approved the investment by SAFA on 25 June 1988.()

The Bank's file contains a handwritten note by Ms Kimber of a telephone call from Mr G Johnston of J P Morgan on 22 June 1988. Mr Johnston told her that a Japanese investor had withdrawn from the transaction. The note records that the Bank would itself take up the shortfall of $US 25.0M, and that J P Morgan would look at ways of selling down the notes within six months.()

In fact, Morgan Guarantee Australia Ltd purchased the notes in respect of which there had been a shortfall of $US 25.0M, subject to the State Bank granting Morgan Guarantee Australia Ltd a put option. The arrangement is evidenced by a letter dated 27 June 1988 from Mr Mallett of the Bank to Mr G Johnston of Morgan Guarantee Australia Ltd.

A file note prepared by Ms Kimber on 27 June 1988 records that SAFA and its affiliates would invest in the issue of notes by the Cayman Island companies to a total face value of $US 125.0M. It also records that the Bank had considered lending $US 53.0M to SAFA, but that was not possible because of Loan Council restrictions. Instead, it was proposed that the Bank would enter a three month foreign exchange swap with SAFA. The effect of the swap was to provide SAFA with the US dollar funds it required to allow SAFA to invest in the notes issued by the Cayman Island companies. The swap was a short-term arrangement, for three months only.()

The files of the Bank include documents sent to Mr Mallett by Mr M Oswald of the Bank's London Treasury. The documents were received by the Bank in Adelaide on 28 June 1988, and were referred by Mr Mallett to Ms Kimber. They include an analysis of a transaction which is essentially the same as that which State Bank was about to enter into. The analysis by Credit Suisse First Boston (an international investment bank) considered the nature of the transaction, and how it should be analysed and accounted for. The analysis of Credit Suisse First Boston, and its assessment of the eligibility of the notes to be treated as capital, was contrary to the position taken by the State Bank.()

A file note prepared by Ms Kimber on 28 June 1988 refers to some of the issues raised by Credit Suisse First Boston. She noted that the particular issue of notes that was the subject of the analysis of Credit Suisse First Boston had been disallowed as capital by the French Government, and that the Bank of England had reportedly stated it would not allow such an issue to be treated as capital either. Ms Kimber noted that the State Bank had received clear advice from the Reserve Bank that the issue would be allowed as Tier 2 capital and that J P Morgan advised there were differences between the transaction considered by Credit Suisse First Boston and that about to be undertaken by State Bank.()

The Quarterly Operating Review to June 1988 noted the completion of the transaction. The transaction was referred to in the Highlights of the Quarter. Also, a section of the report dealing with the Treasury and Internal division states:

"A private placement of face value USD150 million of Perpetual Notes was arranged for the Bank by J.P. Morgan Securities. Under Reserve Bank guidelines the net proceeds of USD106.8 million can be counted as Bank Capital to a maximum of 0.75% of assets." ()

The Quarterly Operating Review was considered by the Board at its July meeting.

The Investigation has considered a number of aspects of this transaction, including:

(a) the cost of funds;

(b) whether alternative sources of funds were available;

(c) the role of SAFA in the transaction;

(d) the accounting arrangements adopted by the Bank; and

(e) the information provided to the Board.

6.6.3 COST OF FUNDS

An important consideration in evaluating the merits of the transaction was the cost of the funds to be obtained by the Bank.

Mr Mallett has described to the Investigation his understanding of the cost of funds provided by the transaction:

"It came down to the best advice that I had from JP Morgan and Alison Kimber was that I could expect this capital tier two initially to be LIBOR + three and in 15 years there is an accounting mechanism where it could become tier one capital".()

The Investigation has sought to assess the actual cost of the transaction, and how Mr Mallett came to the understanding described above.

The Investigation has calculated the effective cost of the funds to the Bank, using the figures projected by the Bank at the time the Board noted the proposed transaction. Those figures are lower than those that actually apply to the completed transaction. Accordingly, the cost of funds as calculated by the Investigation will be less than the actual cost.

The cost of funds to the Bank was calculated by determining the effective annual interest rate resulting from the payments to be made by the Bank over the first fifteen years of the transaction. The calculation assumed payments by the Bank in accordance with the transaction described in Board Paper 169/88. The evidence before the Investigation is that the swap transactions referred to in the Board Paper were executed by the Bank at rates which are higher than those reflected in the Board Paper. Table 6.8 shows the cost of funds to the Bank for a range of LIBOR as calculated by the Investigation.

 


LIBOR
(%)

Table 6.8

Effective
Annual
Interest Rate
(%)

Effective
Margin Over
LIBOR
(%)

4.0

3.77

-0.23

6.0

6.88

0.88

8.0

9.70

1.70

10.0

12.34

2.34

12.0

14.83

2.83

14.0

17.21

3.21

At the request of the Investigation Ms Kimber also made a calculation of the cost of the funds. After making certain assumptions her calculation proceeds as follows:

"The fixed cost of the capital per annum for 15 years is then USD150m x 0.65% + USD42m x 10% = USD5,175,000

The floating cost of the balance must be added, that is USD108m x LIBOR.

Assuming a constant level of LIBOR for 15 years, the Internal rate of return i can be deduced by solving the following equation for i

108 = (5.175 + (180 x LIBOR) :

1

 

1

    1
    (----- +

-----

+ ….. + ----- )
   

1+i

 

(1+i)2

   

(1+i)15

         
       

115

  = (5.175 + (108 x LIBOR )):

1

- ( ------ )
        1 + i
    ( --------------------)
   

i

The following table shows the IRR (i) for various levels of LIBOR and the cost of the capital expressed as a margin over LIBOR.

LIBOR
%
i
%
Margin
%
6.0 6.7 0.7
7.0 8.2 1.2
8.0 9.5 1.5
9.0 10.9 1.9
10.0 12.1 2.1
11.0 13.4 2.4
12.0 14.6 2.6

Clearly the cost expressed as a margin over LIBOR varies substantially with the underlying level of LIBOR assumed." ()

Ms Kimber's calculation is generally consistent with calculations carried out by the Investigation.

The calculations are consistent with the observations about the cost of such transactions made in the paper dated 17 February 1988, which was presented to Executive Committee by Mr G S Ottaway. Mr Ottaway's paper observes that a disadvantage with the "collapsing FRN transaction" is:

"relatively high costs for year 1 to 15 (around LIBOR + 21 - 189 for LIBOR range of 8-10%)".()

Further, the letter to Mr Mallett, from Mr Johnston of J P Morgan, dated 1 February 1988, noted:

"SBSA's effective interest cost on the perpetual for year 1-15 will, of course, be much higher than the nominal coupon referred to above due to the substantial issue discount." ()

The calculations provided by Mr Johnston to Mr Mallett on 4 February 1988 analysed the projected costs of the transaction. The analysis was on a basis consistent with that performed by this Investigation. It calculated the cost of funds based upon cashflows before tax, and after making adjustment for the effect of the payment likely to be made by the Bank for the Corporations Tax Equivalent pursuant to Section 22 of the Act. The after tax calculation assumed that the Bank could deduct the full coupon payment from its income for the purpose of calculating the Corporations Tax Equivalent.

The calculation prescribed by J P Morgan on 4 February was as follows:

 

IRR Margin Over LIBOR

Equivalent
Pre-Tax LIBOR Margin

LIBOR

Per Cent

Pre-Tax
Floating
Per Cent

After-Tax
Floating
Per Cent
Pre-Tax
Floating
Per Cent
After-Tax
Floating
Per Cent
1.00 -13.18 -19.13 -13.18 -36.56
2.00 - 9.35 -15.92 - 9.35 -29.29
3.00 - 6.75 -13.87 - 6.75 -24.31
4.00 - 4.79 -12.42 - 4.79 -20.51
5.00 - 3.21 -11.35 - 3.21 -17.44
6.00 - 1.90 -10.52 - 1.90 -14.87
7.00 - 0.77 - 9.88 - 0.77 -12.66
8.00 0.21 - 9.38 0.21 -10.71
9.00 1.09 - 8.99 1.09 - 8.99
10.00 1.89 - 8.69 1.89 - 7.43
11.00 2.61 - 8.46 2.61 - 6.02
12.00 3.28 - 8.29 3.28 - 4.72
13.00 3.90 - 8.17 3.90 - 3.52
14.00 4.49 - 8.09 4.49 - 2.41
15.00 5.04 - 8.05 5.04 - 1.38

The J P Morgan analysis assumed different values from those used by this Investigation because of differing market conditions between February when the calculation was made and June when the transaction was implemented. The results of the two analyses are, however, consistent on a pre-tax basis. The difference lies in the consideration of the after-tax cost of funds.

The Investigation has obtained from the Bank files a copy of a spreadsheet that compares the net present value of the transaction proposed by J P Morgan with the alternative of raising $US 105.0M at LIBOR plus 35 basis points from the SA Treasury. The analysis ignores the effect of the Corporations Tax Equivalent payable by the Bank, and shows that the J P Morgan transaction compared unfavourably with the alternative of raising capital directly from the South Australian Treasury.

The Investigation has not seen any evidence which corroborates Mr Mallett's view about the likely cost of funds.

Ms Kimber has been examined to identify any analysis that may have been provided to Mr Mallett, but Ms Kimber is unable to recall what analysis of the transaction was undertaken by the Bank. The only evidence is that Mr Mallett was provided with an analysis that showed that the alternative of raising funds directly from the South Australian Treasury was more cost effective than the transaction implemented.

The only basis upon which the transaction could be seen to be cost effective was on an after tax basis. The appropriateness of the Bank entering into transactions or other arrangements which had the effect of reducing the Corporations Tax equivalent payable pursuant to Section 22 of the Act had been raised by the Treasurer in a letter to the Managing Director, on 24 March 1986, in connection with the Bank's announcement of its plans to build the State Bank Centre. The letter included the following statement:

"To put it bluntly, if the effect of a particular proposal is to reduce payment in lieu of tax to the Government that should not be regarded as a plus for that project."

In responding to the Premier's letter Mr Clark wrote:

"We agree that we should consider major projects on a "whole of State" basis and consistently take that approach."

Mr Mallett has made the following submission to the Investigation on this issue. He said:

"The tax treatment of payments was ignored in the decision process, although advice from JP Morgan was that on an after tax basis, which would be adopted by any commercial organisation, the cost of funds would be substantially below LIBOR."

Mr Mallett's submission is consistent with the documentation which evidences the analysis of the cost of the transaction by the Bank. Further, it is Mr Simmons' recollection that any tax advantages of the transaction were not raised with the Board at the time that the transaction was implemented.

The Investigation asked the Bank how the coupon payments by the Bank on the notes was accounted for in calculating the Corporations Tax Equivalent payable by the Bank pursuant to Section 22. The Bank has advised that the tax treatment was the same as the accounting treatment. The accounting treatment is set out in detail later in this Chapter.

In my opinion, this has the result that the Bank overstated its deductions from income for tax purposes by an amount equivalent to the principal repayments, which is contrary to the intent of the Premier's letter of 24 March 1986. That overstatement is compensated for by other parts of the Bank's accounting treatment of the transaction, which spread the deduction of costs over an extended period. Thus, the financial benefit to the Bank of the overstated tax deductions will be lost to the Bank.

The cost of the funds obtained by the Bank from the J P Morgan transaction can be compared with the cost of other capital obtained by the Bank. Concurrently with the transaction, the Bank obtained Tier 1 capital from SAFA in Australian dollars at the Bank Bill rate plus 0.65 per cent. Perhaps more significantly, in December 1988, the Bank received from SAFA further capital denominated in the United States dollars. That tranche was in the form of subordinated debt with a ten year maturity, and was borrowed at a cost of LIBOR flat.

With respect to the cost of the transaction it can be concluded that:

(a) the transaction required the Bank to pay a premium over the cost of alternate forms of capital available to the Bank;

(b) this fact should have been known to the Bank from the very outset of the transaction;

(c) there was only a financial advantage to the Bank from the transaction if the transaction was considered on an after tax basis; and

(d) there is no evidence that the cost on an after tax basis was considered when the decision was made to raise capital funds through J P Morgan rather than, for example, directly from SAFA.

6.6.4 ALTERNATIVE SOURCES OF CAPITAL FUNDS

In June 1987, the Board, acting upon the recommendation of the Executive Committee, resolved:

"that arrangements be put in place with State Treasury to enable the issue of Perpetual Notes and/or capital stock so that further long-term capital can be raised quickly at some future time when the opportunity arises." ()

The raising of Tier 2 capital by the Bank was the subject of discussions between Ms Kimber of the Bank and Mr Ruse of SAFA at the meeting in February 1988 which is recorded in the Call Report set out above. The position of SAFA is clearly indicated by Mr Ruse's statement that SAFA was willing and able to provide capital to the State Bank more cheaply than the Bank could obtain it elsewhere. A copy of the note was provided to Mr Mallett.()

It is evident from Mr Prowse's letter of 10 May 1988 to Mr Matthews, that the requirement of the Board resolution of 25 June 1987, that "arrangements be put in place with State Treasury", was not given effect to.() Mr Prowse's letter also makes it clear that SAFA was prepared to provide additional capital at competitive rates, and that SAFA had requested the Bank to defer the issue of any $US perpetual debt until the Bank had discussed the matter with SAFA.

There is clear evidence that SAFA would have been able to provide the Bank with the additional Tier 2 capital it was seeking in United States currency.

The fact that when J P Morgan did raise the funds on behalf of the Bank, SAFA actually provided the bulk of the funds for the transaction is evidence of the fact that SAFA was capable of providing the funds which were sought via J P Morgan. So, too, is the fact that, in December 1988, SAFA provided an additional amount of US denominated capital to the Bank at the flat LIBOR rate

The Investigation has found no evidence that either the Board or the Executive Committee considered whether the Bank should obtain the additional Tier 2 capital from SAFA or from external parties. Consideration should have been given to the relative costs of the alternatives. The table showing the cost of the funds raised through J P Morgan indicates that when LIBOR is greater than 8.0 per cent per annum, the cost of funds to the Bank will be at least 1.7 per cent over LIBOR. Given that SAFA invested in the transaction to obtain a return of LIBOR + 0.65 per cent it may be concluded that, by entering into the transaction with J P Morgan rather than obtaining funds direct from SAFA, the Bank incurred an increased cost of funds of at least 1.05 per cent per annum. Assuming LIBOR is 8 per cent, and assuming the exchange rates reflected in Board Paper 88/169, the Investigation has calculated the net present value of the additional cost over the fifteen years life of the transaction to be $US 6.5M or $A 8.2M.

There was in the Bank's files the comparison of the J P Morgan transaction and the alternative of obtaining capital direct from the SA Treasury which I have referred to above. The comparison assumed that the Treasury would provide capital at a rate of LIBOR +0.35 per cent. The analysis showed that for any discount rate over 8 per cent the alternative of raising funds from the Treasury was cheaper than raising capital through J P Morgan.

The significant additional cost of raising funds through J P Morgan demonstrates that the Board should have been informed of the alternatives. More importantly, the transaction should have been formally authorised by the Board. These things should have occurred before the Bank "mandated" J P Morgan to raise the funds in April 1988. The Investigation has seen no evidence that the Board was informed of the alternatives, or that the Board was asked to authorise the actual transaction.

There are other occasions on which it would have been appropriate for Bank officers to seek the Board's direction on the proposed course of action. One such occasion arose in May 1988, when Mr Matthews received the letter from Mr Prowse. Similarly, the Board should have been advised when the Japanese investors withdrew in June 1988 and it became necessary for SAFA to provide almost all of the funds. At the very least, the Board should have been advised of and assessed the costs of the alternatives.

6.6.5 THE ROLE OF SAFA AS AN INVESTOR

The transaction ultimately undertaken was substantially different from the one contemplated when J P Morgan introduced the concept to the Bank in February 1988, and even from the transaction which was contemplated when the Bank "mandated" J P Morgan to proceed in April 1988.

In the letter from Mr Johnston of J P Morgan to Mr Mallett, on 1 February 1988, Mr Johnston stated:

"These transactions/structures will be included in the larger presentation I will be delivering this week. However, I thought it worthwhile to put something before you now as we currently have strong investor demand for these types of transactions." ()

When the Bank Board noted the transaction in May, it was advised that, of the dated floating rate notes to be issued by the Cayman Island companies, $US 75.0M would be purchased by SAFA, with the balance of $US 75.0M to be syndicated by J P Morgan. In June, when the transaction was implemented, SAFA and its affiliates purchased notes to the value of $US 125.0M. The balance of $US 25.0M was purchased by Morgan Guarantee Australia Ltd subject to the put option given by the Bank.

It is evident that the proposed investment by SAFA of $US 75.0M, which is reflected in the paper considered by the Board in May 1988, followed upon Mr Prowse's letter of 10 May. Further, it is evident that the subsequent increase in the SAFA investment to $US 125.0M followed upon the withdrawal of the Japanese investors as a result of the Reserve Bank's requirements. The Investigation has not fully investigated the process by which SAFA determined to increase its investment through J P Morgan or whether SAFA considered the alternative of direct investment.

There is no evidence that either the Executive Committee or the Bank Board were informed of the difficulties experienced by J P Morgan in structuring the transaction in the way that was first proposed. Nor was the Board given the opportunity to decide upon the desirability of proceeding with the amended transaction, or resiling and seeking the funds directly from SAFA.

6.6.6 ACCOUNTING ARRANGEMENTS

In evidence to the Investigation, Mr Mallett said that, while the cost of the capital obtained was high, that disadvantage was offset by the opportunity for the Bank to obtain permanent and free capital after fifteen years.() For an assessment to be made of the suggested benefit, the mechanism by which the transaction would provide the Bank with non-repayable capital should be understood. The basic transaction was, in substance, simply a borrowing transaction, with the State Bank repaying the principal amount plus interest over the term of the transaction. Credit Suisse First Boston analysed this type of transaction in the following way:

"The mere fact of calling a 15 year subordinated annuity note either:

a) a perpetual note which is callable at 0% of principal amount at end of year 15; or

b) a perpetual note which ceases to make any payment after year 15;

should not transform the debt into permanent Tier 2 capital.

Furthermore, the annual payments should not be deductible in their totality as interest because each payment includes a portion of principal repayment as well as interest." ()

This view is supported by the approach now adopted by the Australian Accounting Profession in Australian Accounting Standard AAS 23 - "Set-off and Extinguishment of Debt ". Paragraphs 14, 15 and 26 deal with accounting for a transaction such as that entered into with J P Morgan.

The perceived benefit that the transaction would provide the Bank with long term capital only arises because of the accounting treatment adopted by the Bank. A full analysis of the accounting treatment adopted by the Bank is set out later in this Chapter. The factor in the Bank's accounting treatment which enabled the transaction to be represented as providing non-repayable capital relates to the treatment of the coupon (interest) payments to be made by the Bank on the undated floating rate notes. In essence, the Bank proposed to treat the full amount of the coupon payments as an expense to the Bank's profit and loss account. Thus, while the Bank was in fact repaying the principal borrowed, it was not reducing the capital shown on the Bank's balance sheet.

The Bank did, subject to certain other significant accounting devices discussed later in this Chapter, charge the full coupon payment on the undated floating rate notes to the Bank's profit and loss account. Thus it did not, as required by AAS 23, allocate the coupon payment between interest, which should be charged as an expense, and the repayment of principal. Instead of the balance of "Capital" being written off as the principal amount was repaid, the principal repayment component was charged as an expense.

The effect of this accounting treatment was to require the Bank to appropriate profits to the Bank's capital. This appropriation occurred before the determination of the Bank's profit, and before the operation of Section 22 of the Act, so that the Bank's liability to make payments to the State Treasury was reduced by that part of the claimed expense which was in reality a repayment of principal.

As indicated earlier, the impact of the above accounting procedure is affected by other measures which I discuss below.

The funds obtained by the Bank from J P Morgan were segregated from other bank funds and invested by the Bank. The income from the investment of the funds has been credited against the cost of raising the funds. Thus, the gross income of the State Bank does not include a return on the capital funds raised by the transaction.

The Bank calculated the cash outflows it was committed to meet after netting off the income from the investment of the funds received. To the extent that it had net commitments which were affected by floating interest rates, it entered floating to fixed rate swap transactions to enable it to fix its future cash flows as costs were incurred over the fifteen years the Bank was obliged to meet the coupon payments on the Perpetual Floating Rate Notes. For accounting purposes, however, the Bank determined that the costs would be accumulated and written off over the longer period of forty years. The rate at which the costs were to be written off each year was determined at the commencement of the transaction by calculating the anticipated expense over the life of the transaction and spreading it over the longer period. The Bank proposed to write off the capitalised cost of the funds over a period of forty years.

In my opinion, the accounting approach adopted by the Bank was inappropriate. The Bank should not have netted an income item, that is the proceeds from investing capital funds against the cost of those funds. In addition, the Bank should not have adopted a procedure for capitalising the cash outflows it was committed to pay over the life of the transaction with the intent of amortising those costs over a different period. The Bank's income and expenses with respect to the transaction should have been recognised in the Bank's profit and loss statements for the period in which the income and expense items were earned and incurred respectively. The approach adopted by the Bank involved an understatement of the Bank's expenses from year to year, and the inclusion in the Bank's balance sheet of a debit balance representing capitalised coupon payments, of varying amounts, which did not represent a realisable asset.

It is this last element of the accounting treatment that provided the Bank with capital. Capital was obtained as the net cost of the transaction was charged to the profit and loss statement effectively appropriating funds from the Bank's profits. It is significant that this appropriation occurred "above the line", which is before the determination of profit, and consequently avoided the possibility of a distribution of profit pursuant to Section 22.

The approach adopted by the Bank was, in my opinion, inconsistent with the Statement of Accounting Standards AAS 23. This Statement of Accounting Standards was promulgated by the Australian Accounting Bodies in June 1988. The matter of the extinguishment of debt by defeasance had been the subject of much discussion and comment within the accounting profession prior to that time. The relevant paragraphs of the standard deal specifically with a process called partial defeasance of debt which is the process undertaken by State Bank in dealing with this particular transaction.

At the time the above accounting arrangements were implemented, Mr Copley was the Bank executive responsible for accounting arrangements within the Bank. In evidence to this Investigation, Mr Copley could not recall details of the accounting treatment of the transaction. The paper prepared by Ms Kimber, however, and presented to the Board in May 1988, says in respect of the accounting treatment to be adopted by the Bank:

"Chief Manager, Group Finance, advises that this cost can be amortised over a longer period since after fifteen years the capital is virtually free requiring only a servicing payment of USD 150 per annum. If a period of forty years was chosen for amortisation, the cost would be approximately $A 1.8M per annum." ()

The paper indicates that Mr Copley was aware of the transaction, and was involved in the accounting treatment adopted by the Bank.

In May 1988, the Bank's joint auditors provided Mr Matthews with what the auditors considered was an appropriate approach to accounting for the transaction which had been described to them.() They advised that:

(a) the profit and loss account should be charged each year with the coupon payments at LIBOR + 0.65 per cent per annum on the $US 150.0M face value of the transaction;

(b) the discount of $US 45.0M, being the difference between the face value and the actual proceeds of the transaction, should be amortised over fifteen years being the term of the transaction;

(c) the nature of transaction should be described in the notes to the accounts.

The auditors' advice was entirely ignored by the Bank. It must be acknowledged that while the advice provided by the auditors does not accord with current Australian Accounting Standards the advice predated the promulgation of AAS 23 in June 1988.

The role of the auditors in reviewing this transaction is discussed in those Chapters of this Report dealing with the external audit of the Bank's accounts for the years ended 30 June 1988, 30 June 1989 and 30 June 1990.

The Bank has considered the Investigation's analysis of the transaction and responded to that analysis. It acknowledges that the accounting treatment is incorrect, but asserts that the application of AAS 23 is not the only correct approach.

6.6.7 INFORMATION TO THE BOARD

Having regard to Term of Appointment C, I have considered what information was provided to the Bank Board with respect to the J P Morgan fundraising transaction. Primary reliance has been placed on Board Minutes and papers; but I have also had regard to evidence given to the Investigation by a number of witnesses and other contemporary documents.

The capital structure of the Bank was considered by the Board on a number of occasions from the beginning of 1988 until the transaction was finalised in July 1988. In February 1988, the Board was provided with the paper requesting the authorisation of management to commence negotiations with the State Treasury with a view to raising sufficient funds, by way of both capital and subordinated debt, to provide the Bank with capital resources of $1,000.0M at 30 June 1988.() At the meeting on 25 February 1988, the Bank Board adopted the recommendation put to it, and authorised management to negotiate with the State Treasury.()

The Board was not informed, at the time this approval was sought, that Mr Mallett was engaged in discussions with J P Morgan with a view to J P Morgan raising capital on the Bank's behalf. Further, the Board was not asked to authorise those negotiations. The fact that Mr Mallett had been involved in discussions with J P Morgan is evidenced by a letter from Mr Johnston of J P Morgan to Mr Mallett of 1 February 1988. The letter refers to earlier discussions.()

The content of the Board Paper and the recommendations it contained can be contrasted with a paper presented to the Executive Committee on 19 February 1988 on the subject of "Capital Raising Opportunities".() That paper referred to the J P Morgan transaction as one opportunity amongst a number of alternatives, which included proposals from other financial institutions. It included a recommendation to Executive Committee that the Bank approach SAFA to commence negotiation for the provision of $US 200.0 - $US 250.0M in perpetual subordinated debt. The minutes of the Executive Committee also record agreement being reached:

"To recommend to Board the raising of $150 million as capital and up to $250 million in foreign currency as perpetual debts within the total requirement for the Bank to have $1 billion of capital by June 1988." ()

Board Minutes prior to the meeting on 26 May 1988 do not record any reference to the transaction, and no formal submission was made until the May meeting. There is evidence that in March 1988 the Board was informed that a transaction involving J P Morgan was contemplated, and that Board members were invited to attend a briefing by management with respect to the transaction. A meeting was held on 8 April 1988. The occurrence of the meeting is evidenced by an entry in Mr Mallett's appointment diary and a diary note of Mr Simmons. No other documentary evidence of the meeting has been obtained by the Investigation.

Mr Mallett and two directors, Mr Barrett and Mr Simmons, have some recollection of the meeting. It is Mr Mallett's recollection that the meeting was held in his office, and was attended by Mr Barrett and at least three other Directors. He recalls that Mr Matthews provided most of the explanation at the meeting. He recalls that he, Mr Copley, and Ms Kimber attended the meeting.

Mr Barrett recalls attending the meeting but is unable to recollect any further details.

Mr Simmons' recollection is consistent with Mr Mallett's, except that Mr Simmons believes Ms Kimber described the proposed transaction. It is Mr Simmons' recollection that no documents describing the transaction were provided to him by Bank officers. He recalls, and his diary note records, that he was satisfied with the transaction described to him, subject to approval by tax lawyers and accountants.()

In early April 1988, the Bank gave J P Morgan a mandate to arrange the proposed transaction on behalf of the Bank. The minutes of an Executive Committee meeting held on 15 April 1988, however, do record that the Executive Committee was advised that J P Morgan had been given the mandate. This was a significant commitment by the Bank to an important capital raising transaction.

On the evidence before me, I have formed a view that members of the Bank's management failed to adequately inform the Board of the nature of the transaction, or to obtain the Board's approval before proceeding to mandate J P Morgan. There is no evidence that, prior to the Board meeting on 26 May, the Board was provided with any documentation describing the transaction. That meeting was the first time the full Board was given information on which to form an understanding of the transaction.

In my opinion, J P Morgan should not have been appointed to raise capital without the approval of the Board. On the basis of the evidence before the Investigation, I have formed the opinion that Mr Clark should have ensured that the directors were informed of the way in which it was proposed to raise additional capital, and of the comparative advantages and disadvantages of the transaction proposed by J P Morgan. Furthermore, Mr Clark should not have authorised Mr Mallett to enter into the transaction on behalf of the Bank without the merits of the transactions having been properly analysed, and without Board approval.

At the meeting on 26 May 1988, the Bank Board considered and noted the paper prepared by Ms Kimber and presented by Mr Mallett. The paper did not accurately inform the Board of a number of important matters. The figures included in the paper are incorrect; the discount applicable to the Bank Issued Notes is shown as $US 28.0M when it should have been $US 42.0M. That error is carried through to a calculation of the cost of the funds, in that the cost of swapping the Bank's floating rate exposure to a fixed rate exposure is calculated as 10 per cent per annum of $US 28.0M, when it should be 10 per cent per annum of $US 42.0M. Thus the cost of the capital, as disclosed in the paper, is understated by an amount of $US 1.4M ($A1.8M) per annum. This error should have been obvious to any senior bank officer or director who read the paper with the care that such an important transaction required, but the transaction was apparently noted by the Board without comment. The erroneous reference to $US 28.0M presumably found its way into the paper and was carried forward into the calculation of the cost of capital, because $US 42.0M is 28 per cent of $US 150.0M.

The paper is also deficient in that the basis on which it analyses the cost of the transaction is inappropriate. The paper attempted unsuccessfully, because of the arithmetical errors, to disclose the cost of the transaction in dollar terms. It described the charge which would be made pursuant to the transaction to the Bank's profit and loss statement. The paper did not, however, describe in clear terms the assumptions underlying the analysis. Further, the description included in the paper is couched in language that makes it difficult to understand.

Ms Kimber has told the Investigation that the paper was prepared in the way it was because of instructions she had been given to keep the paper simple and that the Board was only interested in the "bottom line".() If that was her objective, she failed. She has observed that the paper was signed off by Mr Mallett, read and considered by Mr Clark, and the Board members, but nobody brought any error in the paper to her attention.()

Mr Simmons gave evidence that this paper, like many others, was presented to Board members only a short time prior to the directors meeting. The paper is dated 24 May and the meeting was held on 26 May. He gave the following evidence with respect to the paper:

"... it came back as a paper for noting, and one of the matters which has interested me in giving evidence is to look at the date of various papers where there have been problems, and unfortunately a lot of those papers are dated after the weekend when papers should have been sent out to the board members, so that the paper for noting of the mandating of Morgans to raise $150 million, which was dated 24 May 1988, the board meeting of 26 May, so that paper would have been either handed out at the board meeting or sent to directors the night before, some of these papers, when you analyse them very carefully and are able to get behind the papers, do not stand close scrutiny." ()

With respect to this evidence, Mr Clark has submitted that if the paper was dated 24 May 1988, it would have been distributed to Directors on that day.

While one can excuse the directors for not understanding a paper which was probably impossible to understand, one can not excuse them for giving their tacit approval to a transaction which they could not have understood, and which was not in the best interests of the Bank.

The paper does not enable a reader to compare the cost of the transaction with the cost of alternative capital raising possibilities, or to compare the cost of the funds with appropriate benchmarks. Such comparisons would require the cost of capital to be expressed as a percentage of the funds to be obtained.

By way of example, a paper presented to the Bank's Executive Committee in February 1988 did consider the cost of funds from various alternative opportunities as a percentage of the funds to be received.()

The minutes of the Board meeting on 26 May 1988 record that the:

"Directors noted that with the support and approval of Treasury, State Bank of South Australia had mandated JP Morgan to arrange an issue of US$150.0M undated or perpetual subordinated debt, on the condition that it would be accepted by the Reserve Bank of Australia as qualifying as Tier Two capital." ()

It is reasonable to infer from this statement - and I so infer - that the Board was somehow led to believe that the State Treasury had endorsed the Bank's action in entering the transaction. There is, however, nothing in the paper presented to the Board which could create such a belief. The directors who have given evidence to the Investigation on this matter do not recall the actual circumstances in which the paper was noted. Accordingly, one can only speculate as to what caused the Board to form this impression of the Treasury attitude to the transaction.

The evidence is clear that the State Treasury did not support or approve the transaction. The question of Treasury approval of the transaction was irrelevant, because it was not necessary, and was not sought by the Bank. Ms Kimber's call note of February 1988 records that SAFA could, and was willing, to provide funds more cheaply than the Bank could obtain capital funds from other sources.() Mr Prowse's letter to Mr Matthews of 6 May 1988 records the displeasure of the State Treasury that the Bank had entered into the transaction.() Indeed Mr Prowse requested that the Bank defer the transaction. The minute to the Treasurer seeking approval for SAFA to invest in the transaction remarked that, while SAFA and Treasury would have preferred to provide all the Bank's capital needs, the transaction must proceed because the Bank was committed to the transaction.()

If the minutes correctly record that the directors noted that the issue had "the support and approval of Treasury", they could not have been made aware of the contents of Mr Prowse's letter to Mr Matthews on 10 May 1988. Mr Clark has said he does not believe he was aware of Mr Prowse's letter.() For a reason which is not apparent to the Investigation, the Directors were, at best, not fully informed and, at worst, may have been misled on a matter of importance.

Mr Barrett, who was chairman of the Bank Board at the relevant time, gave evidence that the contents of the letter of 10 May 1988 from Mr Prowse to Mr Matthews were never made known to the Board.()

Mr Mallett has said to the Investigation that, while he has no recollection of the Board meeting, he did not comment upon the role of State Treasury.

Mr Matthews and Mr Mallett, who were both in attendance at this meeting, were clearly aware of Mr Prowse's concern. Why they did not correct any misunderstanding on this significant matter is difficult to understand, and must be left open to speculation.

In June 1988 the Bank and J P Morgan sought to syndicate the dated floating rate notes to be issued by the Cayman Island Companies. That the syndication was not successful is obvious from the fact that SAFA and its affiliates ultimately invested $US 125.0M, rather than $US 75.0M as originally proposed. Difficulty with the syndication of the transaction is further evidenced by the message from Mr Johnson of J P Morgan to Ms Kimber, on 27 June 1988, that a potential Japanese investor had withdrawn at the last minute.() The withdrawal of the Japanese investor required Morgan Guarantee Australia Limited, an associate of J P Morgan, to purchase the balance of the notes. The investment by Morgan Guarantee Australia Limited was made only in conjunction with the granting to the company of a put option on the notes by the Bank. The nature of the transaction had changed significantly from what had been described to the Board in the paper dated 24 May 1988.

There is no evidence in the Board Minutes or other papers that any of the changes were communicated to the Board. What is evident is that, in June 1988, the course of action preferred by the State Treasury, that is the deferral of the transaction, should have been an option available to the Bank. The changes should have meant that the Bank was no longer constrained by the commitment. The minute from the Under-Treasurer to the Treasurer assumed that the Bank could not cancel the transaction.

Mr Matsui of J P Morgan Securities Asia Limited wrote to Mr Mallett on 8 June 1988,() and suggested that the withdrawal of the Bank from the transaction at that time might prejudice its position in seeking to raise funds from Japanese investors in the future. The same suggestion was also referred to in the Under-Treasurer's minute to the Treasurer seeking approval for SAFA's investment in the transaction.

On the other hand, Mr Mallett has submitted to the Investigation that the Bank could have withdrawn from the transaction at this time.

On all the material before the Investigation, I must agree with Mr Mallett. It may be that the Japanese investors became disenchanted when the Reserve Bank required an amendment to the default provision in the documentation, and withdrew for that reason; but once they had withdrawn there was no binding commitment and the saving of face in the Japanese financial market should have ceased to be a consideration. Any potential loss of reputation had already been suffered. J P Morgan was not in a position to complain, because the difficulties emanated from their mistaken understanding of the conditions that would be required by the Reserve Bank if the funds were to qualify as Tier Two capital. The Bank should have been free to walk away from the transaction.

In the event, the Bank Board was never given the opportunity to consider whether the Bank should withdraw the mandate to J P Morgan and seek capital funds directly from SAFA.

Of more significance is the put option given by the Bank to Morgan Guarantee Australia Ltd. As a result of this option, the Bank could not be said to have obtained capital funds, because it could be required to repay the funds received from Morgan Guarantee Australia's Ltd plus an additional amount, to satisfy the options. There is no evidence that the Board was ever made aware of the put option.

In July 1988, the Bank Board was advised, as part of the operating review provided in the routine monthly papers, that the transaction was completed, and that $US 106.8M of Tier Two capital had been obtained.()

6.6.8 FINDINGS AND CONCLUSIONS

For the reasons stated in this Chapter, I have formed the conclusion that the transaction packaged for the Bank by J P Morgan was not in the best interests of the Bank. Having regard to the fact that the Bank was able to concurrently raise a tranche of $250.0M Tier 1 capital through SAFA at a cost of the Bank Bill rate plus 0.65 per cent, and the other matters which are set out above, I cannot understand why the Bank entered into the transaction at all.

The clear evidence is that the funds obtained by the Bank via J P Morgan would have been available to the Bank from SAFA at a cost which was significantly less than the cost arising from the transaction actually entered into.

Bank officers have given evidence that the high cost incurred by the Bank can be justified because the transaction will produce a tranche of $US 150.0M non repayable capital after fifteen years. That supposed advantage is, in my opinion, illusory, because it depends entirely upon the Bank adopting incorrect accounting practices which effectively appropriate Bank profits without Board approval. The Bank continued to follow these practices despite the adoption by the accounting profession of an accounting standard which specifically require a different approach.

Furthermore, the accounting treatment had the effect of reducing the "operating surplus" of the Bank with a consequential reduction in both the Corporations Tax Equivalent payment and the Section 22 dividend. In other words, the advantage to the Bank is that, by the use of what, in my opinion, is an incorrect accounting treatment, it could disguise what was in reality a capital repayment as an interest expense in such a way as to clandestinely build up a capital sum of $US 150.0M over fifteen years at the expense of the State Treasury. The accounting device is clearly contrary to both the spirit and the letter of the requirement in paragraph 10 of the Premier's

letter to Mr Barrett of 4 April 1985, namely:

"...

10. The Bank accepts, in principle, the Government's view that its operational decisions should be principally based on the maximisation of returns to the State as a whole and not on net returns to the Bank - ie its decision should be based on pre tax and not post tax consideration ...".()

The evidence before me indicates that Bank management failed to provide the Board with a balanced and complete analysis of the transaction. In my opinion, the Board could not have identified the deficiencies in the transaction from the information that was put before them.

In my opinion however, an alert and attentive Board should have identified that the transaction put before it for noting had not previously been authorised by the Board, and that the Board's approval had not been given. The directors should have identified the deficiencies in the Board Paper, and requested a better explanation of the transaction.

On the evidence described in this Chapter, I have formed the opinion that the Board Paper No 88/169 "USD Capital Raising" contains errors which had the effect of materially understating the cost of the transaction, and is misleading. Ms Kimber, who is a qualified actuary, should have appreciated the inadequacies in the information provided to the Board on an important matter. Those inadequacies were immediately apparent to her when she read the paper during the course of an interview for the purpose of this Investigation.

On all the evidence described in this Chapter, I have formed the opinion that Mr Matthews should have ensured that the information in Mr Prowse's letter to him of 10 May was conveyed to the Board and taken into account when assessing the transaction.() In forming this opinion, I bear in mind that Mr Matthews was in attendance at the Executive Committee meeting in February 1988 at which the paper titled "Capital Raising Opportunities" was noted. He should, therefore, have been aware of the cost of capital of the type raised via J P Morgan compared with the cost of capital from SAFA. In addition, Mr Prowse advised in the letter of 10 May 1988 of his concerns about the Bank raising funds "from the rest of the world" at a cost greater than that which applied within the State. Mr Matthews was in attendance at the Board meeting on 26 May 1988, at which this transaction was noted by the Board, but he allowed the transaction to proceed without challenge.

In addition, I have formed the opinion that Mr Mallett should have provided the Board with the information which the Board needed to reach an informed decision regarding the transaction. The information he did provide was not accurate, and he failed to provide a balanced and appropriate analysis of the costs and benefits of the transaction compared with the alternative of raising the funds via SAFA. In reaching this conclusion, I have had regard to evidence that Mr Mallett knew that SAFA was prepared to provide all of the capital required by the Bank at a lesser cost to the Bank than alternative sources of capital. Mr Mallett did not convey that information to the Board. I have also had regard to the failure of Mr Mallett to inform the Board of the events of June 1988 which resulted in a change to the transaction, in that the participation of investors through syndication by J P Morgan no longer formed the basis of the transaction as described in the Board Paper, but the greater proportion of the funds were to be provided by SAFA and the Bank was required to give a put option for the balance. As already discussed, the paper contained arithmetic errors which had the effect of materially understating the cost of the transaction, and incorporated an analysis of the cost of the transaction which was based on an inappropriate assumptions. Most importantly, Mr Mallett caused the Bank to enter into a transaction which was not in its best interests.

On the evidence described in this Chapter, I have formed the opinion that Mr Copley should have advised Mr Mallett that the accounting practices proposed to be adopted by the Bank with respect to this transaction were not acceptable. As the Bank's Chief Finance Officer, he condoned accounting practices,that were inconsistent with Australian Accounting Standard AAS 23. Set off and Extingquisment of Debt.

Mr Copley has told the Investigation that the accounting treatment had been recommended by J P Morgan on the advice of "a Big 6 accounting firm in Sydney ", that the treatment was approved by the Bank's external auditors, and that in July 1991, another "Big 6 " firm in Sydney, which was retained to oversee the preparation of the Bank's accounts, said it was satisfied with the approach.() I have considered Mr Copley's submission, but remain of the view that the accounting treatment of the transaction is incorrect. I have not seen any evidence that J P Morgan recommended the accounting treatment. Mr Copley is wrong when he says that the treatment had been approved by the Bank's external auditors. There is, in fact, a letter containing contrary advice.() I have not seen evidence that accountants in Sydney had approved the accounting treatment, and therefore cannot comment on that submission. Moreover, the advice received by the Investigation from three separate firms of accountants has confirmed my opinion.

On the evidence described in this Chapter, I have formed the opinion that Mr Clark should not have authorised or permitted Mr Mallett to commit the Bank to the transaction without obtaining the authorisation of the Board. In reaching this conclusion, I have had regard to evidence that Mr Clark was present at the Executive Committee meeting on 15 April 1988 at which Mr Mallett advised the committee that he had engaged J P Morgan to obtain capital funds. Mr Clark, more than any other person, should have ensured that a proper analysis of the transaction was carried out, and that the Board was properly informed of the advantages and disadvantages of the transaction.

On the basis of all the evidence before the Investigation, I have formed the opinion that the members of the Bank Board who received and noted the Board Paper 88/169, at the Board meeting of 26 May 1988, failed to identify that the arrangements which they were being asked to note had not been authorised. Further, they failed to identify that the information contained in the paper provided to it was inadequate to ensure that they understood the transaction they were being asked to note, and by implication, approve.

 

6.7 SUBMISSIONS MADE TO THE INVESTIGATION

 

A number of submissions have been made to this Investigation which raise issues relating to the funding of the Bank. Some of the issues and submissions are summarised below, with a minimum of comment. I shall consider their merits later in this Chapter.

6.7.1 SUBMISSION OF CERTAIN PAST AND PRESENT DIRECTORS OF THE STATE BANK OF SOUTH AUSTRALIA AND BENEFICIAL FINANCE CORPORATION LIMITED

In a document submitted on 19 November 1991, Messrs Piper Alderman made a joint submission on behalf of 14 named "past and present" directors of the Bank.() In the interests of brevity I will refer in this Chapter to the submission as "the Piper Alderman Submission". The Piper Alderman Submission carries the reservation that it should not be assumed that all of their clients

would adopt each and every submission made. The preface to the submission also states that if, after time for consideration and reflection, any of their clients wish to express any reservation about the whole or any part of the submission, then Messrs Piper Alderman would advise of such reservation immediately. A submission made on such a basis gives rise to considerable difficulty in determining what can be accepted and what may be the subject of late change.

On 13 December 1991, Mr Prowse stated that he did not agree with some of the views and interpretations offered in the Piper Alderman Submission. A more detailed consideration of Mr Prowse's separate position is set out below. On 29 April 1992, I wrote to Messrs Piper Alderman asking whether any other clients wished to reserve their position in the way that had been foreshadowed; but I have not been told that any other of their clients wish to do so. When interviewed for the purpose of the Investigation, both Mr Barrett and Mr Simmons confirmed their approval of the submission.

Because the Piper Alderman Submission has been made by a group which is representative of both the past and present boards of the Bank, and includes both Mr Barrett and Mr Simmons, who were the only two chairmen of directors of the Bank during the period under review, the submission obviously warrants careful consideration. There is probably no other group which was, and is, collectively in a better position to cast light on the matters raised by the Terms of Appointment. The submissions which have been made are comprehensive and deal with many matters that fall both within, and outside, of the scope of this Chapter.

The introduction to the Piper Alderman Submission says that an assessment of the performance of the clients of Messrs Piper Alderman should take into account a number of matters which are described in detail. They include:

"1. In the first instance, with the benefit of hindsight, it can now be seen that the aim "to be an engine of economic growth" said for the State Bank when it was created was, with the resources (human and financial) that were actually made available, very difficult to achieve. While it is true that in the early years of the Bank's life there was an appearance of vigour, success and prosperity it is now clear that below the facade of success there were at work a number of factors which together or apart were bound sooner or later to cause the Bank Group great difficulty or actual failure. These factors were intrinsic to the concept upon which the Bank was built and the way it was set up. They comprise the inadequacy of the capital base and the irreconcilable contradiction inherent in the charter of the Bank comprised in section 15 of the State Bank of South Australia Act.

2. ...

3. In this context the Board of Directors was entitled and indeed required to rely to an enormous extent upon the executives and management. The facts set out in the submission show that the faith placed by our clients in the management of the State Bank Group was largely misplaced although this fact was not discerned to any material degree until the damage was done. Those facts show that a number of members of the senior management of both the Bank and Beneficial were either incompetent or negligent or delinquent." ()

When interviewed, both Mr Barrett and Mr Simmons were invited to give details of the suggested incompetence, negligence and delinquency. On each occasion, their counsel indicated that there was no suggestion of delinquency in connection with the raising of capital, and that a short memorandum would be provided itemising the suggested incompetence and negligence.()

As to the reasons why the Bank encountered difficulty, the Piper Alderman Submission says, from the "vantage point of hindsight", that the causes of the demise of the State Bank Group include:

"* The inherent contradiction between:

- The balanced development of the State's economy; and

- The need to make profits to the margin contained in section 15 of the State Bank Act.

* The high cost of and the onerous terms of the capital the State Bank Group had available, and in particular, the lack of free capital and the inability to retain profits;

* The difficulty of succeeding against the pressure of the conditions set out on the points above and the effect that had on executive staff who proved to be inadequate as did the systems employed."

It is submitted that these matters, together with the other matters which are listed in the submission "by themselves, made it difficult if not impossible for the Bank to succeed".()

In connection with the changing role of the Reserve Bank of Australia, the Piper Alderman Submission states:

"(d) The maintenance of capital adequacy, the sufficiency of tier one and tier two capital and the 30% limit on large exposures are key planks in prudential supervision. Prior to the issue being raised in evidence before the Royal Commission, it had always been the understanding of the Board of the State Bank that all Reserve Bank prudential guidelines where being fully observed. This was consistent with the Government's intention that the Bank compete on a level playing field with private sector banks (see Section B1.3). It is, however, now clear that, from time to time, the management of the State Bank, unbeknown to the Board, failed to comply with the letter and spirit of these guidelines. Details of those breaches will be discussed in Section C3 below." ()

In connection with the "push for profit" which is identified as a "significant factor in the rapidity of the Bank's growth", the submissions were that:

"...

(c) As the Bank expanded, more capital was required. The Government was quite prepared to provide more capital, but at rates which Professor Valentine has described in the Royal Commission as "expensive".

(d) To fund that capital, even higher profit was necessary." ()

The Piper Alderman Submission comments that, in 1988-1989, management had proposed a projected profit of $54.46M, but that was rejected by Mr Clark who demanded a profit in excess of $100.0M. That projection was, in due course, reduced to $90.0M. It is said that of that amount, "$88.0M was earmarked for the Government with approximately one half of that sum intended merely for the servicing of capital." () Mr Clark has correctly pointed out that the budget, was in part, determined by the Executive Committee.()

The events referred to in the submission are set forth in the Board Paper seeking approval for the profit plan. The paper states that the revised plan was supported by the Executive Committee. The Directors' submissions to the Investigation must be considered in the context of their failure to take steps to address these issues at the time.

The capitalisation of the Bank is specifically dealt with in Section 2.3 of the Piper Alderman Submission. The Submission raises matters which are directly relevant to the Terms of Appointment generally, and this Chapter in particular. The following submission was made:

"2.3 Capitalisation

(a) The question of capital is of such fundamental importance in explaining the problems besetting the Bank in 1990 that it forms the subject of a separate section.

(b) It is enough, for present purposes, to say that the Board now believes that Mr Marcus Clark's overriding objective in the maximisation of profit was due, in large measure to what he considered to be the necessity for the State Bank to honour its interest repayment commitment to SAFA on monies lent by SAFA for the capitalisation of the State Bank.

(c) One of the consequences of having to meet repayment obligations on expensive tier two capital is the need to achieve higher rates of return on monies lent. This will inevitably mean a greater emphasis on high yield - high risk lending.

(d) That the inadequacy of the manner in which the State Bank was capitalised was not brought to the attention of the Board until the then chairman Mr Simmons, demanded to see the documentation confirming the terms of SAFA's lending, is illustrative of the failure of management to keep the board fully informed of matters fundamental to the development and viability of the State Bank." ()

Mr Clark says that the submission in paragraph (b) is totally incorrect and that the objective was purely to derive profit as a measure of excellence, and because the Bank had set a target of 15 per cent return on shareholders funds.()

On the specific topic of "Capital and Capital Adequacy", the Piper Alderman Submission contends that:

"... the true position concerning the State Bank's capital structure which emerged in the latter part of 1989 ... was at variance with assurances which had previously been provided to Mr Simmons and his predecessor, Mr Barrett, about the capital structure of the State Bank." ()

The overall submission of the directors on the issue of capital is made clear by the following:

"(d) The key point to be made on the capital structure is that:

Far from being one of the best capitalised banks in Australia, the State Bank had little or no free capital, a fact which:

(i) contravened Reserve Bank prudential guidelines; and

(ii) placed serious financial burdens upon the State Bank to maximise its profitability in order to service the interest due on loan facilities, mutually provided by SAFA which bore interest at a significant rate over and above ordinary Bank Bill rate." ()

Tables are included which compare the State Bank with other Australian Banks with respect to the proportion of free capital to total capital and resources.() The sources of the material set out in the tables are not disclosed. The submission was put:

"(g) As table 1 shows, the State Bank was starved of free capital, a conclusion even more pronounced when the capital position of the State Bank is viewed against the capital position of the private banks." ()

The directors also make the submission that, for reasons which are elaborated, the accuracy of capital adequacy figures submitted to the Board and the Reserve Bank was always highly questionable.() Calculations based on the Bank's own Group Operating Reviews are put forward to support the submission that "there is considerable doubt as to whether the capital adequacy ratios of the State Bank ever exceeded 4%, one half of what was prescribed by the Reserve Bank as the minimum acceptable standard." () It is suggested that the Bank Group capital adequacy ratio at 30 June 1990 was not 9.15 per cent as had been claimed, but was between a high of 3.65 per cent and a low of 1.09 per cent, with a likely figure of 1.6 per cent.()

The Piper Alderman Submission refers to the fact that neither management of the Bank, nor the Reserve Bank, bothered to inform the Board about the Reserve Bank's concerns over capital, and continued to allow the Board to state in the Bank's 1988 Annual Report that the Bank remained "one of the best capitalised banks in Australia".() The directors now submit that it was clearly not the case. They say that the Board was never informed of Reserve Bank queries about the State Bank's capital structure.()

Mr Clark has considered the Directors' submission regarding the drive for profits. He said the drive for profits had nothing to do with the bank's commitments to SAFA. He saw profits as a measure of excellence. The Bank itself set a target of 15 per cent return on shareholders funds. This target rate of return was known and endorsed by Directors.()

6.7.2 STATEMENT OF MR D W SIMMONS - CAPITAL STRUCTURE

While Mr Simmons is one of the directors on whose behalf the Piper Alderman submission has been made, he has also submitted a separate statement of his own on the capital structure of the Bank.()

In the statement, Mr Simmons says that, upon becoming Chairman of the Board in 1989, he became interested in the capital structure of the Bank when it became apparent that, of the $90.0M profit earned by the Bank in the year ended 30 June 1989, the Bank was required to pay $88.0M to the State Treasury by way of fixed dividends at the rate of ".65 above LIBOR" which was payable on funds made available by Treasury/SAFA as part of the capital of the Bank. In fact, the rate was the Bank Bill rate plus 0.65 per cent, not LIBOR plus 0.65 per cent, but that is inconsequential.

Mr Simmons repeats the criticism in the Piper Alderman Submission of the role of management in negotiating capital on those terms. He is critical of the fact that the cost of capital was treated as a "dividend" payment out of profit rather than a cost to be taken into account before determining profit.()

Without attempting to summarise Mr Simmons' statement comprehensively, there are several issues raised which are relevant to this Chapter. Mr Simmons repeats the comment made in the Piper Alderman submission that the management attitude to compliance with the Reserve Bank capital adequacy guidelines was "less than satisfactory".()

Mr Simmons refers to a paper, which had been prepared by Mr Matthews and Mr C W Guille and was considered by the Bank Board at a meeting in October 1989,() as an indication of the fact that, at the time, the Bank had only $125.0M of true "free" capital. The balance of the Tier 1 capital which, at that time, totalled $840.7M, was made up of reserves of $57.2M, retained earnings of $119.6M and the sum of $538.9M which was made up of dividend bearing SAFA facilities. Mr Simmons refers, in paragraph 3.9 of his statement, to the following observation of Mr Guille and Mr Matthews:

"While most of the dividend bearing/interest bearing capital is backed out into bills etc, the Bank is not always making the margin of .65% that it needs to pay on most of the facilities. More importantly, compared to the major private banks, the Bank's capital structure is predominantly "debt" rather than equity and it is debt at currently high rates. In other words, the Bank's capital structure is a competitive handicap (page 2).

In the present financial year, therefore, the Bank needs to accept the critical importance of having sufficient management earnings to pay the fixed dividend/interest payments on capital (page 2)." ()

The statement made in the Board Paper to which Mr Simmons referred is evidence of a belief which was developing within the Bank, at least amongst the directors, that, in the latter months of 1989, the Bank lacked "free capital, ie: capital upon which the Bank is not required to pay a dividend each and every year".() The fact that a large proportion of the capital which had been subscribed by SAFA/Treasury carried a fixed dividend was perceived to be a problem. Mr Simmons refers to the conclusion in the paper of Mr Matthews and Mr Guille which stated:

"In the present economic/political climate, the high cost element of the Bank's capital base needs to be raised with the Government as a (sic) issue of major importance to the prudential standing and profitability of the Bank. Possible options of reducing this cost need to be explored with the Government. The options basically mean the Government accepting the Bank needs more free capital and it needs to build up more retained earnings. The Government also needs to know that if Bank profit is insufficient to pay the dividends, they (the dividends) will need to be waived or deferred (page 4)." ()

The suggestion in the paper that the Bank needed more free capital is one which Mr Simmons has adopted both in his statement and in evidence given by him to the Investigation.

A table, appended to Mr Simmons' statement, contains a calculation by Leadenhall Australia Ltd which estimates that in the 1989-1990 financial year an amount of $135.9M was required to meet the fixed dividends on the Bank's capital, of which $89.7M was payable to SAFA on Tier 1 capital. Mr Simmons relies on the calculation to make the observation that "SBSA was required to earn almost $136 million in profit simply to cover the fixed dividend and interest commitments of its capital".() The observation, however, overlooks the fact that the cost of the Tier Two capital was charged as an expense before the determination of Bank profit.

Mr Simmons sets out what he describes as "the essential problem" in the following way:

"The Essential Problem

6.1 In addition to the comparatively high cost of capital in the form of the fixed dividend payment on the preference shares, the treatment of those repayments as dividends, as opposed to interest, whilst ensuring that the profitability of the Bank looked better than would otherwise have been the case, essentially meant that the Bank's profits were inflated, as was the payment to the State Government of the equivalent of Commonwealth Corporations Tax, as this figure was calculated as a percentage of the gross, as opposed to the adjusted, profit. In other words, the State Government got "two bites of the cherry", insofar as it got a payment for the equivalent of Commonwealth Corporations Tax on the full unadjusted profit and, in addition, out of what was left of the profit, received a fixed dividend on its preference shares.

6.2 A more equitable scenario would have been to deduct the cost of the repayments on the preference shares before determining profit, so that your profit was reduced and, thereby, the total tax due to the State Government on the equivalent of Commonwealth Corporations Tax was also reduced.

6.3 The obligation to pay the fixed rate dividend after the determination of profit was disadvantageous to the Bank for two reasons, ie:

(1) because the State Government was being paid more than it was legitimately entitled; and

(2) because the dividend repayments were fixed, there was greater pressure on the Bank to maximise profit to ensure that those repayments could be met.

I believe that the need to pay a significant portion of pre-tax/pre-interest profits to the Government by way of fixed interest/dividend pervaded the Bank and drove Management to seek ever increasing profits and/or to grow the business.

6.4 I was told on a number of occasions by Marcus Clark that the State Bank was one of the "best capitalised Banks in Australia". For the reasons set out I do not believe this was so.

6.5 My view was that the Bank did not have enough "free capital". By "free" I mean capital on which the payment of dividend was truly discretionary."

A chart annexed to Mr Simmons' submission compares the free capital of the State Bank to other State banks and the Commonwealth Bank. Because the source of the information contained in the chart is unknown, and has not been the subject of evidence before the Investigation, I have treated the chart with reservation. In addition, there is evidence before the Jacobs' Royal Commission which puts the accuracy of this chart in question.

A quite separate issue raised by Mr Simmons relates to the conversion of concessional housing loans to capital in 1988. That matter is considered separately elsewhere in this Chapter.

6.7.3 SUPPLEMENTARY SUBMISSION TO THE AUDITOR-GENERAL ON MATTERS OF LAW

On 13 December 1991, Messrs Piper Alderman made a further submission to the Investigation on matters of law. The reach of the submission extends far beyond those matters which are relevant to this Chapter. The submission, however, once again, raises "grave doubts ... as to the adequacy and accuracy of a significant amount of the information being passed to the Board, particularly in respect of matters of which the Board most certainly should have been made aware, including concerns being expressed to the State Bank senior management over a number of years, by the Reserve Bank of Australia and State Treasury".()

As to the obligation of the directors to "know the business" the directors submitted:

"5.3 Bearing in mind:-

(a) the public nature of the office;

(b) that each of the directors of the State Bank were appointed by the Government;

(c) that each of them were appointed for a variety of reasons, best known to the Government, but generally reflecting the Government's objective in creating a Board with a diversity of interests, including political and social;

(d) that no director, with the exception of the CEO, had any relevant banking experience;

(e) that many of the appointees had little or no experience of commercial life, other than by way of professional practice; and

applying, by analogy, the comments of Romer J in City Equitable referred to in paragraph 5.9 below, it is clear that, with the exception of the CEO, none of the directors appointed to the Board of the State Bank can be expected to have possessed, and nor should be judged by, the knowledge and experience of those directly involved in the banking industry.

5.4 It is the submission of our clients that the State Bank Board, as constituted between 1984 and 1991, was not obliged to acquire or exhibit any detailed understanding of the minutiae or fundamentals of the business of banking but was, instead, entitled to rely upon the judgment of, and the accuracy and adequacy of information flowing from, trusted senior management and that, in the absence of any clear evidence of lack of judgment or misinformation, the Board was entitled to place its faith in the skill and honesty of management. As Lord Parker CJ said in Huckerby v Elliot [1970] 1 ALL ER 189 at 194:

"... I know of no authority for the proposition that it is the duty of a director ... to acquaint himself with all the details of the running of the company."

5.5 This is, of course, not to say that the Board of the State Bank did not devote a considerable proportion of its time to the consideration of "fundamentals". A consideration of the volume of papers of a "technical" nature (many of them presented to the Board at short notice) illustrates the volume of work expected of and undertaken by the Board in respect of such matters.

5.6 However, the central point which flows from City Equitable is that, in dealing with such material, a director can only be expected to exhibit the degree of skill that "may reasonably be expected from a person of his knowledge and experience". (page 428).()

In connection with the obligation of the Board in respect of strategic and profit planning, the directors have submitted "that debate about and the preparation of, the strategic plans, was a matter for management subject to ratification by the Board".() This submission is relevant to this Chapter, because one of the questions which arises is who had responsibility to plan and oversee the capitalisation of the Bank, which was regarded by some as part of the strategic planning process.

On the matter of the obligations of the Board in respect of the reporting functions within the Bank, the directors have submitted:

"8.2 It is submitted that methods of reporting to the Board by Management were essentially adequate, but that, on occasions, papers and figures forwarded to the Board were misleading and inaccurate, either by omission or misdescription or both, and that this contributed significantly to the problems now under investigation." ()

That submission is of particular relevance to the information provided to the Board in connection with the raising of additional capital in 1988. As can be seen from the discussions relating to the raising of $250.0M Tier 1 capital from SAFA at the Bank Bill Rate plus 0.65 per cent, and to the raising of $US 150.0M Tier 2 capital through J P Morgan, the Board was given misleading and inaccurate information, or were kept uninformed, on matters which were of fundamental importance to the capital structure and the fixed obligations of the Bank.

Similarly, the submission is relevant to the accuracy of information provided to the Board at the time concessional housing loan funds were converted into capital.

The submission of the directors that the fixed obligations which were attached to these tranches of capital were matters that contributed to the Bank's problems makes the information given to the Board on these matters relevant to the Term of Appointment.

6.7.4 SUPPLEMENTARY STATEMENT OF MR D W SIMMONS - JULY 1992

Mr Simmons provided the Investigation with a Supplementary Statement dated July 1992. Pages 65-81 of the Supplementary Statement are concerned directly with matters which are the subject of this Chapter. The main thrust of Mr Simmons' Statement is made clear by the first paragraph which says:

"2.1 It was clear to me by the latter months of 1989 that the reason why the Bank had to pay to Treasury some $88 million of the $90 million profit earned in the year ended 30 June 1989 was due to the fact that a significant part of the funds made available by the Bank to Treasury/SAFA was in the form of "preference shares" in respect of which a fixed "dividend" was calculated on the basis of an interest rate fixed at .65% above Bank Bill Rate." ()

Both in his Supplementary Statement and his evidence before the Investigation, Mr Simmons has elaborated upon what he perceives to be the problem caused by the fact that a large proportion of the Bank's capital attracted a dividend which, first, was fixed and, secondly, carried interest at the Bank Bill rate plus 0.65 per cent, a rate which Mr Simmons has said and Messrs Piper Alderman have submitted was "expensive".

Mr Simmons said that he did not fully understand the extent of the problem until he was made aware of the matter by Mr Prowse in August 1989.

The information provided to the Board in connection with the capital of the Bank is described by Mr Simmons in the following way:-

"2.3 Whilst there have been a number of papers presented to the Board on capital over the years, none of these gave a complete picture of the Bank's capital structure. In fact we never had an "overview" of our capital until Mr Guille's paper of 20 October 1989 ...".()

The degree of participation and understanding of the Board in and with respect to the terms which attached to the Bank's capital is brought into sharper focus by the statement:

"2.7 Although I and, probably, other directors were not entirely clear about when the additional "preference share" capital was negotiated with SAFA or Treasury, it seemed that this occurred in the financial year 1987/88, with the first "dividend" on that capital due in the financial year 1988/89. At the Board meeting of 24 August 1989 we found that out of a $90 million profit, the Bank was having to pay $45.1 million to SAFA for the cost of capital alone and some $88.1 million in all to the Government." ()

If those statements are correct (and there is no reason to suspect that they are not) the directors were not adequately informed on matters of fundamental importance to the management of the Bank. The fact that the fixed interest obligation on a large proportion of the capital has been identified by directors as a cause of the Bank's problems itself indicates the importance of the Bank's capital structure. Yet the directors were apparently ignorant of the terms which attached to a significant proportion of the Bank's capital until the second half of 1989. The terms on which capital was being provided to the Bank should have been clearly made known to and approved by the directors, by a formal Board resolution.

Mr Simmons repeats the statement made in the Piper Alderman submission that of $840.7M Tier 1 capital "the Bank only had, at best, $125 million of true "free capital"." () He says that:

"At the Board meeting of 24 August 1989 we found that out of a $90 million profit, the Bank was having to pay $45.1 million to SAFA for the cost of capital alone and some $88.1 million in all to the Government." ()

The implication is that, prior to 24 August 1989, the Board had either not been made aware of, or had not appreciated, the significance of the interest commitment which was attached to the funds which had been provided to SAFA. The position of the directors, other than himself, is described by Mr Simmons in the following way:

"2.8 By this time, I was aware that we had a problem with our capital. However, other Board members - with the possible exception of Messrs Bakewell and Searcy - were not ...".()

Mr Simmons' statement suggests that it was not until the members of the Board had received the paper, dated 20 October 1989 from Mr Guille, on the subject of the Bank's capital that the directors had an "overview" of the Bank's capital structure, and knew that the true "free capital" was no more than $125.0M of a total of $840.7M and that, after allowing for retained earnings of $119.6M and reserves of $57.2M, the balance of the Tier 1 capital was $538.9M, made up of dividend bearing SAFA facilities which carried a fixed interest rate of 0.65 per cent. On this evidence, the members of the Board were, until October 1989, unaware of the details of the capital structure of the Bank. There is no reason to cause me to disbelieve the statement of Mr Simmons.

Mr Simmons said that when he started to take an interest in the capital structure of the Bank he experienced difficulty in obtaining the documentation which evidenced the Bank's capital arrangements.() He was surprised to learn that there was no legal documentation relating to the provision of the capital.() He has also alluded to uncertainty about the way in which the capital was contributed.() This Chapter has already referred to the fact that what was proposed in January 1988, as an injection of $150.0M Tier 1 capital, developed into the provision of $250.0M Tier 1 capital by SAFA with a further $US 150.0M being provided as Tier 2 capital through J P Morgan. The Investigation has not heard any evidence that explains the metamorphosis.

It is implicit in Mr Simmons' statement that, until he was provided with and read the documents which evidence the terms on which the capital had been provided, he (and presumably the other directors) had not been informed of the terms that applied. This statement itself evidences an uncertainty about the way in which the interest commitment was to be calculated, caused by the poor documentation and communication.()

In both his statement and his evidence to the Investigation, Mr Simmons refers to a table which had been provided to him by Mr Prowse. The table demonstrates historically the payments made by the Bank to the Government in the years 1985 to 1989, and contains a projection of the payments that would have been payable in the year ended 30 June 1990.() Mr Simmons has the opinion that the table was in fact used to determine the Section 22 dividend, and that a consequence of the table was "that the more the Bank earned the more it had to pay".()

Mr Simmons set out his concerns in a letter to the Under-Treasurer dated 14 December 1989. The letter refers to the fact that the free capital from the Bank was only $125.0M. He described the capital structure of the Bank as "unsatisfactory" because the "majority of the Bank's capital is really moneys provided in the nature of preference shares carrying a fixed dividend". He sought a meeting with the Under-Treasurer to discuss the matter. Mr Prowse replied acknowledging the Board's belief that the Bank required further free capital. Mr Simmons related his views to the Treasurer at meetings on 9 and 12 February 1990.

Mr Simmons states that a paper prepared by the late Mr M G Hamilton on the restructuring of the capital base of the Bank was presented to the Board on 20 April 1990.() Mr Simmons was not happy with the paper, and none of Mr Hamilton's proposals had been "actioned" by the time Mr Simmons ceased to be Chairman.()

Mr Simmons' statement addresses what he refers to as "the essential problem".() Matters which are referred to include the treatment of the payment required to be made on tranches of capital as a dividend, rather than an expense, so that the tax equivalent payable pursuant to Section 22 was inflated. Mr Simmons says in his statement:

" ... In other words, the State Government got "two bites of the cherry" in so far as it got a payment for the equivalent of Commonwealth Corporations Tax on the full unadjusted profit and, and in addition out of what was left of the profit, received a fixed dividend on its "preference share" capital. In addition the Bank Bill Rate was at a very high level. It is only in the last six months or so that rates have dropped substantially.

2.32 A more equitable scenario would have been to deduct the cost of the repayments on the SAFA capital before determining profit, so that the Bank's profit was reduced and, thereby, the total tax due to the State Government on the Commonwealth Corporations Tax equivalent was also reduced.

2.33 The obligation to pay the fixed rate dividend after the determination of profit was, in my opinion, disadvantageous to the Bank for two reasons, ie:

(1) the State Government was being paid more than it could be said to be legitimately entitled to; and

(2) the individual repayments were based on the Bank Bill Rate, not on profit. There was therefore greater pressure on the Bank to maximise profit to ensure that those repayments could be met.

2.34 I believe that the need to pay a significant proportion of pre-tax/pre interest profits to the Government by way of fixed interest/dividend probably drove management to seek ever increasing profits and/or to grow the business too fast in order to generate that additional profit." ()

This last statement is central to the contention of Mr Simmons and the other directors. Mr Simmons believes that the push for profits was also fuelled by an erroneous understanding on Mr Clark's part, that if the Bank defaulted, the default would have precipitated increased interest by the State Treasury in the affairs of the Bank.()

Mr Simmons concludes his statement with the observation that the comment that the State Bank was "one of the best capitalised banks in Australia" was not correct, and that the "free" capital of the Bank was disadvantageously low compared with other banks.() He says that there was ongoing discussion between the Bank and Treasury officers during 1990 in an effort to resolve the problem.

Finally, Mr Simmons refers to the conversion of concessional housing loan funds to capital in late 1988 in a way increased the cost of the relevant funds to the Bank from 7 per cent to the Bank Bill Rate plus 0.65 per cent. He refers to the paper from Mr Copley, which supported the change, and suggests that the reason for entering into the arrangement (which substantially increased the cost of the funds to the Bank) may have been the fact that there was a problem with the Bank's capital adequacy ratios at the time. The inference is that the directors were deliberately not informed of the problem. Mr Simmons states that the "profit improvement" of $26.0M, which was referred to in Mr Copley's paper, arose as a consequence of a movement of the former interest cost to a dividend; but that the amount, in fact, payable by the Bank to SAFA was to increase from $28.0M to $52.0M in a way that, contrary to what was stated in Mr Copley's paper, disadvantaged the Bank.

Mr Simmons' Statement therefore questions the accuracy of Mr Copley's paper. It also raises the question whether a proper analysis of the paper by the directors should have revealed a different position. That, in turn, raises questions of the role of the Board in the planning of the Bank's capital structure, and the accuracy of information provided to the Board by the Management.

6.7.5 FURTHER SUPPLEMENTARY SUBMISSION ON BEHALF OF THE FORMER CHAIRMAN, MR D W SIMMONS, 13 DECEMBER 1991

Messrs Piper Alderman presented a Further Supplementary Submission to the Investigation on behalf of Mr Simmons which is dated 13 December 1991.

That submission set out certain initiatives which were taken by Mr Simmons upon his assumption of the Chairmanship of the Board. It repeats that, in the latter part of 1989, Mr Simmons began to identify a number of problem areas, including the capital structure of the Bank. It also points out that Mr Simmons' concern was passed on to the Premier.() It does not, however, take the matters which are relevant to this Chapter any further than the earlier submissions.

6.7.6 MR A R PROWSE

By letter dated 26 November 1991 to Piper Alderman, Mr Prowse expressly disassociated himself from the Piper Alderman submission. A copy of that letter was provided to the Auditor-General, with a letter of 13 December 1992. In the letter, Mr Prowse said:

"... I do not support the contention that Section 15 of the State Bank of South Australia Act and the Bank's capital base, "were bound sooner or later to cause the Bank Group great difficulty or actual failure"."

Mr Prowse also said that "the submission greatly overweighs the "pressure" to pursue profits".

6.7.7 SUBMISSION OF THE STATE BANK OF SOUTH AUSTRALIA

The Bank itself has delivered an extensive submission to the Investigation.() It is not confined to matters relevant to this Chapter. The introduction describes it as an overview of the economic conditions, and the management processes affecting the performance of the Bank since 1984.

In a discussion of "Planned v Actual Growth" the submission observes:

"It is useful to relate the growth in assets to the corresponding growth in capital resources because the ready availability of capital seems to have enabled the growth or facilitated attitudes which led to asset growth without full regard to the rate of return and the cost of capital." ()

It is suggested that "the availability of additional capital also enabled larger transactions".()

By reference to a chart, which contrasts the projected and actual profit performance with asset growth, the Bank submitted that the graph demonstrates "that the Bank's planning was driven by growth in Assets rather than profitability or the rate of return to the `shareholder'".()

In connection with the role of the Board of Directors, the Bank has submitted that:

"The former directors can probably offer mitigating explanations, but the ultimate responsibility to maintain the viability of the Bank (without resort to the guarantee) rested with the Board." ()

It is also said:

"It appears that the Board placed too much faith on the competence of executives, some of them, although having been in banking for some time, did not have experience relevant to their new responsibility; others who were recruited externally were asked to take on responsibilities beyond their experience." ()

The submissions of the Bank are consistent with the evidence before the Investigation.

6.7.8 SUBMISSION OF THE SOUTH AUSTRALIAN TREASURY

A submission has been made to the Investigation by the South Australian Treasury,() on the matters which are the subject of this Chapter. It contains a combination of submissions and factual statements. To the extent that it contains factual statements, there is no verification of the statements, and the source of the stated facts is, in most cases, not disclosed. The substance of the submission is largely responsive to the submissions of the directors. The submissions made by S A Treasury include the following:

(a) the classification of particular tranches of capital as either Tier 1 or Tier 2 may be difficult in practice;

(b) capital adequacy is less relevant for a Government guaranteed bank than for a non-guaranteed bank because if all of the Bank's liabilities are guaranteed then, at least in principle, the Bank should not need capital at all.()

A detailed submission is made with respect to the cost of capital. The State Treasury submitted:

"It is not at all apparent that the State Bank's business strategy was influenced by the "cost" of Government provided capital. Rather, achieving its own target return on shareholders funds appears to have been the major driving force." ()

This submission is, of course, a direct denial of the statement by directors, in particular Mr Simmons, that the cost of capital gave rise to a push for profits.

The Treasury submitted that the Tier 2 capital provided by SAFA as subordinated debt was provided at interest rates consistent with market rates.()

As to the interest rate of the Bank Bill rate plus 0.65 per cent, which was payable on the Tier 1 capital provided by SAFA, it is said that rate was "based on the prevailing yield on a State Bank of Victoria Government guarantee perpetual debt issue in the secondary market".() That submission is also supported by contemporaneous documents, which have been produced separately to this Investigation. The Treasury has submitted that consideration was given to the Bank's capacity to meet dividends at the rate of Bank Bill plus 0.65 per cent, and it was considered that the returns were achievable.()

The submission points out that a minimum return was only specified on the SAFA Tier 1 capital, and that there was no minimum return specified or expected on the capital regarded as subscribed by the Treasurer, at June 1989, or prior to that on earnings retained in the Bank.()

State Treasury has observed that "essentially State Bank determined its own profit targets and in fact its "return on capital target" was fixed over the medium term at 15% p.a. and not related to the bill rate". That observation is supported by the other evidence before this Investigation. The Treasury submission also states:

"The fact that the target return was not set in relation to the bill rate throws doubt on the assertion that the allegedly "expensive" return on the SAFA capital component drove the Bank's internal targets. Even if State Bank had been a private bank with a greater level of "free" capital, similar profit targets as adopted by the State Bank would be expected." ()

There is no evidence before this Investigation to suggest that this submission is not correct. If correct, it has the effect of disproving the assertion of the directors that the "push for profit" was generated by the dividend rate which attached to funds provided by SAFA.

The submission refers to an analysis of the State Bank by Australian Ratings in February 1990 which concluded that "SBSA has a very competitive edge in the marketplace".() There is no evidence to suggest that the conclusion by Australian Ratings is not correct.

State Treasury also refers to a comparison of the minimum cost of equity for the State Bank over the period 1987-1991 and the cost of equity for other Australian banks during the same period.

The study is annexed to the submission. The conclusion of BT Corporate Finance was:

"Our analysis indicates that over the period 1987-1991, the assumed minimum cost of equity for SBSA has been less than the estimated total cost of equity for major Australian listed banks. Our analysis also indicates that the assumed minimum cost of equity for SBSA has also been lower than the cost of various subordinated-quasi equity issues of the sample banks. The implication is that the assumed minimum cost of equity for SBSA over this period may have been relatively low given the risk of an equity investment in the Bank." ()

The ultimate submission put by the State Treasury on the consequences of the alleged high cost of equity for the State Bank is expressed in the following terms:

"It is therefore not valid to argue that a relatively high cost of equity for State Bank (as compared to other Australian banks) over the study period meant that it was necessary for State Bank to pursue relatively higher risk margin business in order to achieve a satisfactory level of profitability. If State Bank management had believed this to be the case, a more prudent management policy could have been to avoid relatively high risk business and simply return any excess capital to the shareholder." ()

On all the evidence before the Investigation, and for reasons which are discussed further below, I have come to the conclusion that I should accept this submission of State Treasury and reject the submissions of the directors.

State Treasury also refers to the comparison between the State Bank and other Australian banks by BT Corporate Finance to observe that "equity investors in private banks would expect a return of the same or higher order of the minimum return set by the Government from the Bank, except that the return would be by way of cash (dividend) and capital gain on their shares".() That observation is a substantial answer to the submission put by the directors. Even though the return that investors in private banks receive as a consequence of any capital gain on their shares is not something that gives rise to an obligation on the part of those banks to make a fixed annual payment to the investors, it nevertheless requires the private banks to achieve a minimum level of profitability.

Attachment 7 to the State Treasury submission is a table (derived from Australian Ratings and annual reports) which compares the dividend pay-out ratio of ANZ, Westpac, Commonwealth Bank of Australia, National Australia Bank, State Bank of Victoria, State Bank of New South Wales, and the State Bank of South Australia, for the financial years ending 1986-1990 inclusive. The table is relied on by State Treasury to make the observation that the Bank's profit distribution in four of the five years was significantly higher than the average, but that the Bank's distribution was much closer to the average if taxes are included and the total pay-out (dividends plus taxation) is measured as a proportion of net operating profit before tax.()

State Treasury comments that the Corporations Tax Equivalent paid by the Bank to State Treasury was comparatively low because the SAFA dividend payment was deductible for tax purposes.() That observation is directly contrary to the submission put by Mr Simmons that State Treasury had "two bites of the cherry" in that the tax equivalent was calculated on the profit of the Bank before payment of the fixed dividend which attached to the capital which had been contributed by SAFA.()

An examination of the Bank's records discloses that the State Treasury submission is correct, and Mr Simmons' submission in this respect is factually incorrect. The fact that that submission is based on an erroneous premise tends to erode the basis of the submission of Mr Simmons and the other directors.

Attachment 8 to the submission of State Treasury contains tables that show net profit before tax and net profit after tax as a percentage of average shareholders' funds, respectively. State Treasury makes the observation that the tables illustrate that the State Bank's distribution of profits and taxation, relative to shareholders' funds, was below the average of the seven banks compared in each of the financial years.()

With respect to the distributions made to SAFA and the consolidated account, the State Treasury submission concludes that:

"The total distribution by State Bank to Government (SAFA dividend and dividends plus payments in lieu of taxation to the Treasurer) was not significantly out of line with that for other banks when account is taken of:

. the fact that shareholders in private banks receive part of their return as capital gains on their shares (which can be realised);

. the lesser reliance of State Bank compared to other Government banks on retained earnings as a source of capital;

. the specific timing of capital injections to the State Bank;

. the no better than adequate profit performance of the Bank over the period." ()

In my opinion, the evidence put forward by the State Treasury provides an answer to the claim by directors that the high cost of servicing the Bank's capital gave rise to the "push for profit" and therefore contributed to the problems of the Bank.

In connection with the provision of capital, the State Treasury submission observes that the Act does not prescribe any limitation on the size of the Bank's balance sheet or any "gearing limits" such as those contained in the Reserve Bank Capital Adequacy Guidelines. The submission observes that the provision of the Government guarantee overshadowed the requirement of capital adequacy so far as the protection of depositors and creditors was concerned.() The State Treasury does submit, however, that, notwithstanding that fact, Treasury regarded the Bank's capital base as an important matter.()

Another matter dealt with by the State Treasury submission is the fact that the sum of $250.0M, provided as Tier 1 capital by SAFA in June 1988, did not contravene the requirements of the Act because the possibility of capitalising the Bank in the way provided by Section 22 of the Act did not exclude the possibility of the Bank obtaining capital from other sources. I do not wish to conduct a detailed analysis of this issue because I do not think that it has any ultimate relevance to the Terms of Appointment. I am, however after consideration of the submissions which have been made on the topic, inclined to agree with the submission made by State Treasury.

 

6.8 OTHER MATERIAL CONSIDERED BY THE INVESTIGATION

 

For the purposes of this Chapter, the Investigation has had regard to the minutes of Board and Executive meetings. A large volume of documents has been examined, and a number of Bank Officers have been interviewed, both in connection with the matters referred to in this Chapter and the matters discussed in connection with the Asset and Liability Management and Treasury Operations of the Bank in Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank". Those witnesses include Mr Barrett, Mr Simmons, Mr Clark, Mr Matthews, Mr Copley, Mr Mallett and Ms Kimber. Witnesses whose evidence in connection with the matters raised by Chapter 7 is also relevant to this Chapter include Mr Ottaway and Ms Meeking.

I do not propose to summarise the evidence of all those persons, and I have only referred to it in so far as it is relevant to an observation which has been made in the Chapter.

 

6.9 ISSUES WHICH HAVE ARISEN AS A CONSEQUENCE OF THE SUBMISSIONS AND EVIDENCE RECEIVED BY THE INVESTIGATION

 

6.9.1 THE PLANNING OF THE BANK'S CAPITAL STRUCTURE

The evidence is clear that, for most of the period under review, the capital structure of the Bank was not controlled by a predetermined plan, but was responsive to the growth taking place in the assets of the Bank. As the assets grew, so did the requirement for additional capital to comply with the Reserve Bank capital adequacy requirements. Every person who has given evidence to the Investigation has agreed that the growth in the Bank's capital was entirely responsive to the growth in assets.

Mr Clark was clearly of the attitude that the Bank should obtain as much capital as it could, because that provided the base on which the growth which was required to generate profits could be founded. His priority was to grow the Bank, and its capitalisation was a secondary but essential matter. In my opinion, he did not give sufficient emphasis to this important aspect of the Bank's operations. This lack of emphasis was reflected right through the Bank's Management.

6.9.2 THE RESPONSIBILITY FOR PLANNING THE BANK'S CAPITAL

The capitalisation of the new bank was considered by the Merger Advisor Committee. Mr Barrett was the Chairman of that Committee. When asked whether the Committee had considered the extent of the capital likely to be required by the new bank, Mr Barrett said:

"We gave quite detailed consideration to that and examined various ways where the capital may come from, but I think in the final analysis we finished up - the capital came from the old bank, as I understand it in broad terms." ()

That evidence is consistent with the information which is contained in the Bank's opening balance sheet.

From the time when the new Bank commenced business it is difficult to identify who was vested with the responsibility to plan the capital structure of the Bank.

The capitalisation of the Bank was incidental to the matters considered in the annual strategic plans, but because the growth in assets invariably exceeded what had been anticipated in the strategic plans, there was no connection between what was planned and what occurred.

There was a view that State Treasury had the ultimate responsibility. For example, a Bank Paper associated with Minute 76 of 1985 states:

"State Treasury holds ultimate responsibility to ensure capital adequacy of the Bank's capital to meet accepted prudential guidelines." ()

In practice, however, State Treasury did not assume responsibility to oversee the Bank's capital adequacy. The attitude of State Treasury was that the Bank could have whatever capital was required. Mr Clark gave evidence that:

"The Bank was on an aggressive growth path which was clearly known to the Board, Treasury, the Treasurer and supported by them all. As I have said, I saw my function to ensure that the Bank always had adequate capital to grow, so we always looked at having adequate capital, so it is not a case of getting a bit of money and gearing up. We had an owner who said: there's plenty of capital, go for your life." ()

Mr Clark said that "in the discussions with Treasury their attitude was (that) there was always plenty of cover" and that "we were never restricted by capital." ()

Mr Barrett was asked whether the Premier had made it clear to him that the Bank would be provided with whatever capital was necessary to enable the growth to continue and he said:

"Yes he did, without saying from where it would come, but obviously through the Treasury in one form or another. But he made it clear that the Premier, the Government, would support the Bank. Not willy nilly of course but within the recognised policy ... and there was a need to keep the capital injected into the Bank to maintain the growth, which he acknowledged and accepted." ()

Mr Barrett said that as the assets grew, Mr Matthews and Mr Copley were the two persons within the management of the Bank who monitored the requirement for increased capital. He also referred to Mr Guille, Mr Mallett and Mr Ottaway as being involved in a peripheral way.()

There is no evidence that the Directors were concerned to put in place a firm plan for the capitalisation of the Bank. The evidence indicates that the Board's only consideration was compliance with the capital adequacy requirements and that the Board was content to leave the matter to management. Mr Barrett said:

"We were always assured by management, particularly Mr Marcus Clark, that the Bank was one of the best capitalised banks in Australia, and that was made reference to in my annual report for that particular year. But we were often told this by management, that we were one of the best capitalised banks in Australia and our capital raisings were cost effective as far as the Bank was concerned."  ()

Mr Barrett's chairmans' report for the year ended 30 June 1988 contains the statement:

"During the year the capital resources of the group were increased ... as a result the State Bank has maintained its position as one of the best capitalised banks in Australia."

It is clear that that statement was made by Mr Barrett on the basis of what he had been told by other people. He said:

"Quite frankly, this report was prepared for me by the Bank, by the Public Relations department. I don't write these reports personally - no chairman does. It was a report prepared by management for me. Of course I perused it and was satisfied with it before I issued it." ()

Mr Barrett suggested that the prime responsibility for the provision of capital rested with the Government. After referring to a Board Paper associated with Minute 76 of 1985, Mr Barrett said:

"That is the broad statement, and that was the way we understood we worked. Now the board responsibility of course was to see that we made demands on Treasury as we required capital to meet the growing asset base and that's what we endeavoured to do, but I am suggesting that the prime responsibility was that the Government had to provide the capital, and if they didn't provide the capital, then of course we would be restricted. We had to work within what was provided to us." ()

That evidence indicates that attention was directed simply to the obligation to provide capital rather than the responsibility for planning the Bank's capital base.

When asked who should have been taking an overview of the Bank's capital structure Mr Barrett said:

"I think Tim Marcus Clark number one but of course Matthews was the main person involved. He was the main person involved." ()

When asked about responsibility for planning the funding and capitalisation of the Bank, and the participation of the Board in the funding and capitalisation of the Bank, Mr Clark gave the following evidence:

Mr Clark: "They received strategic plans which showed that capital would be needed. They received annual profit plans which showed where capital would be needed and they received, discussed and approved proposals put up by management for increasing capital of the Bank.

Question: Did the Board ever engage in the process of planning what the capital of the Bank should be?

Mr Clark: As far as initiating it no. They reacted to the proposals presented by management." ()

Mr Clark regarded his own role as "to ensure that the Bank was adequately capitalised to grow, to meet opportunities." ()

Mr Clark said that, beneath him, Mr Matthews and Mr Copley handled matters relating to capital. When asked to what extent they had responsibility to determine what the capital requirements of the Bank were, Mr Clark said:

"... there would generally be reports and proposals coming from the planning department and they would be working on those." ()

Mr Clark's only concern was to see that the bank was adequately capitalised, so that the growth did not contravene the capital adequacy requirements.()

Mr Matthews gave evidence that the funding requirements of the Bank were formally considered each year when the five year strategic plan was developed. He said:

"What would be required as capital was assessed from there" and "this plan was approved by the Board."

Mr Matthews was asked who was it that stood back and took an overview of what was happening and gave direction to the Bank in terms of the Bank's capitalisation, and he said:

"That is the responsibility of the Board to do that on being advised by the Managing Director."

and

"Whether the Board in fact did that I am not certain." ()

Mr Matthews said he did not see the determination of the Bank's funding requirements or capital requirements as part of his duties. He believed that that was part of the responsibility of the Managing Director.()

Mr Matthews evidence is inconsistent with that of Mr Clark, other Bank officers and the documentary evidence. The evidence suggests Mr Matthews did in fact play an important role in the management of capital. I am unable to accept that the second most senior officer of the Bank did not have a responsibility to consider and provide counsel to his Managing Director and the Board on matters with which he was clearly directly concerned.

Mr Copley was asked whether there was any planning of the way in which capital should be sought by the Bank. He referred to the additional tranches of $250.0M from SAFA and $US 150.0M via J P Morgan in June 1988 and said:

"Now there was no heavy planning done at that point in time. That was not the climate that existed in the State Bank at that stage. There was a planning conference which took place every year and there was a strategic plan prepared, but the organisation was being run on an opportunistic basis very clearly ...".()

As to Mr Clark's role in the raising of capital Mr Copley said:

"It is fair to say that Mr Clark was the driver of all things that happened in the Bank, as was his responsibility. That's why he was there. And it is fair to say that he did and would have dominated the discussions at Executive Committee when it was discussed, when the capitalisation was being discussed ...".()

Mr Copley gave evidence that:

"The tranches which were added to the Bank's capital in June 1988 were a precaution to ensure that the Bank complied with whatever requirements might come out of the Basle convention at some stage in the future." ()

Mr Copley said:

"... a five year strategic plan was prepared each year but the organisation was being run very much on an opportunistic basis, and therefore if an opportunity came up it was taken." ()

He agreed that:

"... the planning process was something that was left with Mr Clark rather than something which the board drove." ()

He also said:

"So the strategic plans were prepared, they were approved, and the Board had the opportunity and did approve them. Whether the Board read them or not is another question, but they certainly had the opportunity for discussion of them. But from then on, if the strategic plan said: We will grow in such and such a way, but then all of a sudden an opportunity came up, then whack, we took the opportunity."

Mr Copley said Mr Clark stood above himself and Mr Mallett to co-ordinate the Bank's capitalisation. He said

"Mr Clark was the person who acted as the catalyst for everything, as is his responsibility." ()

With respect to the additional capital taken on in 1988:

"[Mr Clark's] reasoning was ... that with the Basle convention going to change the structure of capital adequacy, we were going to be requiring more capital to meet that at a stage in the future, and with the availability of the Government being prepared to provide more funds, lets do it now rather than later." ()

Mr Simmons gave evidence that the directors never sat down in a formal way to consider the way in which the Bank should be capitalised. He said:

"... in a normal corporate structure, discussions take place as the capitalisation of an entity. The entity is then structured that way. I believe that those discussions probably took place at the merger committee level, and the Board then accepted the capitalisation." ()

Mr Simmons holds the view that it was the prerogative of the State Treasury to determine how the Bank should be capitalised. He referred to a paper of 28 March 1985 which stated:

"State Treasury holds ultimate responsibility to ensure adequacy of the Bank's capital to meet the accepted prudential guidelines ...".()

After he became chairman of the Board of Directors, Mr Simmons took a much closer interest in the question of capital. His evidence with respect to that has already been discussed.

On the basis of all the evidence, one or two simple conclusions have emerged. First, it was never clear who, in fact, had the ultimate responsibility for planning the capital structure of the Bank. Secondly, while the capital base of the Bank grew, that growth was not in accordance with a master plan but was consequential upon the growth taking place in the assets of the Bank. That asset growth was itself substantially unplanned.

A consequence of the fact that there was no overall planning of the capitalisation of the Bank was the potential for the Bank to enter into commitments that were inappropriate. If one accepts the Piper Alderman Submission, the terms and conditions on which the bulk of the Bank's capital had been arranged were inappropriate.

In my opinion, it is not open for the Directors to complain now about the inappropriate terms which were attached to the Bank's capital. The obligations conferred on the directors by the Act required them to give the management of the Bank direction with respect to the capitalisation of the Bank, and to ensure that the commitments which attached to the additional capital, which the Bank accumulated over the years, could be serviced by the Bank's normal trading activities. I do not suggest that they should have undertaken detailed calculations themselves. In my opinion, what they should have done was to ensure that the management of the Bank had taken appropriate steps to ensure that the capital which the Bank was accumulating was necessary and could be serviced. The Board had the ultimate responsibility to achieve the objects set out in sub-section 15(2) of the Act by administering the "Bank's affairs in accordance with accepted principles of financial management and with a view to achieving a profit."

With the exception of the steps taken by Mr Simmons after he became chairman, there is no evidence to indicate that any of the directors of the Bank took an interest in the planning or implementation of the capitalisation of the Bank. The evidence is that they did no more than to put an imprimatur on recommendations presented to the Board by members of Bank management. As appears from the J P Morgan fundraising, which has been discussed above they approved a transaction notwithstanding the fact that it was not capable of being understood from the material placed before the Board. They cannot have accurately considered whether the transaction was in the best interests of the Bank.

Mr Barrett was asked whether he thought the directors should have concerned themselves with the capital structure of the Bank, and provided some initiative to ensure that proper planning was taking place. His response was:

"No because very early in the piece the Board accepted the premise that the provision of capital of the Bank was for Government, the Treasury, and that was the way it was put to us."

If the Directors did hold that view, it was inconsistent with the obligations placed on them by the Act.

6.9.3 THE NEED OF THE STATE BANK FOR CAPITAL

This matter has been discussed in general terms earlier in this Chapter.

Paragraph 11 of Prudential Statement of the Reserve Bank's capital adequacy guidelines suggests that:

"Bank's need capital:

. as a cushion to absorb losses;

. to evidence the willingness of shareholders to commit their own funds on a permanent basis;

. to provide resources free of fixed financing costs; and

. to finance investment and infrastructure and associates."

The Bank enjoyed the benefit of the government guarantee. Many people would argue that the guarantee was a more effective demonstration of the shareholder's willingness to commit funds than any contribution of capital could ever be. The guarantee was permanent whereas capital can be lost. Accordingly, the argument would conclude the State Bank did not need capital to evidence the willingness of the shareholder to commit funds.

When the Bank commenced business it inherited the infrastructure of its predecessors. The Bank, therefore, did not need capital to meet establishment costs.

The Piper Alderman Submission contends that the Bank needed "free" capital. The Reserve Bank guidelines suggest that a Bank should have capital to provide resources which are free of fixed financing costs, and as a cushion to absorb losses. The free capital which is suggested by Piper Alderman would have served those purposes.

The requirement that a Bank should have capital to act as a cushion to absorb losses only arises after losses have been sustained. In the case of the State Bank, there was the guarantee and the State Treasury did provide the necessary funds after the Bank's losses became known. In my opinion, the absence of capital which might act as a cushion to absorb losses is not a cause of the matters which are the subject of this Investigation.

Whether the State Bank needed capital really becomes a question of whether the Bank needed capital which could "provide resources free of fixed financing costs". As appears from the submission of State Treasury, private banks which obtain funds from shareholders in the form of ordinary shares are faced with a practical requirement to service that capital. The shareholders' expectations and possible sharemarket movements if the performance of a bank meets with the shareholders' disapproval are, in the case of private banks, not that far removed from the fixed obligations which were attached to the capital of the State Bank.

The effect of the directors' submission is that the obligation to make a fixed payment on capital gave rise to a need to derive profits and consequential need to grow which in turn led to a deterioration in the asset base and the consequent problems of the Bank. The Directors provided a memorandum which deals with the connection between the problems of the Bank and the requirement to pay a fixed dividend.()

The Piper Alderman submission that the Bank needed more free capital is corroborated by the paper of Mr Matthews and Mr Guille. There is no evidence before the Investigation, however, that establishes that the problems of the Bank have been in fact caused by the lack of free capital. In particular, there is no evidence that the push for profits was actually a consequence of the need to generate a fixed return on capital. The Bank itself accepted a "permanent persistent aim" to achieve a return of 15 per cent on capital.()

Mr Barrett did not regard the cost of the Bank's capital as burdensome. He said:

"In my day this cost factor wasn't very major, because the Bank was very profitable up to the time I retired. This wasn't a major consideration. But I can see the problems which have developed since of course." ()

When asked about the Piper Alderman submission that the cost of capital was too high, Mr Barrett said:

"In so far as my knowledge of the Bank events taking place after I left the Board, I think I would have to agree with that. But as I say, this was after my time. That's the way events had worked out." ()

Mr Barrett said:

"I believe we did have a pretty good free capital base as a bank."

Mr Clark was asked whether there was any connection between the problems which the Bank has had and the fact that the Bank did not have "free" capital. His reply was:

"I see none whatsoever. It is a furphy raised by the directors to put it bluntly. In my opinion the problems of the Bank were not whether we paid $50 million dividend or $80 million dividend. They were not the problems of the Bank. They did not cause the problems." ()

It is obvious that a Bank or any other business would like to have as much free capital as possible. On the basis of all the evidence described in this Chapter, however, I am unable to conclude that the problems of the Bank were caused either by the lack of free capital or the fact that much of the Bank's capital had fixed interest obligations attached to it.

Even if the Bank did have capital which could be described as "free", that does not mean that the State Treasury could not have expected, and been entitled to, a return on that capital in the same way that the holders of ordinary shares in private banks are entitled to a dividend on their shareholding. The only difference may be that a shareholder in a private bank will measure his return over the long term, and the private bank will have the capacity to vary the dividend in the short-term, whereas the fixed dividend requires a set payment from year to year.

There have been many references in evidence before the Investigation to what has been described as a "push for profit". The evidence is, however, that the "push for profit" was a consequence of many factors including the targets which the Bank set itself. It is not possible to say that the obligation to make a fixed payment on capital was not a matter that, in some small way, gave rise to the "push for profit". There were many other reasons for the "push for profit" and, in my opinion, the evidence establishes that the fixed commitments on capital were not a dominant factor. Mr Clark did not see the cost of capital as a contributing factor. He said the safeguard was that the Bank was only required to pay a dividend out of profits."()

Mr Simmons gave evidence that, after he had read the documentation relating to the obligations which attached to the Bank's capital in order to understand the capitalisation of the Bank, he "dealt with the Under Treasurer who accepted that the structure was not appropriate and the Bank needed more free capital".() That evidence is not consistent with the submission of Mr Prowse which is referred to above. Nor is the evidence corroborated by contemporaneous documents. While it is clear that Mr Prowse did acknowledge the fact that Mr Simmons was asserting that the Bank needed more capital, there is no document that evidences the acquiescence by Mr Prowse in the accuracy of the statements that the capital structure of the Bank was inappropriate, or that the Bank needed move free capital.

 

6.10 THE COST OF THE STATE BANK CAPITAL

 

For the reasons which have already been discussed, it is my opinion that the Tier 2 capital obtained via J P Morgan was unduly expensive.

When it was suggested to Mr Clark that the Tier 2 capital arranged through J P Morgan cost the Bank LIBOR + about 2.65 per cent, he said "that surprises me" and that "we would never have knowingly made that sort of margin because there were occasions when we were talking about raising capital and whenever we wanted - from then on Treasury said: we will match it. Do not do it anywhere else. We want to do it. ...".()

Most of the capital of the Bank had attached to it a dividend rate of the Bank Bill Rate plus 0.65 per cent.

Mr Simmons gave evidence that the price paid for the capital was too high. He believes that SAFA should have gone to the marketplace and negotiated a specific price which it should have passed on to the Bank.() He complains of the fact that SAFA was making a margin on the funds that were passed down to the Bank. Mr Simmons was also critical of the way in which the rate had been negotiated by Bank management.() He said "SAFA had out-manoeuvred the Bank hands down".()

Mr Simmons gave evidence that the directors were not as well informed as they should have been on the cost of the Bank's capital, and that they had not been able to consider the implications of taking on capital with a fixed rate of interest attached to it. He said:

"I believe that the directors are entitled to have their attention to a complex matter like capital drawn to the total capital structure, what that means and more details of the terms of repayment, and it was not until I became Chairman, and having been given a copy of the chart used by Treasury and Bank Management that I was able to put together the capital structure of the Bank, albeit somewhat superficially. As soon as that picture became apparent, I brought it to the Board's attention and then brought it to the Treasurer's attention and the Under Treasurer's attention. I do not believe the Board, where it has competent management, should be placed in that position ...".()

Mr Copley was asked whether the cost the Bank was paying for its capital was too high and he said "with the benefit of hindsight I would say it was probably too high".() Mr Copley does not believe, however, that the price paid for capital was relevant to the Bank's problems.() Mr Copley has pointed out that the Bank was able to gear up to twelve times on its capital, so that the tranche of $250.0M which he negotiated in June 1988 permitted the Bank to increase its assets by a further $2.0B. He observed that if $2.0B was lent at a favourable margin above borrowing costs, the Bank should increase its profit, and it should not matter if a small proportion of that profit was required to satisfy the fixed dividend obligation which attached to the capital.()

On the face of it, that evidence of Mr Copley provides a complete answer to both the Piper Alderman submission and Mr Simmons' evidence that the obligations attached to capital were a cause of the Bank's problems. The profit opportunities the additional capital created should, in my opinion, have nullified any problem caused by the obligation to pay a fixed dividend. If the Bank was not able to realise those profit opportunities, then there was no point in taking on additional capital.

Mr Copley said that the cost of Bank Bill rate plus 0.65 per cent was agreed with respect to the tranche of capital negotiated in June 1988 because that rate had already been established between the Bank and SAFA. He said that, at the time the loan was negotiated, he was not in a position to tell whether the rate was reasonable or unreasonable. He said people who had been with the Bank for a longer time thought it was reasonable. His recollection is that the rate was approved by the Board.()

Mr Clark gave evidence that he would not disagree with a suggestion that the price that the Bank paid for the capital, namely Bank Bill plus 0.65 per cent, was excessive. However, Mr Clark did put the matter into its true perspective. He said:

"There was a feeling that maybe it was a little high. You were talking ¼%. Now a ¼% is irrelevant in the scheme of things, when the Government owns the Bank, they put in the capital and they can take out whatever dividends they wanted." ()

When discussing his requirement that the Bank should achieve a return of 15 per cent on funds, Mr Clark said:

"I remember everybody was well aware of the 15%. There could be an argument that at a point in time Bill Rate + .65 could be in excess of 15% but that its not a strong argument because that is only for a fraction of time and we were getting permanent capital and the permanent capital allows you to gear 12 times, so that is not really a relevant factor. The safeguard to me was the arrangement that Copley worked at with Treasury whereby we could only pay out of the profit." ()

After considering all the evidence described in this Chapter, I have reached the conclusion that the rate of Bank Bill plus 0.65 per cent paid to SAFA for capital may have been marginally high, but that fact is not relevant to the matters which are the subject of the Terms of Appointment. The difference between what was payable at the rate of Bank Bill plus 0.65 per cent and what would have been payable at an appropriate rate is relatively insignificant in the overall scheme of things. In addition, the additional capital did provide the Bank with the opportunity to gear up and the profits that were possible on the additional assets which the capital supported should have more than compensated for any small increase in the cost of the capital. Mr Clark said "that was not even a factor in the problems that the Bank has had".() Mr Barrett said that the cost of capital "wasn't a major consideration" and that it was not a burden in his time.() In my opinion, Mr Clark's assessment is correct.

Accordingly, I am unable to accept the Piper Alderman submission or the evidence of Mr Simmons on this topic.

Finally, I make the observation that I am not completely satisfied that the cost of the capital was excessive or out of line with what other State banks paid for funds which were to be treated as capital. It is important that a distinction be drawn between the rate that is payable on loan funds and the rate which is payable on funds that qualify as capital. If the capital was expensive, it was only marginally so.

It is significant that there was no suggestion that the rate was too high at the time that much of the capital was raised. For example, in June 1988, there was no suggestion that the rate was too high.

Mr Copley said:

"The only time that the question of the rate being too high became a factor was after David Simmons became Chairman, and David Simmons then started to take a greater interest ... in what was going on than he had done before, when he would sit at meetings when I was in attendance and wouldn't speak. But when he became Chairman he started to take an interest, and when he started to take a deeper interest and realised what rates were being paid on these things, he started to jump up and down. But at that stage also there were a couple of executives who were becoming concerned about the squeezing of the profitability and they started to take the same view." ()

Mr Clark gave evidence to the same effect.()

 

6.11 COMPLIANCE WITH THE RESERVE BANK OF AUSTRALIA CAPITAL ADEQUACY REQUIREMENTS

 

During the course of the Investigation, suggestions have been made that some of the capital of the Bank did not really qualify as Tier 1 capital, and that the Bank did not satisfy the capital adequacy requirements.

At the outset, I should indicate that I have formed the opinion that compliance with the Reserve Bank capital adequacy requirements was an end in its own right which dominated the Bank in its fundraising activities. There is evidence that compliance with the capital adequacy requirements is regarded as an important matter by potential lenders, particularly overseas.

There is no evidence or submission suggesting that the problems of the Bank are a consequence of the failure to comply with the capital adequacy requirements.

The fact that the Bank was conscious of the fact that some of its tranches of capital may have been incorrectly classified for capital adequacy purposes appears from a paper to the Executive Committee entitled "State Bank Capital Discussion Paper" prepared by the Chief Manager, Finance and Planning, and Chief Economist and presented by Mr Matthews on 16 February 1988.

The question was raised again in September 1990 in a paper to the Chief General Manager, Financial Services, from Mr Guille, General Manager, Group Risk Management. The paper records that Mr Guille had reviewed the file "on the SAFA provided SBSA capital in terms of the Reserve Bank guidelines". The paper discusses the requirement that Tier 1 capital be "a permanent and unrestricted commitment to funds which does not impose any unavoidable charges against earnings". The question considered was whether the SAFA capital which attracted the fixed dividend rate of Bank Bill plus 0.65 per cent was really Tier 1 capital.

The paper pointed out that non-cumulative irredeemable preference shares can qualify as Tier 1 capital provided there is no doubt on the capacity of the Bank to waive or defer interest payments. The SAFA capital would not qualify in any of the categories of Tier 1 capital listed in the definition of capital in the Prudential Statement.

The paper concludes that the question really required a ruling from the Reserve Bank and that the result would be hard to predict. The author said that his feeling was that the Reserve Bank would say that the SAFA capital was not Tier 1, because of the essential cumulative nature of the dividend and the inability of the State Bank Board to waive the dividend.

If the SAFA capital did not qualify as Tier 1 capital, then the Bank would obviously not satisfy the capital adequacy requirements. The suggested course of action was described as follows:

"An easy option is to close the file and rely on SAFA's goodwill and co-operation in the event the RBA questions our classification of the SAFA capital.

Another option is to test informally the willingness of SAFA to modify its agreement with SBSA that is to provide some rack of technical (capacity) for the Bank to weigh the dividend commitment. I think we should try this option - if it hasn't already been tested."

Mr Simmons said:

"When you look at the totality of the capital structure of the Bank most of the Bank's capital requires a payment to be made, or apparently a payment to be made, and therefore I believe that was an unacceptable structure for capital, and there is an argument that if the Reserve Bank scrutinised carefully the capital structure of the Bank it may not be acceptable within the Reserve Bank requirements itself." ()

In my opinion, there is some force in what Mr Simmons has said. What has been regarded as Tier 1 capital from SAFA certainly does not comply with the spirit of the definition of Tier 1 capital.

The Investigation has not pursued this issue to finality. The matter has been raised in this Report because it indicates that, while there was, as early as February 1988, doubt which had been made known to the Executive Committee by Mr Matthews about the eligibility of the funds from SAFA to qualify as Tier 1 capital, that fact was not disclosed to the Board. The non-disclosure assumes significance when one has regard to the fact that members of the Bank management made recommendations to the Board and permitted the Bank to raise substantial sums of further Tier 1 capital after February 1988, without disclosing to the Board the doubts that existed as to whether such capital would really qualify as Tier 1 capital or not.

Mr Simmons has suggested that the restructure of concessional housing loan funds into capital in 1989 in the way suggested in the memorandum of Mr Copley, was caused by a fear that the Bank had a problem with capital adequacy. In all the circumstances, there must be some doubt as to whether the conversion of the concessional housing loan funds into capital could have improved the Bank's capital adequacy ratio in any event.

An issue has been raised as to whether the Government Financing Authority Act, 1982, allowed SAFA to provide capital which qualified as Tier 1 capital at all. It is suggested that the powers conferred on SAFA by Section 11 of the Government Financing Authority Act only empower SAFA to provide capital which would qualify as Tier 2 or loan funds. Because the Reserve Bank was, in fact, prepared to treat funds provided by SAFA as true Tier 1 capital and to treat the Bank as having complied with the capital adequacy requirements, the Investigation has not pursued this issue to a conclusion. This uncertainty has not contributed to the matters which are the subject of the Terms of Appointment.

It may be that what has been treated by the Bank as Tier 1 capital is, in fact, capital that is described by the definition of Hybrid capital in Attachment 2 to the Explanatory Memorandum to Prudential Statement PSC1 which is set out above.

So far as the Terms of Appointment are concerned, I am able to conclude that the way in which the Bank complied with the capital adequacy requirements is not a matter that has led to the poor quality of the Bank's assets, or the matters described in Term of Appointment A.

 

6.12 REPORT IN ACCORDANCE WITH THE TERMS OF APPOINTMENT

 

6.12.1 TERMS OF APPOINTMENT A

For the reasons set out above, I have reached the conclusion that the manner in which the Bank was funded did not give rise to any matters or events that caused the financial position of the Bank. I have also concluded that the processes associated with the funding of the Bank did not lead the Bank to engage in operations that have resulted in either material losses or the Bank holding non-performing assets.

The Piper Alderman submission contends that there was a connection. Mr Simmons was asked what were the consequences of the Bank not being properly capitalised. He said:

"I think the consequences were that the way the Bank was capitalised, there was a need to pay profits, and there was a drive to create profits, and that may have led to some transactions being pursued which otherwise would not have been pursued." ()

He stated in evidence that the drive to create profits was associated with growth "and that may have accounted for the acquisition of some of the subsidiaries". He cited the purchase of Oceanic as an example.() It was suggested by Mr Abbott QC, who represented Mr Simmons at the interview, that increased growth led to increased risk, which in turn led to an increase in non-performing assets. Reference was made to the practice of taking "front-end fees" which is discussed in detail in the Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank".()

I have given careful consideration to the Piper Alderman submission and to the opinions of Mr Simmons. I understand the logic of what they have put. As I have mentioned above, Mr Clark said he could not see any connection between the capital of the Bank and the losses. He described the matter as "a furphy raised by the directors". Mr Barrett also said that the question of capital was not relevant to the losses suffered by the Bank.() He also said "it might have had an effect on the profitability of the Bank or profits ... (of) a few millions here or there, but I don't think it had any effect on the losses or non-performing loans of the Bank, quite frankly".() Other witnesses such as Mr Prowse() and Mr Copley have specifically stated that they disagree with the submission.()

I am satisfied that Mr Simmons had a genuine concern about the way in which the Bank was capitalised. This is evidenced by his own diary note of 12 February 1990 (p 33), and by his evidence to the Investigation.() I have no doubt that it was quite appropriate for Mr Simmons to pursue his concerns about the Bank's capitalisation with the Under-Treasurer and Treasurer in the way that he did. The question of whether the capital provided by SAFA was, in fact, true Tier 1 capital had not been specifically identified by Mr Simmons but it is an incident of the concern that he had identified. In my opinion, the problem is one which did need to be addressed. I am not, however, persuaded that the problem gave rise to a deterioration in the quality of the Bank's assets.

In essence, the former Directors submit that the capital provided to the Bank was such that it caused the Bank officers to push for profits, and that this push for profits, in turn, has played a significant part in causing the Bank's problems.

Having considered the oral and written submissions of the former Directors, having heard the evidence of other parties with respect to the matters raised by the Directors, and having tested the evidence on which the former Directors rely, I do not accept the Directors' submissions. Set out below are my reasons for reaching this conclusion.

First, the cost of the capital provided to the Bank directly by the Treasury and SAFA was not, in all the circumstances, excessive. On the other hand, the Tier 2 capital raised by the Bank through J P Morgan was more expensive than that available directly from SAFA. In reaching this conclusion, I have had regard to the following:

(a) Evidence put before the Investigation by the Treasury department which shows that the return to shareholders of the nationally operating banks by way of dividend was greater than that provided under the capital arrangements with the Bank.

(b) It is plain that the provider of risk capital, that is capital which is non-repayable and provides a return that may vary with profitability, will expect a premium over the return available on debt to compensate for accepting that risk. In all the circumstances, the premium that applied to the SAFA capital of 0.65 per cent per annum over the Bank Bill, or debt rate, was not excessive. It was comparable with the rate payable for capital by the State Bank of Victoria.

(c) The margin on new lending required to be earned to meet the cost of capital was not excessive, and could not have caused the Bank to modify its lending behaviour. Further, the Bank could use the capital to gear up and raise debt funds equal to approximately twelve times the amount of the capital at favourable rates.

Secondly, the capital provided to the Bank by SAFA and Treasury was, in practice, no different from equity, because companies with shares on issue are subject to significant consequences if they fail to maintain constant or increasing dividend streams to shareholders.

Thirdly, and importantly the terms on which capital was provided to the Bank by SAFA included provision for non-payment of dividends if profits were insufficient to fund those dividends.

The profit objectives embodied or implicit in the capital provided by SAFA to the Bank were clearly appropriate because:

(a) The Bank itself adopted an objective of 15 per cent per annum return on shareholders' funds, which was at least as demanding as that reflected in the cost of capital. This objective was known to, and endorsed by, the Board.

(b) The failure of the Bank to adopt strategies and measures to ensure that acceptable profits were earned would clearly be grounds for criticism.

(c) SAFA and the Treasury could reasonably be criticised if they failed to set commercial return on capital objectives for the Bank.

In all the circumstances, I am not satisfied that there was a connection between the funding of the Bank and the matters which are the subject of Term of Reference A.

6.12.2 TERM OF APPOINTMENT C

This Term requires me to investigate and inquire into, with reference to the matters in Terms A and B, whether the operations, affairs and transactions of the Bank were adequately or properly supervised, directed and controlled by the Board of Directors, the Chief Executive Officer and other officers and employees of the Bank.

6.12.2.1 The Board of Directors

There is clear evidence - and I am satisfied - that the Board of Directors may not all have fully understood the way in which the Bank was capitalised. In certain respects, this is understandable because the issues involved called for a degree of financial accounting and banking expertise that was not possessed by most members of the Board. For example, Mr Simmons stated in evidence, with respect to a fundraising which had been approved by the Board, that:

"The directors would have relied upon the recommendation from Management. The directors would not have expertise, while many of the directors, probably all of the directors would not have the expertise to negotiate an arrangement like this with SAFA, nor would they have ever been involved with negotiating an amount of capital or amount of this amount ...".()

In the area of the funding of the Bank, the Directors had to rely on the expertise of senior members of management.

The evidence is clear that the Directors were not adequately informed about the way in which the Bank was funded. The discussion of the transaction involving J P Morgan illustrates that.

On the whole of the evidence described in this Chapter, however, I find that, with the exception of enquiries made by Mr Simmons when he became Chairman, the Directors did not take any initiative with respect to the planning of the Bank's funding. It was a difficult and esoteric matter. The Board is, however, the ultimate governing body of the Bank. In my opinion, the directors had an obligation to ensure that they were properly informed as to the funding of the Bank. It is an important feature of the way in which the Bank is structured. The question of the Bank's capital goes to the heart of the Bank's size and the nature of its operations.

Mr Simmons did take steps to understand the capital base of the Bank. Apart from that there is no evidence to suggest that the Directors took a positive role with respect to planning the capital structure and direction of the Bank. They did no more than to place an imprimatur on recommendations put to them by members of the Bank management. In many cases, those recommendations may not have been fully understood by members of the Board. In fact some papers presented to the Board were incapable of being understood. The papers relating to the fundraising through J P Morgan and the conversion of concessional housing loan funds to capital are examples.

Nevertheless, it must steadily be borne in mind that if a paper, report, proposal, or recommendation, submitted to them was, so far as the Director's viewed it, couched in terms of fuliginous obscurity, it was their joint and several responsibility to probe, and to demand explanations for, all matters of importance, including those under consideration here, until they were satisfied that they had a sufficient grasp of the question before them to discharge their statutory responsibility.

Mr Simmons has stated that, at the time he was appointed Chairman, he did not understand fully the Bank's capital arrangements. To his credit, he did take steps to understand the capital structure of the Bank and then to correct what he perceived to be a problem. His action to correct the problem had not resulted in any action being taken by the Bank when he resigned as a director. In any event, the damage had probably already been done by the time it was identified by Mr Simmons.

The Directors now say that the terms on which capital was provided to the Bank by SAFA were onerous. Those terms, however, had actually been approved by the Board without question. For example, on 17 December 1987, the directors approved a recommendation that management be given authority to negotiate with SAFA on the very terms that are now criticised. A Board Paper which was relied on for the purpose of the resolution which is Minute 87/383 refers to the use of a Bank Bill rate plus a margin as being acceptable.()

With respect to his own position, Mr Simmons gave the following evidence:

"I think I did not understand in complete detail the capitalisation of the Bank. Until I became Chairman there was no paper presented to the Board which set out the specific tranches of capital and the interest coupons that attached to each respective tranche of capital." ()

Mr Simmons said he was the first of the directors to show any detailed interest in the way in which the Bank was capitalised, and many of the directors did not fully understand the Bank's obligations with respect to the capital provided by the Government to the Bank.

In my opinion, the directors should have fully understood this topic and insisted that Bank staff properly briefed them on such an important matter.

For the reasons as stated in this and Chapter 7 - "Treasury and the Management of Assets and Liabilities at the State Bank" of this Report, I am forced to the conclusion that the operations, affairs, and transactions, of the Bank were not adequately or properly supervised, directed, and controlled, by the Board.

6.12.2.2 The Chief Executive Officer

The comments made with respect to the Board of Directors apply with even more force to Mr Clark. He was one person who, more than anybody else, who should have taken the initiative to ensure that appropriate information was placed before the Board of Directors so that they could understand and plan the funding of the Bank.

I have already made comments with respect to Mr Clark's role in connection with the fundraising through J P Morgan.

The evidence indicates that Mr Clark did not involve himself in negotiation of the terms that attached to the capital provided to the Bank. That function had been delegated to other executives. In my opinion, however, Mr Clark should have shown a greater interest in those terms and should have ensured that the Board was properly informed of the terms attached to the capital which they were being asked to approve. In so far as he was responsible for the papers presented to the Board, his acts and omissions as Managing Director fairly attract the comments made below, in connection with Term of Appointment D, about the timeliness, reliability and adequacy of reports given to the Board.

Mr Clark has told the Inquiry that as Managing Director, initially on a three year contract, he delegated various responsibilities throughout the Bank. He said funding was initially the responsibility of Mr Matthews, and subsequently of Mr Copley and that International Funding was the responsibility of Mr Mallett. He accepts, however, that as Managing Director he had the final executive responsibility.()

Generally, the capitalisation and funding of the Bank, in particular, the size of the Bank's capital and the terms of the capital, were matters of such importance that they should have been "controlled, supervised, and directed" by the Chief Executive Officer.

So far as the funding of the Bank was concerned, I have concluded that the operations, affairs and transactions of the Bank were not adequately or properly supervised, directed, and controlled, by Mr Clark.

6.12.2.3 Other Officers and Employees of the Bank

I am forced to conclude that the operations, affairs, and transactions, of the Bank were not adequately or properly supervised, directed, and controlled, by the other officers and employees of the Bank.

I have made some specific findings with respect to the fundraising through J P Morgan. In addition to those findings, I have seen evidence of deficiencies in the conduct of other officers and employees of the Bank. Generally, they amount to errors of judgment of a relatively minor nature.

As I have mentioned above, I have not received the written detailed submission from Piper Alderman to supplement the statement in paragraph A3 of the Piper Alderman submission "that a number of members of the senior management of both the Bank and Beneficial were either incompetent or negligent or delinquent". The question thus foreshadowed remains unanswered.

6.12.3 TERM OF APPOINTMENT D

On the information which is set out above, I have no hesitation in reporting that the information and reports given by the Chief Executive Officer and other Bank officers to the Bank Board were not timely, reliable, and adequate, or sufficient to enable the Board to discharge adequately its functions under the Act.

The Report relating to the fundraising through J P Morgan is an example of a report which was inaccurate and misleading.

Mr Simmons has given evidence about the timeliness and accuracy of papers presented to the Board. The importance of the reports provided to the directors of the Bank is made clear by the evidence of Mr Simmons that:

"What must be remembered is that a director of an organisation only has before him or her the Board papers and the presentation of those Board papers by Management so that the knowledge of the Board would be the knowledge obtained through the Board papers." ()

Mr Simmons also said, whilst discussing the paper relating to the J P Morgan transaction, that:

"One of the matters which has interested me in giving evidence is to look at the date of various papers where there have been problems, and unfortunately a lot of those papers are dated after the weekend when papers should have been sent out to the Board members, so that the paper for noting of the mandating of Morgans to raise $150 million, which was dated 24 May 1988 the Board meeting of 26 May, so that paper would have been either handed out at the Board meeting or sent to directors the night before, and some of these papers, when you analyse them very carefully and are able to get behind the papers, do not stand close scrutiny." ()

Mr Clark has considered Mr Simmons' evidence on this matter and has submitted that if the paper was dated 24 May 1988 it would have been distributed to Directors on that day.

My own analysis of papers presented to the Board on the subject of funding is consistent with the evidence of Mr Simmons.

Mr Simmons also stated in evidence that he had difficulty in understanding the paper relating to the conversion of concessional housing loan funds into capital. That was an important matter because of the large amount concerned, and because it had the effect of substantially increasing the rate at which the Bank was obliged to pay interest to SAFA on the funds in question. Mr Simmons said that he had spent at least a day going through the paper with his Counsel for the purpose of his examination before the Royal Commission in order to understand it. Mr Simmons said:

"The arrangements that were in place were that the Board papers, which were quite a considerable package, would be delivered each Friday evening prior to the Thursday of the following week for the Board meeting. All the Board papers -it was agreed that a few Board papers would be given to the Board after the Friday, but invariably there were always Board papers that were presented, and most of the papers that had been problem papers were papers presented the day before or the day of or the night of or the night preceding the Board meetings ... or at the Board meeting. What I have been doing is I have been looking at the date of the Board meetings and then looking at the date the papers were presented, so that if you look at a hypothetical position, that you wanted to snow the Board, the best way of snowing the Board would be to put a paper to the Board at the Board meeting, or delivered to the night before the Board meeting, and then to have that paper in a position on the Board agenda where the Board was running out of time or was under considerable pressure with the business that it had.

Also the paper would be presented in a simple form with a simple recommendation, and invariably on the basis that a considerable amount of work had been done and it was a strong recommendation, and that it unfortunately I think the situation in a lot of these papers which I have now had to give evidence on." ()

Mr Simmons pointed out that all of the Board Papers had to be approved by the Managing Director. I have no reason to disbelieve this evidence of Mr Simmons. The object of reports to the Board was to ensure that the Board was properly informed of the matters under consideration so that the directors could make an informed decision. Many of the papers which I have seen did not achieve that objective. Mr Simmons said that the Board never saw the total picture so far as the capital structure of the Bank was concerned,() and I believe him.

As to Term of Appointment D, the provision of information to the Board is dealt with in the Piper Alderman submission.() The matters referred to by Mr Simmons in the evidence discussed above are repeated. The view is expressed that "the directors have expressed the view on several occasions that they felt that they were "swamped with data". It may be assumed that that expression correctly conveys their reaction, but the remedy was to ask questions and persevere until they had mastered what was before them, not to submit to being left in ignorance.

The Piper Alderman submission also contends that the management of the Bank failed to convey to the Board concerns of the Reserve Bank.() On the evidence before the Investigation, I accept that these submissions are correct.